Overview of Cost Structure Decisions
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.
Comparisons of Cost Structure to Profit Stability
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.