What is a Cost Function?

A cost function is a formula used to predict the cost that will be experienced at a certain activity level. This formula tends to be effective only within a range of activity levels, beyond which it no longer yields accurate results. Beyond the outer thresholds of these activity levels, the cost function must be adjusted to account for such factors as changes in volume discounts and the incurrence of step costs.

The Cost Function in Budgeting

Cost functions are typically incorporated into company budgets, so that modeled changes in sales and unit volumes will automatically trigger changes in budgeted expenses in the budget model. For example, a company budget might include a cost function for the cost of goods sold line item, where the cost of goods sold is set at 40% of the actual net sales figure experienced for a reporting period. This means that the budgeted cost of goods sold for a period in which actual net sales were $1 million would be $400,000.

The Cost Function in Breakeven Analysis

Cost functions are also used in break even analysis, to determine the sales level at which a business will begin to generate a profit. It combines fixed costs (which do not change with the level of production) and variable costs (which change with the level of production). The calculation is as follows:

Fixed costs + (Variable costs per unit x Quantity) = Total cost