Meaning of Cost Structure
The Cost structure of a company comprises of two types of costs– fixed and variable. Fixed costs are those that remain constant up to a certain level of production. These fixed costs continue even if production or other business activities do not occur. Some examples of such costs are rent, wages, direct labor, electricity bills, interest expenditure, etc.
Variable costs vary directly with the amount of production or other business activities a company undertakes. The higher the production or related activities, the higher will be the variable costs and vice versa. Examples of such costs are direct materials consumed, wages based on the number of pieces produced, commissions, etc.
Fixed and variable costs may differ from industry to industry. A manufacturing unit may have different types of fixed and variable costs than a service provider. A fixed cost for a manufacturing unit may become variable for a service-providing unit. For example, rent may be a fixed cost for a manufacturing unit with a fixed production premise. In contrast, a service provider may keep changing offices and godowns depending upon its need and requirement. Hence, its rent payout may vary every month.
Usage and Importance
The idea of identifying the cost structure is to allocate costs between fixed and variable costs effectively. These costs are then associated with individual products and product lines to ascertain their correct pricing. Also, cost allocation could happen to different projects, departments, and service lines as per some basis which a business may choose. Proper cost allocation is essential to identify and calculate the profits with each product and product line.
Failure to correctly identify and allocate the costs in business may prove very dangerous for a business. It may continue to overprice or even under-price a product. Overpricing will dent its sale and drive its products out of the market. Therefore, the company will lose its business to its competitors. Under-pricing may increase sales for a while, but eventually, it will eat away the profits. Hence it will lead to the erosion of capital.
Identifying the cost structure and its proper allocation also helps in finding out which products are most profitable and which are less profitable. Therefore, a business can then effectively allocate its resources to the production and sale of more profitable products. Also, a company can get insights on how to improve its profitability. It will also help to identify the scope to cut costs, and it can take corrective decisions.
Factors affecting the Cost Structure
Economies of Scale
The concept of economies of scale is vital for any organization and directly affects its cost structure. The larger the production, the more it will benefit up to a certain level of production. As discussed above, fixed costs are the same up to a certain level of production, and only the variable costs will go up with an increase in production.
Let us continue with the above example of fixed costs of US $10000 for a year and production of 100000 units of a product. The fixed cost share per unit of the product is US $0.10. But suppose production rises to 200000 units per year. The fixed cost share per unit will go down to US $.05. Thus, the company can either pass on this lowering of its cost to the consumers and experience an increase in sales or simply earn more profits without lowering the price.
The concept of economies of scale also affects the cost structure of a company. A large company will always enjoy economies of scale in its operations. A single umbrella brand can be marketed instead of individual products. All the products under it will reap its benefits. Similarly, process centralization like distribution can also happen for different categories of products. It may save a lot of costs.
Types of the Cost structure
There are two broad categories of businesses based on their choice of cost structures:
Some business models work and succeed only by minimizing costs regularly on their day-to-day operations to beat the competition. Low-cost airlines are an example of such a business model. Such businesses cut costs wherever possible, maintain the lowest possible inventory, offer cheap services and propositions, and extensively outsource activities to keep costs in control.
The other category of business believes in providing maximum value to its customers, and the cost is a secondary issue. Luxury hotels are an example of such a business model. They offer expensive services and propositions, luxury, and style with a high degree of customization and personalized service.
An important point to note is that majority of the businesses across the globe are a mix of the above two types of cost structures. Providing value to customers at the best possible price is the primary goal of most of companies.
A manufacturing unit decides to put a proper cost structure in place to identify its fixed and variable costs. After correct identification, the fixed costs turn out to be US $10000 for one year. Let us suppose that it manufactures only one product with annual sales of 100000 units. Hence, per unit fixed cost portion is easy to work out as the US $ 0.10 (10000/ 100000). Allocation to every unit of the product and valid pricing could happen subsequently.
A more complicated situation will arise if the unit produces multiple products. It will become tough to correctly allocate the fixed cost portion as different products will have different values and various production processes. The business may decide to calculate total annual fixed costs and total direct labor hours for production for the year. It will then divide the total fixed costs with the total direct labor hours to find out the fixed cost per labor hour.
The next step is to identify the total direct labor hours for producing one unit of each product. The fixed cost per labor hour gets multiplied with this figure. Thus, we will arrive at the fixed cost allocation portion to each unit of a product or products from different product lines.
Refer to Costing Terms to learn more about basic cost concepts.