Cost Structure Essay

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Cost structure has traditionally been defined as the relative proportion of fixed and variable costs in an organization and how these costs behave in response to changes in production or sales volume. Additionally, cost structure is generally discussed in the context of long-run and short-run production, with an emphasis on a particular function. Modern definitions of cost structure, however, encompass a much more holistic definition, namely, rethinking business models to reduce costs across entire processes in order for organizations to remain competitive in the globalized business environment.

In economics, cost structure is defined as the relationship between costs and quantity. Embedded in this definition, firms have at least one fixed factor of production in the short run—all other costs are assumed to be variable. In the short run, fixed factors of production are assumed to have no impact on the firm’s decisions since they cannot be changed over a short time period. For example, most products require raw materials, labor, machinery, and factory space. If demand increases for a particular product, it is generally quite easy to increase raw materials and labor in proportion to the increased demand. However, adding new machinery and a factory is not as easy since these are capital investments that generally require large financial outlays and a certain amount of time for completion.

In contrast to the short run, the long run is the period over which firms are assumed to be able to vary all factors of production. The implications therefore of the short run/long run at the industry level are that in the short run, firms can increase/decrease production in response to demand, while over the long run, firms can enter/exit the market.

A proper understanding of cost structure hinges on the fundamental distinction between fixed costs and variable costs. Fixed costs can be classified into two categories: (1) committed fixed costs, and (2) discretionary fixed costs. Committed fixed costs are costs associated with investments in basic organizational assets and structure (e.g., depreciation, insurance expenses, property taxes, and administrative salaries). Such costs are long term in nature (several years) and cannot be significantly reduced in the short term even during periods of diminished activity. In contrast, discretionary fixed costs (e.g., advertising, repairs and maintenance, research and development) are short term in nature (one year). Such costs can be altered by current managerial decisions with minimal damage to an organization’s long-term goals. As a result, these costs are generally the first to be cut during bad times.

In terms of per unit and total comparisons, fixed costs that are expressed on a per-unit basis will vary inversely with the level of activity. In other words, unitized fixed costs will decrease as volume increases and vice versa. However, in total, fixed costs remain constant within the relevant range. For example, rent will not increase if a factory is working at full capacity or at minimum capacity, or if an outpatient clinic serves one patient or 20 patients daily. The relevant range is the range within which a factory, business, hospital, school, etc. can operate without increasing the size of its operations in the short run. Within this range, assumptions about variable and fixed cost behavior are reasonably valid.

In contrast to fixed costs, variable costs are expenses that vary in total according to the size of the program or in direct proportion to the level of business activity, but which remain constant on a per unit basis within the relevant range. For example, the number of latex gloves used in a hospital will increase with the number of patients; however, the cost per latex glove will not generally change if one glove or 100 gloves are used. Typical variable costs include direct materials, sales commissions, and supplies. Note that variable costs will be zero when business activity is zero. In order for a cost to be variable, it must be variable with respect to some activity base or cost driver. Business activity can be expressed in many ways such as beds occupied, units sold or produced, miles driven, customers served, or products serviced. Knowing what drives cost is crucial in order for cost reduction to be targeted in the right areas. Notwithstanding, it is important to recognize that no cost driver is a perfect prediction of cost. For example, although machine hours may be used as a cost driver to predict electricity consumed in a factory, it has no relationship to the actual price charged per kilowatt hour.

A question that may frequently be asked is “which cost structure is better?” This answer depends on numerous factors including type of industry, long run sales trend, and flexibility to risk. Firms with higher proportions of variable to fixed costs tend to enjoy greater profit stability and are better protected against losses. In contrast, firms which are characterized by high levels of fixed costs (e.g., the airline industry) experience greater profits in good years. However, the downside to this type of cost structure is that greater losses are experienced in bad years. If demand falls, profits decline swiftly and turn into losses. For example, United Airlines’ fixed costs for pilots and flight attendants was so high in comparison to its competitors that the company could not cover its higher operating costs—the airline was forced to file for bankruptcy in 2002. Cost structures with high proportions of fixed costs are therefore quite risky when demand is uncertain and fluctuating.

One option that can help to minimize risk in high-fixed-costs industries is to lease rather than purchase, since leases can be cancelled. In general, decision makers have some flexibility in trade-offs between fixed and variable costs. For example, variable labor costs can often be replaced with automation. However, organizations will not move toward automation unless the long-run sales trend suggests that this may be a viable alternative. These types of decisions can generally be facilitated through the use of cost analytical techniques.

Closely aligned with the term cost structure is the concept of operating leverage, that is, a measure of the sensitivity of net operating income to a given percentage change in sales dollars. Operating leverage is computed as contribution margin (sales minus variable expenses) divided by net income. If two firms have identical revenues and expenses but different cost structures, the firm with the higher fixed expenses will have greater operating leverage. The effects of operating leverage can be quite dramatic when a company’s sales are near the break-even point. However, as sales and profits rise, operating leverage declines.

Given the dynamics of the 21st century, it is important that organizations recognize that proactive strategic vision on cost structure is the key to business success and survival. Such vision requires that organizations take a holistic view of cost structure, rather than a strictly departmental/functional view. Moreover, this holistic view needs to encompass not only internal issues/factors but also external issues/factors, since the external environment can greatly affect an organization’s success. For example, inflation/deflation, that is, fluctuations in money value that cause the price of goods and services to change, and supply/ demand conditions that circularly influence price, are all factors beyond the control of management. Nonetheless, these factors can greatly affect profitability.

Profitability can also be affected by external factors that can be controlled to some extent by management. For example, higher oil prices may necessitate using a different transportation route, sourcing from a different vendor, or purchasing in bulk in order to reduce transportation costs. Generally, bulk purchasing is adopted in order to reduce unit costs of either raw materials or products. However, a more holistic vision considers not only the discounts that could result from buying in bulk, but also the savings that could be realized on transportation and handling costs.

Proactive strategic vision may, however, frequently necessitate that organizations make difficult strategic choices about the business model itself, for example, removing organizational or supply-chain layers, embracing outsourcing, or sharing service centers. Nonetheless, today, the key to success hinges on an organization’s ability to expeditiously redesign its business model to respond rapidly to changing dynamic economic conditions. Continuous review of cost structures is therefore critical for organizations to maintain a competitive edge and avoid bankruptcy or hostile takeovers.

Bibliography:

  1. Ray H. Garrison, Eric W. Noreen, and Peter C. Brewer, Managerial Accounting, 12th ed. (McGraw-Hill, 2008);
  2. Michael R. Kinney, Jenice Prather-Kinsey, and Cecily A. Raiborn, Cost Accounting: Foundations and Evolutions, 6th ed. (Thompson, 2006);
  3. KPMG International, Rethinking Cost Structures: Creating a Sustainable Cost Advantage (KPMG, 2007);
  4. Henry M. Levin and Patrick J. McEwan, Cost-Effectiveness Analysis, 2nd ed. (Sage, 2001);
  5. Nadini Persaud, Conceptual and Practical Analysis of Costs and Benefits in Evaluation: Developing a Cost Analysis Tool for Practical Program Evaluation (Unpublished doctoral dissertation, Western Michigan University, 2007).

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