The relevant range, in managerial accounting and cost accounting, refers to the range of activity within which certain assumptions about cost behavior are valid. In other words, it’s the range of production or sales volume where the total fixed costs remain constant, and journal entry for accrued income or income due the variable cost per unit stays the same. Outside this range, these assumptions may no longer hold, and costs may behave differently. The assumed cost of a product, service, or activity is likely to be valid within a relevant range, and less valid outside of that range.
If actual sales were to exceed that amount, then ABC would need to construct a new manufacturing facility. The relevant range refers to a specific activity level that is bounded by a minimum and maximum amount. Within the designated boundaries, certain revenue or expense levels can be expected to occur. Outside of that relevant range, revenues and expenses will likely differ from the expected amount. The concept of the relevant range is particularly useful in two forms of analysis, which are noted below.
What is the Relevant Range?
Most professors and authors blow by it pretty quickly but it is a foundational concept that most other assumptions rely on. During the financial year 2014, sales dropped but they kept producing bikes so they ended up with too many bikes to store in the rented space. They had to rent another space for $50,000 to store the extra finished goods inventory.
Perhaps we get a discount after we purchase 100 components, at which time the cost of direct material will drop to .80 per widget. With variable costs then, the relevant range will be the range where the cost of adding one more, will be the same as the last. In this example, from widgets, each additional widget will add $1 in cost to our direct materials. As a fourth example, ABC Company constructs a manufacturing facility, which has a fixed cost of $10 million to operate and maintain every year. However, if production levels exceed 3 million units per year, then this fixed cost will increase, because of additional wear and tear on the facility. Thus, the relevant range of this fixed cost is up to a maximum of 3 million units per year.
In accounting, the term relevant range usually refers to a normal range of volume or normal amount of activity in which the total amount of a company’s fixed costs will not change as the volume or amount of activity changes. The term relevant range is included in the definition of fixed costs, because if a company’s volume were to decline to an extremely low level, the company would take action to decrease its total amount of fixed costs. Similarly, if the company’s volume were to increase dramatically, the company would likely have to increase the total amount of its fixed costs . Perhaps, there is a discount on additional direct material at a given point. So from a relevant range standpoint, we need to determine at what point that number will change.
A relevant range is a range or span of behavior in which certain activities related to a business operation are anticipated to remain within certain boundaries. This applies to fixed costs as well as variable costs that may be averaged https://www.bookkeeping-reviews.com/using-excel-for-small-business-accounting/ for the period of time under consideration. 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.
- Also, if you ignore relevant range, you may hit capacity issues where you don’t realize you physically cannot make all of the goods needed because you have hit your capacity for the time period.
- To reduce costs, the school district’s administration decided to consider closing one of the smaller elementary schools in the district.
- In this case, the relevant range is most likely to be fairly close to the current activity level of a business, with minor modifications.
- Malcolm’s other interests include collecting vinyl records, minorleague baseball, and cycling.
If she expects to operate outside of that range, she’ll need to adjust her cost assumptions and business strategy accordingly. The concept of the relevant range is critical for budgeting, forecasting, and decision-making purposes because it helps managers and decision-makers understand the limits within which their cost assumptions are accurate. As a third example, if ABC Company were to produce more than 20,000 of its yellow LED lights, it would need a third shift to produce them, which would require an additional $70,000 annual salary for a shift supervisor. Thus, the initial cost of the LED light is only valid for a relevant range that stops at 20,000 units.
Definition of Relevant Range
The school district ultimately decided not to close the school because of the large committed fixed costs involved, as well as a lack of community support, and budget cuts were made in other areas throughout the district. We discuss the relevant range concept in more detail later in the chapter. For now, remember that the accuracy of cost behavior patterns is limited to a certain range of activity called the relevant range. When identifying a relevant range, there is a strong need to make use of factual information. While it is possible to develop some sort of range using all sorts of criteria, including hopes and dreams for the future of the company, those may or may not be grounded in reality. What sets a relevant range apart is that the process calls for remaining grounded in what has a reasonable chance of occurring during the upcoming budgetary period and making allowances for those events.
Above that amount, a new relevant range can be assumed for a different cost that assumes the inclusion of the cost of the shift supervisor in the cost of the product. Relevant range is important because if you make the assumption that all of your costs will remain constant, whether they are fixed or variable, you may make errors on your projections. Also, if you ignore relevant range, you may hit capacity issues where you don’t realize you physically cannot make all of the goods needed because you have hit your capacity for the time period. You could rent more space in your existing facility, if possible, or rent another facility. Your fixed costs will go up because you cannot make more units with your existing $4,000 per month rental cost.
Malcolm’s other interests include collecting vinyl records, minorleague baseball, and cycling.
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They store the finished inventory in a rented warehouse which is designed to accommodate 25,000 bikes at one time. The warehouse rent per annum is $100,000 regardless of the number of bikes parked there, so it is a fixed cost. In fixed expenses, if our facility is designed to build 5,000 widgets per month, what will happen when we reach sales of 5,001 widgets? For example, ABC Company constructs a budget within a relevant revenue range of no more than $20 million.
When a company constructs a budget for a future period, it makes assumptions about the relevant range of activities within which the business is likely to operate. As long as the actual activity volume falls somewhere within the relevant range, and other assumptions are valid, budgeted revenues and expenses are more likely to be correct. In this case, the relevant range is most likely to be fairly close to the current activity level of a business, with minor modifications. Most of the costs were committed fixed costs (e.g., teachers’ salaries and benefits) and could not be eliminated in the short term.
Relevant range and cost behavior analysis
Hence, an experienced accountant would say that the company’s fixed costs are approximately $200,000 per month within a relevant range of activity. For example, suppose Bikes Unlimited’s production capacity is 8,000 units per month, and management plans to expand capacity in two years by renting a new production facility and hiring additional personnel. This is a long-term decision that will change the cost behavior patterns identified earlier. Variable production costs will no longer be $60 per unit, fixed production costs will no longer be $20,000 per month, and mixed sales compensation costs will also change. All these costs will change because the estimates are accurate only in the short term.
Doing so means the chances of being overwhelmed by shifts in the economy are lessened, which in turn means the business has a better chance of surviving whatever chain of events should come to pass. 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. When looking at costs and how costs behave, relevant range is the range of output or production in which our assumptions are true. If you move outside the relevant range, your cost assumptions are no longer valid. The new warehouse will be big enough until they reach 55,000 bikes, so the total rent will remain at $150,000 until that time.