Cost behavior often changes outside of the relevant range of activity due to a change in the fixed costs. When volume increases to a certain point, more fixed costs will have to be added. When volume shrinks significantly, some fixed costs could be eliminated.
Here’s an illustration. A company manufactures products in its 100,000 square foot plant. The company’s depreciation on the plant is $1,000,000 per year. The capacity of the plant is 500,000 units of output and its normal output is 400,000 units per year. When the company is manufacturing between 300,000 and 500,000 units, it needs salaried managers earning $400,000 per year. Below 300,000 units of output, some of the salaried manager positions would be eliminated. Above 500,000 units, the company will need to add plant space and managers.
For this example, the relevant range is between 300,000 units and 500,000 units of output per year. In that range the total of the two fixed costs is $1,400,000 per year. Below 300,000 units, the fixed costs will drop to less than $1,400,000 because some salaries will be eliminated and some of the space might be rented. When the volume exceeds 500,000 units per year, the company will need to add fixed costs because of the additional space and the additional managers. Perhaps the total fixed costs will be $2,000,000 for output between 500,000 units and 700,000 units.
