Cost structure definition
/What is Cost Structure?
Cost structure refers to the types and relative proportions of fixed costs and variable costs that a business incurs. The concept can be defined in smaller units, such as by product, service, product line, customer, division, or geographic region. Cost structure is used as a tool to determine prices, if you are using a cost-based pricing strategy, as well as to highlight areas in which costs might potentially be reduced or at least subjected to better control. Thus, the cost structure concept is a management accounting concept; it has no applicability to financial accounting.
How Cost Structure Varies by Industry
Cost structures vary by industry because fixed and variable costs differ substantially. Manufacturers often have high fixed costs from factories, machinery, and technology, while materials, labor, and utilities vary with production. High production volumes help spread fixed costs across more units. Retailers and e-commerce businesses generally have lower fixed costs but substantial variable costs for inventory, packaging, and shipping. Service businesses such as consulting typically incur relatively limited physical infrastructure costs, while employee compensation represents a major expense. Airlines and utilities have especially high fixed costs because of aircraft, power plants, and infrastructure. Companies with high fixed costs require sufficient demand and capacity utilization, while businesses with higher variable costs can adjust expenses more readily as sales and operating activity change.
Cost Structures of Cost Objects
To define a cost structure, you need to define every cost incurred in relation to a cost object. A cost object is an item for which a cost is compiled. For example, a cost object can be a product, product line, service, project, customer, distribution channel, or activity. The following bullet points highlight key elements of the cost structures of various cost objects:
Product cost structure
Fixed costs. Direct labor, manufacturing overhead
Variable costs. Direct materials, commissions, production supplies, piece rate wages
Service cost structure
Fixed costs. Administrative overhead
Variable costs. Staff wages, bonuses, payroll taxes, travel and entertainment
Product line cost structure
Fixed costs. Administrative overhead, manufacturing overhead, direct labor
Variable costs. Direct materials, commissions, production supplies
Customer cost structure
Fixed costs. Administrative overhead for customer service, warranty claims
Variable costs. Costs of products and services sold to the customer, product returns, credits taken, early payment discounts taken
Some of the preceding costs can be difficult to define, so you may need to implement an activity-based costing project to more closely assign costs to the cost structure of the cost object in question.
How to Alter a Cost Structure
You can alter the competitive posture of a business by altering its cost structure, not only in total, but between its fixed and variable cost components. For example, you could outsource the functions of a department to a supplier who is willing to bill the company based on usage levels. By doing so, you are eliminating a fixed cost in favor of a variable cost, which means that the company now has a lower break even point, so that it can still earn a profit at lower sales levels. This would be quite useful when a business has a history of experiencing sharp declines in its sales levels.
The Impact of Capacity Levels on Cost Structure
A knowledge of the capacity levels associated with the existing fixed cost structure can also allow a business to increase its profits by lowering prices sufficiently to maximize the utilization of a fixed cost item. For example, if a company has spent $100,000 on a high-capacity automated machine and it is currently only being utilized 10% of the time, a reasonable action would be to obtain more work to increase the amount of cash earned from that machine, even at prices that might normally be considered low. This type of pricing behavior is only possible if you have a detailed knowledge of the cost structure of a business.
Cost Structure FAQs
How does cost structure affect pricing flexibility?
Cost structure affects pricing flexibility by determining how much of a firm’s costs must be recovered regardless of sales volume. Firms with high fixed costs often have greater pressure to price aggressively to maintain volume and cover fixed obligations. In contrast, firms with a higher proportion of variable costs can adjust prices more readily without materially affecting profitability.