What is Cost Structure?
Cost Structure refers to those costs or expenses (fixed as well as variable costs) which a business will incur or will have to incur to produce the desired objective of the business; such costs include the cost of from purchasing the raw material to the cost of packaging the finished products.
- The cost structure of every business is directly related to the nature of the activity of the business, i.e., all different businesses will have different structures. For instance, some businesses will require working capital more as compared to fixed capitalFixed CapitalFixed capital refers to the investment made by the business for acquiring long term assets. These long term assets don’t directly produce anything but help the company with long-term benefits. and vice versa.
- Every business aims to reduce all costs to the minimum, so the gains of the business could maximize. These structures include different types of costs. Those costs which either could be reduced to zero also such as variable costs which we have to incur only in case when we do some activity therefore in case no activity is done then no costs will be incurred. Those costs could not be reduced as well, such as fixed costsFixed CostsFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity., i.e., these costs will have to be incurred whether we produce something or not.
- These costs are related to the size of the enterprise. Small enterprises need less planning and analysis of such costs as compared to those which are operating at a global or large scale.
- Level of organization, i.e., the level at which organization is going to work as the higher the level of output the lower will be the costs.
- The Costs relating to any product may reduce on account of those fixed costs which are to be allocated based on output or revenue generated from the segment.
- It also includes costs that may be variable or fixed or both.
Types of Cost Structure
The different types are as follows:
- Variable Cost, which includes Purchase costs, etc.
- Irrelevant Costs such as Sunk CostSunk CostSunk costs are all costs incurred by the firm in the past with no hope of recovery in the future and are not considered while making any decisions since these costs will not change regardless of the decision's outcome.;
- Fixed CostsFixed CostsFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity., this could not be reduced.
- Those costs which additionally have to incur if we proceed with our business activity;
The main attributes are as follows:
- It gives an early view of earnings from the activity of the business, clarifying to the analyst whether or not to proceed with manufacturing.
- An early view of all the situations will help the analyst to examine the position of the business. Whether to accept such a proposal or not, as it involves money, resources, and manpower as well, which they could utilize somewhere else if not here, resulting in some value addition.
Example of Cost Structure
For instance, let us take an example of 2 businesses, namely X and Y. Company X is a newly set up enterprise and has invested a substantial amount in machinery and other facilities of manufacturing the product. On the other hand, company Y is an established enterprise and is being operated in the field of manufacturing for the last three years and now planning to outsource the manufacturing of its product.
The variable costs of company X are meager as compared to company Y. Company Y has to incur a fixed agreed sum of the purchase cost of manufactured product, and the fixed cost of the company Y is very low as it has outsourced the product manufacturing and only have to bear purchase cost only.
Now suppose company X and Y both have 5,000 units of its product, and both of them are selling their product at $150 per unit, and the purchase cost of product outsourced by company Y is $210,000 and per-unit cost of company X is $80 per unit. Now,
Profit of Company X
- = $(150-80) * 5,000 units
- = $ 70 * 5,000
- = $ 350,000
Profit of Company Y
- = $(150*5,000) – 210,000
- = $540,000
From the above calculations, it is very much clear that Company Y has earned more profits as compared to company X as it has lower costs of products.
The cost structure plays a vital role in the success of any product or business and hence is vital from the following point of view:
- It helps in understanding the overall outlay that a product has to go through throughout its phase from raw material to finished product.
- The price of any new product should be fixed by keeping in mind all other substitutes available in the open market, which could easily be examined at the time of preparing cost structure.
- By correctly analyzing the cost of a product, the analyst could quickly determine the level of output at which the profits of the business are maximized.
The benefits are as follows:
- That it helps in the fixation of the price of a product that could be charged in an open market and competitive as well.
- The analysis of such a cost structure would show us the areas where the costs could be reduced by making some further efforts.
Cost Structure is mainly connected with the costs which are necessary to be incurred while working on the goal of the organization; these costs may be purchase cost or maybe manufacturing cost which includes the cost of raw material, labor costs, other overhead costsOverhead CostsOverhead cost are those cost that is not related directly on the production activity and are therefore considered as indirect costs that have to be paid even if there is no production. Examples include rent payable, utilities payable, insurance payable, salaries payable to office staff, office supplies, etc. such as transportation cost, electricity cost, etc. which needs to be incurred. The concept of cost structure is designed outlay of the funds which we need during the business process of a particular segment or for a business as a whole. The main focus of cost structure is to allocate the costs in such a manner that the costs should be minimized and the profits earned thereupon be maximized.
This article has been a guide to what is cost structure and its definition. Here we discuss characteristics, types, attributes, and examples of cost structure along with its importance and benefits. You may learn more about financing from the following articles –