5 5: The Relevant Range and Nonlinear Costs Business LibreTexts

Your fixed costs will go up because you cannot make more units with your existing $4,000 per month rental cost. Since we categorize costs as either fixed or variable, the combination managing and recording cash receipts examples and more of the two gives us total costs for various levels of production. The relevant range refers to a specific activity level that is bounded by a minimum and maximum amount.

If the factory runs three shifts, three shift
supervisors are required. Although this is probably a more accurate description of how variable costs actually behave for most companies, it is much simpler to describe and estimate costs if you assume they are linear. As long as the relevant range is clearly identified, most companies can reasonably use the linearity assumption to estimate costs.

• The high-low method of separating costs is illustrated using the following information over a six-month period.
• In particular, a “fixed” cost is likely to remain fixed only within a relevant range of activity.
• Normally, you know the fixed and variable cost components of whatever contract you might have that has resulted in a mixed cost, but if you didn’t, you could calculate the fixed and variable components.
• Perhaps we get a discount after we purchase 100 components, at which time the cost of direct material will drop to .80 per widget.
• Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years.

They had to rent another space for $50,000 to store the extra finished goods inventory. The upper and lower levels of activity within which the business expects to be operating within the short-term planning horizon (the budget period). If we graph the data points we have and then apply a best-fit line to the data, we can see that our formula looks reasonable within a relevant range.

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You start to panic a bit, but you hire more workers and start running three shifts per day. By reconfiguring your machinery to add more capacity, you are now able to make 40,000 mugs per month. Even with the excess capacity, you still can’t keep up with the orders. The difference between the high and low prices traded during a period of time;
with commodities, the high/low price limit established by the exchange for a specific commodity for any one day’s trading.

Subtracting variable costs from total mixed costs gives us $35,000 ($69,800 – $34,800). In this example, your monthly rent of $4,000 has a relevant range of zero units to 40,000 units. If you want to make more than that, you are outside the relevant range and will incur additional costs.

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It stores ready-to-sell motorbikes in a rented warehouse which is designed to accommodate 50,000 units at one time. The warehouse rent per annum is $200,000 regardless of the number of bikes parked there; hence, it is a fixed cost. A prepaid cell phone plan might include a base rate of $30 for 1G of data and $5 for each additional 300 megabytes of data. A salesperson might earn a base salary of $25,000 per year plus $3 for each unit of the product she sells. Equipment rental may cost $8,000 per year plus $1 for each hour used over 10,000 hours.

relevant range definition

The idea behind identifying a relevant range is to allow businesses to effectively project expenses as well as revenue so that workable budgets for upcoming periods can be prepared. The relevant range is the range of activity where the assumption that cost behavior is a straight line (linear) is reasonably valid. Managerial accountants like to assume that the relationship between a cost and an activity run in a straight line. As an example, if you make 10 widgets, and the direct materials in the widget cost $1, then the assumption would be that for each widget above 10, you would need to purchase another $1 worth of direct materials. Where the number of units times the variable cost (VC) per unit gives us total variable costs.

Variable Costs

For purposes of analysis, mixed costs are separated into their fixed and variable components. Normally, you know the fixed and variable cost components of whatever contract you might have that has resulted in a mixed cost, but if you didn’t, you could calculate the fixed and variable components. Also, fixed costs remain the same regardless of the number of units manufactured until capacity has been reached, at which time the company cannot produce or sell any more without spending money for expansion.

The following two charts depict this relationship between variable costs and
output volume. As defined earlier, the relevant range is a term used to describe the range of activity (units of production in this example) for which cost behavior patterns are likely to be accurate. The relevant range for total production costs at Bikes Unlimited is shown in Figure 5.8. It is up to the cost accountant to determine the relevant range and make clear to management that estimates being made for activity outside of the relevant range must be analyzed carefully for accuracy.

If sales were expected to increase in the future, the company would have to increase capacity, and cost estimates would have to be revised. Afterward, Alex’s company’s fixed costs are approximately $300,000 every month within a relevant activity range. One way to understand a relevant range is to consider the task of preparing a budget for the upcoming year. As part of the process, review of each fixed cost currently incurred by the company is evaluated. The goal is to determine if any of those fixed costs are likely to increase during the new budget period, and if so what allowances must be made for that change.

5: The Relevant Range and Nonlinear Costs

For example, ABC Company constructs a budget within a relevant revenue range of no more than $20 million. If actual sales were to exceed that amount, then ABC would need to construct a new manufacturing facility. A particular activity level bound by a minimum and maximum amount. The high-low method of separating costs is illustrated using the following information over a six-month period. Your company hires college students as independent contractors to assemble the books, paying them $2.00 for each journal assembled.

Within this relevant range of activities, the company’s manufacturing operations run smoothly with the same amount or quantity of monthly fixed costs. On average, a fixed cost is approximately $300,000 per month, covering the cost of supervisors, rent, depreciation, and other fixed expenses. However, the fixed cost per unit decreases as production increases, because the
same fixed costs are spread over more units. The following two charts depict
this relationship between fixed costs and output volume.

A forward exchange rate contract that places upper and lower bounds on the cost of foreign exchange. The high and low prices, or high and low bids and offers recorded during a specified time. The company, BlankBooks, Inc., sells the journals to a wholesaler for $10.00 each. The retail outlet pays $15 and sells them to the consumer for $19.99.