How to Analyze the Cost Structure
Thus far, we’ve discussed what the term “cost structure” describes in a company’s business model and the differences between fixed and variable costs.
The reason the cost structure, i.e. the ratio between fixed and variable costs, matters for a business is tied to the concept of operating leverage, which we briefly alluded to earlier.
Operating leverage is the proportion of the cost structure comprised of fixed costs, as we briefly mentioned earlier.
- High Operating Leverage → Greater Proportion of Fixed Costs in Comparison to Variable Costs
- Low Operating Leverage → Greater Proportion of Variable Costs in Comparison to Fixed Costs
Suppose a company is characterized by high operating leverage. Given that assumption, each incremental dollar of revenue can potentially generate more profits, since most of the costs remain constant.
Beyond a specific inflection point, the excess revenue generated is reduced by fewer costs, resulting in a more positive impact on the company’s operating income (EBIT). Therefore, a company with high operating leverage in periods of strong financial performance tends to exhibit higher profit margins.
In comparison, suppose a company with low operating leverage were to perform well. The same positive effects on profitability would likely not be seen because the company’s variable costs would offset a substantial portion of the incremental increase in revenue.
If the company’s revenue increases, its variable costs would also increase in tandem, thereby limiting the capacity for its profit margins to expand.
Cost Structure of Business Model: Industry-Specific Analysis
1. Manufacturing Business Example (Product-Oriented)
The implicit assumption of the effects discussed in the prior section is under favorable market conditions, wherein each company’s revenue is performing well.
Suppose the global economy enters a long-term recession, and the sales of all companies falter. In such a case, those with low operating leverage, like consulting firms, are in a far more favorable position than those with high operating leverage.
While companies with cost structures comprised of high operating leverage, such as manufacturers, can outperform those with low operating leverage, speaking purely from a profitability standpoint (i.e. the impact on profit margins), the reverse occurs in periods of underperformance.
A manufacturing company with high operating leverage is not afforded much flexibility in terms of areas for cost-cutting to mitigate the losses.
The cost structure is relatively fixed, so the areas in which operational restructuring could be done are limited.
- Increased Production Volume (Output) → Relatively Unchanged Incurred Fixed Costs
- Reduced Production Volume (Output) → Relatively Unchanged Incurred Fixed Costs
Despite the reduction in customer demand and revenue, the company is restricted in mobility, and its profit margins should soon begin to contract in a downturn.
2. Consulting Company Example (Service-Oriented)
Using a consulting firm as an example for a service-oriented company, the consulting firm can reduce headcount and only retain its “essential” workers on its payroll during hard times.
Even with the expenses related to the severance packages taken into account, the long-term benefit of the firm’s cost-cutting efforts would offset those payments, especially if the recession is a long-lasting economic downturn.
- Increased Production Volume (Output) → Increase in Incurred Variable Costs
- Reduced Production Volume (Output) → Decrease in Incurred Variable Costs
Because the consulting industry is a service-oriented industry, the direct labor costs contribute the most significant percentage of a consulting firm’s expenses.
Any other cost-cutting initiatives, such as shutting down offices, establish a “cushion” for the firm to withstand the recession.
In fact, the consulting firm’s profit margins could even increase in these periods, albeit the cause is not “positive” per se, since it stems from urgency.
The consulting firm’s revenue and earnings have likely dropped significantly, so the cost-cutting is done out of necessity to avoid the risk of financial distress (and potential bankruptcy) during the recession.
How Cost Structure Impacts Profit Maximization
- Manufacturer (High Operating Leverage) → The manufacturer with a cost structure comprised mostly of fixed costs would suffer from volatile earnings and likely need to obtain outside financing from banks and institutional lenders to get through the recessionary period.
- Consulting Firm (Low Operating Leverage) → Since a cost structure composed mostly of variable costs is tied to output, the risks from the reduced production volume can be mitigated by incurring fewer costs to ease the pressure off the company. In short, the consulting firm has more “levers” to support its profit margins and sustain operations, contrary to the manufacturer.
What are the Different Cost Structure Types?
The pricing strategy within a company’s business model is a complex subject, where variables such as the industry, the target customer profile, and competitive landscape contribute to the “optimal” strategy.
But generally speaking, two common pricing strategies are cost-based pricing and value-based pricing.
- Cost-Based Pricing → The pricing of the company’s products or services is determined by working backward, i.e. the unit economics of the manufacturing and production process serves as the basis. Once those specific costs are estimated, the company establishes a price range, with a minimum (i.e. price floor) in mind. From there, management must use sound judgment to gauge the maximum range (i.e. price ceiling), which is largely contingent on the current prices in the market and customer demand forecasting at each price point. For the most part, cost-based pricing tends to be more prevalent among companies that sell products or services that are commoditized, and in competitive markets with many sellers selling similar products.
- Value-Based Pricing → On the other hand, value-based pricing starts with the end in mind, i.e. the value received by their customers. The company attempts to quantify the value derived by the customer, to accurately price their products or services. Considering the inherent bias of the company, where their own value proposition is prone to be inflated, the resulting pricing is generally higher relative to companies that utilize the cost-based pricing approach. The value-based pricing strategy is more common among industries with higher profit margins, which is attributable to less competition in the market and customers with more discretionary income.
