A virtual machine functions by simulating a complete computer system within a physical machine. It achieves this through a hypervisor that allocates hardware resources to the virtual instance, allowing multiple operating systems to run concurrently on a single hardware platform. This capability facilitates software testing, reduces hardware costs, and enhances operational efficiency. Virtual machines also provide isolation and security since issues in one VM do not affect the host or other VMs. Overall, they are essential for cloud computing and development environments.