Malcolm’s other interests include collecting vinyl records, minor
league baseball, and cycling. Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years.
- The cost of labor to produce the product and the fixed cost of the warehouse used to store the inventory are then calculated.
- If volume of activity doubles, total variable costs also double, while the cost per unit remains the same.
- However, for every night that a room is rented, Ocean Breeze must remit an additional tax amount of $5.00 per room per night.
- In other words, they will often have an initial cost, in Ocean Breeze’s case, the $2,000 fixed component of the occupancy tax, and a variable component, the $5 per night occupancy tax.
- In other words, fixed costs remain fixed in total but can increase or decrease on a per-unit basis.
Managerial accountants implement accounting reporting systems to minimize or prevent fraud and promote ethical decision-making. If the minimum or maximum expense range is exceeded, obsolete inventory this can indicate that management is acting without authority or is pursuing unauthorized activities. Excessive costs may even be a red flag that possible fraud is occurring.
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.
It employs around 200,000 people, and it’s indirectly responsible for more than a million jobs through its suppliers, contractors, regulators, and others. Its main assembly line in Everett, WA, is housed in the largest building in the world, a colossal facility that covers nearly a half-trillion cubic feet. After many years in the teleconferencing industry, Michael decided to embrace his passion for
trivia, research, and writing by becoming a full-time freelance writer.
Normally, sunk costs and future costs (not changing with alternatives under consideration) are irrelevant costs. A cost item in one situation cannot be both relevant and irrelevant cost at the same time. Irrelevant costs are things like sunk costs, which include the cost of the lemon squeezer, and fixed overhead costs, which would be the costs of maintaining the lemonade stand. The concept of relevant cost is used to eliminate unnecessary data that could complicate the decision-making process.
Sunk costs are those costs that cannot be changed because they were from prior decisions. Sunk costs are irrelevant in your business decision-making process. People tend to focus an inappropriate amount of attention to sunk costs. Step costs are best explained in the context of a business experiencing increases in activity beyond the relevant range.
How to calculate the relevant range
For this reason, the production supervisors’ salary would be classified as indirect labor. However, if you are considering the supervisor’s salary cost on a per unit of production basis, then it could be considered a variable cost. 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.
Relevant range in production
Cost accounting helps ensure that financial costs are within an acceptable range and helps an organization make reliable forward-looking financial decisions. Not all costs can be classified as purely fixed or purely variable. Mixed costs are those that have both a fixed and variable component.
Relevant & Irrelevant Costs for Decision-Making
As a result, it may be necessary to analyze some fixed costs together with some variable costs. Ultimately, businesses strategically group costs in order to make them more useful for decision-making and planning. Two of the broadest and most common grouping of costs are product costs and period costs. If, at any point, the average variable cost per boat rises to the point that the price no longer covers the AVC, Carolina Yachts may consider halting production until the variable costs fall again. Recall that Bikes Unlimited estimated costs based on projected sales of 6,000 units for the month of August.
Thus she determined that a sales level of 6,000 units was still within the relevant range. However, Susan also made Eric (CFO) aware that Bikes Unlimited was quickly approaching full capacity. If sales were expected to increase in the future, the company would have to increase capacity, and cost estimates would have to be revised. Why is it so important for Bert to know which costs are product costs and which are period costs? Bert may have little control over his product costs, but he maintains a great deal of control over many of his period costs. For this reason, it is important that Bert be able to identify his period costs and then determine which of them are fixed and which are variable.
An objective measure of the cost of a business decision is the extent of cash outflows that shall result from its implementation. Once you incur a fixed cost, it does not change within a given range. For example, Pat can take up to five people in one car, so the cost of the car is fixed for up to five people. The condo rental and the gasoline expenses would also be considered fixed costs, because they are not going to change in the reference range. While in the example Carolina Yachts is dependent upon direct labor, the production process for companies in many industries is moving from human labor to a more automated production process. For these companies, direct labor in these industries is becoming less significant.
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To summarize relevant costs and irrelevant costs in accounting, we learned that determining these costs depends on the situation. Differential, avoidable, and opportunity costs are considered relevant costs. Using examples to demonstrate these costs show us that which costs are included in what places depend on what decision is made and the specific situation. Unlike fixed costs that remain fixed in total but change on a per-unit basis, variable costs remain the same per unit, but change in total relative to the level of activity in the business. Revisiting Tony’s T-Shirts, Figure 2.16 shows how the variable cost of ink behaves as the level of activity changes.
This is a committed fixed cost because the lease cannot easily be broken, and the company is committed to using this facility for years to come. Other examples of committed fixed costs include salaried employees with long-term contracts, depreciation on buildings, and insurance. Now that we have identified the three key types of businesses, let’s identify cost behaviors and apply them to the business environment. In managerial accounting, different companies use the term cost in different ways depending on how they will use the cost information. Different decisions require different costs classified in different ways.