Cost behavior is the manner in which costs change based on the level of activity or production. It is important for businesses to understand how their costs are related to different levels of production, as this knowledge can be used to make more informed decisions about pricing and cost management. The two main types of cost behaviors are variable costs and fixed costs.
Variable costs refer to any cost that increases as production increases. An example of a variable cost would be materials or labor needed for a specific product; these costs increase with each additional unit produced. Variable costs are typically lower in the short term because they only increase when there is an increase in output. In addition, variable costs tend to be predictable since they remain relatively stable over time due to their relationship with output levels.
Fixed Costs refer to any cost that does not change regardless of the level of output produced or activity completed. An example of a fixed cost would be rent or insurance payments; regardless if one unit or one hundred units were produced, these expenses do not change (unless there’s an agreement between parties). Fixed costs tend to stay constant over time, making them less risky than variable expenses when budgeting for future activities and outputs.
The major difference between variable and fixed costs is that while fixed expenses remain largely unchanged over time, variable expenses vary depending on activity or output levels – meaning they can either increase or decrease at different times during operations. For example, when production increases sales revenue will also rise but so too will labor hours resulting in higher wages paid out (variable expense). Conversely, should sales decline then fewer raw materials may need purchasing thus decreasing material expense (again another form of variable expense). As such it’s important for businesses acknowledge this difference so as better manage both types of expenses throughout operations and/or plan appropriately within longterm budgets/plans accordingly ensuring cash flow remains positive at all times without unnecessary strain being placed upon resources available.
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