Understanding cost behavior is fundamental to managing a business. Serious errors can occur when firms do not understand how their costs move and the split between fixed and variable costs (operating leverage). The split between the cost patterns impacts most other decisions and the firm's profitability.
Variable costs are incremental costs, costs that increase when activity goes up or decreases when costs go down. All the special decisions rely on a clear understanding of which costs are variable, and thus incremental. Variable costs are budgeted differently than fixed costs, relying on a forecast of demand and activity to discern the budget level. Variable costs are treated differently during performance evaluation because performance is measure at ...
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