Question

When we are discussing Cost Volume Profit analysis how do costs behave? Why is cost behavior important to management?

Answer 1

A)

a) By examining costs behaviour and the ways in which costs are predicted, and then we consider the application of th\is information to decision making using the technique of Cost-Volume-Profit Analysis. This technique examines the interrelationship between costs, profits and volume at different activity levels.

To understand how costs behave, first of all it is necessary to know the nature of costs. Some are fixed in nature and others are variable in nature. Unfortunately not all costs fall under these categories, therefore it is necessary to make some simplifying assumptions.

There are two important variables involved in the constructon of cost functions. i.e.,

1. The dependent variable 'Y' is the cost to be predicted.

2. The independent variable 'X' is the level of activity.

The dependent variable is expressed as a function of the independent variable:

Y = f ( x )

This expression states that consumpion is a function of the level of income. That is, the level of consumption in one year will be dependent upon the level of income.

Here, there is only one indpendent variable. But there may be cases that there maybe more than one independent variable.

b) The cost behavior determines the effect of changes in organizatioal activities on the cost associated with them. In other words,cost behavior is determined by the manager to analyze the changes in cost due to changes in output level wthin the organization.

Analysing cost behaviour is important for managerial decision making purpose for the following reasons:

• Managers would be able to reduce total cost incurred on activities.
• cost behavior helps the management make decisions to increase the profitability.
• Cost behavior helps the manager to attain economics of scale by increasing the production volume.
• Cost is compared with the predetermined standards to check the cost effeciency is organization.