M5Required Assignment 2—Manufacturing Budget Analysis

When analyzing overhead costs, it is essential to distinguish between variable and fixed:

· Total variable overhead costs vary in proportion to total changes in activity.

· Total fixed costs do not change within the relevant range.

This distinction is important when constructing flexible budgets and when computing overhead variances.

It is also important to understand the relevant range. Imagine a sports stadium that has a seating capacity of 55,000 fans. If the team playing in the facility is not winning games, ticket sales will be low. Therefore, it is likely that selling the capacity of 55,000 seats will be difficult. When a game is played, certain costs will be incurred regardless of the number of fans in the facility. These costs are known as fixed overhead costs and are incurred for aspects such as general lighting, property taxes on the building, insurance, and heating. In many cases, the stadium management would be willing to do whatever possible to fill up the stadium and get 55,000 fans into the seats, even if it means giving away free or very low cost tickets. This is because the relative cost of letting one more fan into the arena is low, so any revenue generated from the low cost ticket will help cover the fixed utility costs. At the same time, once the fans are in the arena, they often spend money on food and other souvenirs within the facility. Such spending generates substantial revenue that covers the fixed overhead costs. This revenue would not have been generated if the seats had been empty.

On the other hand, if the team is playing really well, there will be a strong demand for all 55,000 seats. In this case, tickets will not be given away, and in fact, fans would be willing to pay a premium cost to get in. Suppose the team plays well over a number of seasons and the demand for seats is consistently more than the capacity. Stadium management would need to make significant renovations of the arena to accommodate these fans. This would increase the fixed costs. In this scenario, the relevant range is the capacity of the facility. Fixed costs would not change if the number of fans seated in the stadium were between 0 and 55,000. However, above 55,000 fans, the relevant range is exceeded and the capacity would need to be increased, which in turn would increase the fixed cost. This is the only way in which the fixed cost can increase.