Explain why it’s important for most senior managers to have a sound knowledge of cost behaviour ie fixed costs, variable costs, semi-variable costs and sunk costs.
Understanding cost behaviour helps manager in anticipation of changes in cost when there is a change in their activities like production, sales, inventory pile up etc. It provides good assistance in planning, cost management and decision making.
A number of behaviour patterns exist ranging from fixed to variable and from linear to curvilinear. Many cost predictions techniques are used to forecast sales and costs or any other factor.
Profit planning has two main questions: (1) how much sales and (ii) what cost? First question can be answered by simply multiplying Quantity with Price. Second question is a bit cumbersome to answer as firstly (i) cost data would be analyzed to ascertain the cost-behaviour ( fixed, variable or semi variable), (iI) the cost behaviour would be reduced to mathematical formula for each cost item, and finally (iii) cost prediction would be made at X level of activity.
Unlike Variable costs, fixed costs do not change with any movement in some other activity. For example, lease rental would be same whether a plant is operative or not, Similarly, salaries of permanent staff, depreciation on straight-line methods, plant insurance etc would remain the same irrespective of capacity level or capacity utilization or production efficiency. Fixed costs are becoming more prevalent in many industries because of automation. Modern technology enables a plant to reduce to a negligible amount and to use cheap materials. A plant in Vietnam was successful using river-grass for the production of fine paper. It was later closed down due to paper dumping by some industrialized countries like China. Also, the automation is replacing direct labour with engineers which are mostly permanent. Direct labour is gradually become non-existent in capital...
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