In: Accounting
Explain the concept of relevant range. How does relevant range impact costs? Which costs are impacted by the relevant range? Provide an example of how relevant range can impact a cost structure.
The relevant range refers to a specific activity level is bounded by a minimum and maximum amount. Within the designated boundaries, certain revenue or cost 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:
1. Budgeting: 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 fall somewhere within the relevant range and other assumptions are valid, budgeted revenue 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.
2. Cost Accounting: The assumed cost of a product, service or activity is likely to be a valid within a relevant range and less valid outside of that range in particular, a fixed cost is likely to remain fixed only with a relevant range of activity. Also volume discounts from supplier are only for certain purchasing volume quantities.
For Examples, 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 new manufacturing facility.
ABC Company assumes that the cost of a green widget is $10.00 within a relevant range of no less than 5000 units per year and no more than 15000 units per year. If the actual unit volume is less than 5000 units, the purchased cost of materials increases sufficiently to make the assumed cost of $10.00 per unit too low.Conversely if the actual unit volume is higher than 15000 units, the purchased cost of materials decreases sufficiently to make the assumed cost of $10.00 per unit too high.
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 millions unit per year.
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