A business can be surprised – rudely or pleasantly – when fixed costs don’t remain fixed. When accounting for the costs of products and services, a company assumes that certain costs remain fixed as long as the level of activity stays within a certain range. This is the “relevant range,” and it’s a critical qualifier when budgeting and allocating fixed costs.
It Isn’t Fixed
The relevant range is a level of activity with minimum and maximum values. The range might be number of widgets produced, number of supervisory hours or some other indicator of activity. A business assumes that, given an activity level within the relevant range, the fixed costs are known and correct. For example, a widget manufacturer might specify its fixed costs at $100,000 a month as long as it turns out between 20,000 and 40,000 widgets – the relevant range -- each month. When production falls outside this range, fixed costs might no longer remain fixed.
Exceeding the Range
Normally, a company has to spend money when it wishes to expand production beyond the relevant range. Some of the additional cost might include an increase in fixed costs. For example, if the widget manufacturer receives a long-term order for an additional 30,000 units per month, it may have to pay for another assembly line and more labor hours, including supervisory staff. In this example, if it decides to accept the order, its new monthly fixed costs might rise to $125,000, and its updated relevant range would be 50,000 to 70,000 widgets per month.
Falling Short
Should a company experience a downturn in activity, it can decide to cut its fixed costs to accommodate a lower relevant range. For example, suppose the widget company needs four customer service technicians to support its normal production level. If the demand for widgets dries up and production falls below 20,000 units per month, the company might decide to lay off one or two of the service technicians to lower its fixed costs. It might also close a production line and cut fixed labor costs.
Unit Costs
A merchandiser normally has a fixed cost per unit that depends on the price it pays for its inventory items. The relevant range might indicate the minimum and maximum amount of units it can buy for a given cost per unit. Should demand for the product increase, the merchandiser might benefit from lower unit costs through volume discounts. Conversely, it might have to pay more per unit if it lowers its relevant range. Manufacturers experience similar considerations when their purchase volumes for raw materials are outside the bounds of a relevant range.
What is relevant range?
Relevant range is one of those REALLY important concepts in managerial accounting. It’s pretty major but it does not get the attention it deserves. Most professors and authors blow by it pretty quickly but it is a foundational concept that most other assumptions rely on.
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.
An example regarding relevant range and fixed costs
Let’s say that you run a company that makes travel coffee mugs that can keep your coffee hot for 14 hours. The rent on your production facility is $4,000 per month. Running one shift per day, your employees can produce 10,000 mugs per month. One day, you wake up and your overnight sales were 7,000 mugs. Over the course of the day, you get 20,000 more orders. A celebrity was seen with your coffee mug and now everyone wants one!
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. You just can’t make more than 40,000 mugs per month.
What do you do? You could rent more space in your existing facility, if possible, or rent another facility. Either of those options means that you will pay more for rent. Your fixed costs will go up because you cannot make more units with your existing $4,000 per month rental cost.
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.
Why is relevant range important?
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.