Cost-Volume-Profit (CVP)

Product Cost Structure

Overview of Cost Structure Decisions

The way a company organizes its costs is called its cost structure.

Cost structure is the proportion of a company's fixed and variable costs in relation to its overall operation cost. A product cost structure has variable costs, such as materials, supplies, and commissions. A product cost structure's fixed costs usually include manufacturing overhead, such as rent and equipment. However, a company's cost structure depends on the industry it is in. For example, a clothing manufacturer has a different cost structure than a furniture manufacturer, and a law office has a different cost structure than a dry cleaner. The first step a company takes when determining its cost structure is to find out what costs the company has incurred or will incur as a result of the product. Second, the company categorizes those costs as either fixed or variable. Operating leverage, which is the effect that fixed costs have on a company's operating income, can be calculated by dividing a company's contribution margin by its net income. The more fixed costs a company has compared to variable costs, the higher its operating leverage.

Once a company has established a cost structure, it can identify costs that could be reduced without sacrificing the quality of the product. Also, a company may modify its cost structure to become more competitive. For example, many companies have legal departments to help with intellectual property issues that may arise with their products. A company can eliminate its internal legal department and instead hire a private intellectual property firm on a per-case basis. This would decrease the company's fixed costs and make legal expenses a variable cost. By removing this fixed cost, the company does not have to sell as many products to break even or make a profit. Thus, this transformation from a fixed to a variable cost might help with the company's break-even analysis. This change might allow the company to reduce the price to be more competitive in the market.

Comparisons of Cost Structure to Profit Stability

The cost structure is linked to stable profits.

Companies design their cost structures to create a mix of variable and fixed costs that maximize profits. Companies that have more fixed costs than variable costs have what is called a high fixed-cost structure. When a firm has this type of structure, it is said to have a high degree of operating leverage. Operating leverage is the effect that fixed costs have on a company's operating income.

When companies have a high fixed-cost structure, they operate at high risk because their revenue must reach a certain amount to cover fixed costs. Operating leverage can also affect a company's operating income. For instance, the more fixed costs a company has, the more its net income will vary with any changes in its sales revenue. However, this is not to say that a high fixed-cost structure is always bad. Companies that have consistently good sales operate successfully under this model because their contribution margins are large due to their low variable costs. This means that for every sale the company makes, it keeps more of its revenue because that revenue is not being spent on variable costs.

In contrast, companies with more variable costs compared to fixed costs are considered to have a high variable-cost structure. This means that the companies operate with less risk because if the company does not reach its sales goal, the variable costs used to make the product would not have been incurred. In contrast, fixed costs are certain to happen despite the company's sales.

Each company has special considerations as it considers which structure to use. A company may be more profitable with a high fixed-cost structure compared to a high variable-cost structure. It depends on the circumstances of the industry, company, market, and product.