Cost Structure

Updated on April 16, 2024
Article byVishal Garg
Reviewed byDheeraj Vaidya, CFA, FRM

What is Cost Structure?

Cost Structure refers to those costs or expenses (fixed and variable costs) that a business will incur or will have to incur to produce the desired objective of the business; such costs include the cost of purchasing the raw material to the cost of packaging the finished products. It helps with determining the profitability of different product lines.  

What is Cost Structure

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A company cost structure plays a vital role in how their products are priced and the quality of services they can offer. Therefore, keeping in mind the fluctuations in price for fixed expense could help the company determine a efficient structure where they can concentrate of boosting the profitability rather than getting stuck with pricing issues time and again.

Cost Structure Explained

Cost structure refers to the different of expenses incurred by a company. They comprise of direct and indirect costs or fixed and variable costs. A detailed cost structure analysis is conducted to ensure the products and services are sold at prices that bring out maximum profitability for the business.

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.read more 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 were reduced to zero. Also, such as included costs which we have to incur only if we do some activity; therefore, if 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.read more, i.e., these costs will have to be incurred whether we produce something.

These costs are related to the size of the enterprise. Small enterprises need less planning and analysis of such costs compared to those operating at a global or large scale.

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Characteristics

Different factors and characteristics come together to form a detailed company cost structure. Let us understand them through the points below.

  • Level of organization, i.e., the level at which the 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

Since a company is a multi-dimensional entity, the costs involved in maintaining and boosting the growth of each section contributes to the cost structure analysis. Let us understand the different types through the discussion below.

Cost Structure Types

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  1. Variable Cost, which includes Purchase costs, etc.
  2. 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.read more;
  3. 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.read more, this could not be reduced.
  4. Those costs which additionally have to incur if we proceed with our business activityBusiness ActivityBusiness activities refer to the activities performed by businesses to make a profit and ensure business continuity. read more.

Breakdown

Despite the fact that the breakdown of a company’s expenditures could be different for different structures. However, there are common occurrences in most businesses. Let us understand the breakdown through the discussion below.

  • Company cost structure gives an early view of earnings from the business activity, clarifying to the analyst whether or not to proceed with manufacturing.
  • An early view of all the situations will help the analyst examine the business’s position on whether to accept such a proposal, as it involves money, resources, and staffing, which they could utilize somewhere else if not here, resulting in some value addition.
  • 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, and other
  • such as transportation cost, electricity cost, etc. which needs to be incurred.
  • The cost structure concept is designed to outlay the funds 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 so that the costs should be minimized and the profits earned thereupon be maximized.

Examples

Let us understand the concept of cost structure analysis with the help of a couple of examples. These examples will give us a practical outlook of the concept and its intricacies.

Example #1

Two businesses, namely X and Y. Company X is a newly set up enterprise and has invested a substantial amount in machinery and other manufacturing facilities. On the other hand, company Y is an established enterprise and has been operating in the field of manufacturing for the last three years and is now planning to outsource its product manufacturing.

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 products, and the fixed cost of the company Y is very low as it has outsourced the product manufacturing and only has to bear purchase cost only.

Now suppose company X and Y both have 5,000 units of their product, and both of them are selling their product at $150 per unit, and the purchase cost of the product outsourced by company Y is $210,000, and the 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 clear that Company Y has earned more profits than company X as it has lower costs of products.

Example #2

In November 2022, after a weak last quarter for the entertainment giant Disney+, their stock price plummeted to its 52-week low which was lead majorly by huge losses in their streaming business.

As a result, the top management sent out a public statement which said that they will be seriously reconsidering their marketing and content costs. Moreover, they shall be inculcating a targeted hiring freeze to avoid incurring added costs until the situation is averted.

Disney+ and other market leaders such as Hulu and ESPN+ lost a mammoth $1.5 billion combines in the fourth quarter which came after a similarly dull third quarter where they lost a combined $1.1 billion.

However, the other side of the news for Disney+ was that their total subscriber list grew by 12 million more subscribers which was significantly higher than the estimated 9 million.

Importance

The company 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 understand 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 when preparing the cost structure.
  • By correctly analyzing the cost of a product, the analyst could quickly determine the level of output at which the business’s profits are maximized.

Benefits

The benefits of curating a data set and conducting cost structure analysis are as discussed below.

  • That helps in the fixation of the price of a product that could be charged in an open market and competition.
  • The analysis of such a cost structure would show us the areas where further efforts could reduce the costs.

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