How do companies choose their cost structure? What is the nature and function of operating scales? What are the sources of functional and dysfunctional scales of operation? These policy questions relate to the optimal overhead of a business enterprise: the right mix of expenses that maximizes return on investment and shareholder wealth while simultaneously minimizing the cost of operations.
Clearly, effective economies of scale (MES-Minimum Efficiency Scale) correlate with an optimal cost structure and are critical to sound business strategies designed to maximize a firm’s wealth-producing capacity. In this series on effective expense management, we will focus on the relevant strategic overarching issues and provide some operational guidance. The primary purpose of this review is to highlight some basic cost theory, strategic expense ratios, and industry best practices. For specific financial management strategies, consult a competent professional.
As we have already established, the optimal cost structure and the appropriate scale of operation for each company differ markedly depending on the general dynamics of the industry, the structure of the market: the degree of competition, the height of entry/exit barriers , the market competition, the life cycle stage of the industry and its competitive position in the market. In fact, as with most market performance indicators, the position of a company’s specific cost structure is revealing only in reference to industry expected value (average) and industry benchmarks generally. accepted and best practices.
One of the most important contributions of economic science to management science is the optimization principle, derived from the Bellmann equation, the dynamic programming method that divides the decision problem into smaller subproblems and the first applications in Beckmann economics , Muth, Phelps, and Merton. and the resulting recursive model. In practice, any optimization problem has some objectives that are often called objective functions, such as maximize production, maximize profit, maximize profit, minimize total cost, minimize cycle time, minimize distribution cost, minimize the cost of transportation, etc.
Types of cost structure:
Cost structures consist of a combination of fixed costs, variable costs, and mixed costs. Fixed costs include costs that remain the same regardless of the volume of goods or services produced within the current scale of production. Examples may include salaries, rents, and physical manufacturing facilities. A number of capital-intensive companies, such as airlines and manufacturing companies, are characterized by a high proportion of fixed costs that can be effective barriers to entry for new entrants into the industry. Note that effective exit barriers are effective entry barriers. When companies cannot easily exit unprofitable markets due to high exit barriers, they should not enter such markets in the first place.
Variable costs vary proportionally with the volume of goods or services produced. Labor-intensive businesses focused on services such as banking and insurance are characterized by a high proportion of variable costs. In practice, variable costs often take into account profit projections and the calculation of break-even points for a business or project.
Mixed cost items have fixed and variable components. For example, some management salaries do not normally vary with the number of units produced. However, if output drops dramatically or goes to zero, then wear and tear can result. This is evidence that all costs are variable in the long run.
Finally, a company with a large amount of variable costs (compared to fixed costs) may exhibit more consistent unit costs and thus more predictable unit profit margins than a company with fewer variable costs. However, a business with fewer variable costs (and thus a higher amount of fixed costs) may magnify potential profits (and losses) because revenue increases (or decreases) are applied at a more constant cost level. .
Most commercial companies define the cost structure in terms of the costs incurred in relation to a cost object or activity. And because some expenses can be difficult to define, we often implement an activity-based project to map expenses more closely to the cost structure of the activity or cost object in question and use activity-based accounting. Note that the time required to complete any given activity is the critical factor in cost management. Therefore, to minimize the overhead of any activity or project, it is critical to minimize the time required to complete the activity or project. The following are examples of key elements of cost structures for various expense objects:
Product cost structure: Under this structure there are fixed costs that can include direct labor and general manufacturing expenses; and Variable expenses which may include direct materials, production supplies, commissions, and piece rate wages. Service cost structure: Under this cost structure there are fixed expenses that may include general administrative expenses; and Variable costs that may include staff salaries, bonuses, payroll taxes, travel, and entertainment.
Product Line Cost Structure: Under this structure there are fixed costs that can include administration overhead, manufacturing overhead, direct labor; and Variable costs which may include direct materials, commissions, production supplies; Y Customer cost structure: Under this structure: Under this cost structure there are fixed costs there are general administrative expenses for customer service, warranty claims; and Variable costs that may include costs of products and services sold to the customer, product returns, credits taken, discounts for early payment.
The optimal cost structure is the combination of fixed and variable costs that minimizes total operating overhead while simultaneously maximizing net operating income. The cost structure describes all the costs (fixed and variable) incurred to operate a business model. Further away, cost structure refers to the types and relative proportions of fixed and variable costs incurred by a business enterprise. In practice, the concept of cost can be classified by region, product line, product item, customer group, department or division, etc.
In the cost-based pricing strategy, the cost structure is used as a technique to determine effective prices as well as to identify areas where expenses could potentially be reduced or at least put under better management control. Therefore, the cost structure concept is a useful managerial accounting tool that has many financial accounting applications.
All business models have costs associated with value creation, which occurs by adding real or perceived value to a customer for a superior good or service; value delivery: creating and maintaining effective, mutually beneficial and satisfying customer relationships; and value capture, which occurs through changes in the distribution of value in the good or service and the production chain. The objective function is to minimize total operating expenses. Such overhead costs can be calculated relatively easily after isolating cost drivers, key activities, key inputs; key resources and strategic alliances.
In our experience, operating costs can be minimized in all business models. Furthermore, low-cost structures are more important for some business models than for others. Therefore, it is useful to distinguish between two broad categories of business models: cost-based and value-based (many business models fall between these two extreme categories).
DuPont’s model demonstrates that the return on investment is calculated as the product of the profit margin (net income/sales) and the turnover rate (sales/total assets). DuPont’s analysis indicates that ROE is affected by three factors: operating efficiency, which is measured by profit margin; Efficiency in the Use of Assets, which is measured by Total Asset Turnover; and Financial Leverage, which is measured by the Equity Multiplier: ROE = Profit margin (profit/sales) * Total asset turnover (Sales/Assets) * Equity multiplier (assets/equity).
Types of business models:
cost-based business model-Most cost-based business models focus on minimizing overhead wherever possible. This approach aims at standardization and least cost method by creating and maintaining the most efficient cost structure possible, using dynamic low price value propositions, maximum automation and strategic outsourcing.
Value-driven business model– Under this business model, most companies are often less concerned with the cost implications of a particular business model design and instead their primary focus is on value creation. Premium value propositions, customization, and a high degree of personalized service often characterize value-based business models.
Some operational guidelines:
In practice, companies seeking to optimize cost management must optimize time management. One of the most significant revelations of activity-based accounting is the impact of time and activity on the overall operating cost of companies: cost structure is activity-driven, and activity is time-driven. Therefore, time is the most critical factor for effective cost management. Simply put, companies must reduce the time required to execute a specific activity in order to reduce the cost associated with the specific activity, ceteris paribus.
Furthermore, companies looking to take advantage of and optimize economies of scale must optimize the cost savings derived from the specific scale of operation. Note that operating scales can be functional and derived from the experience curve that reduce logarithmic costs; learning effects; range savings; Division of work; specialization; both horizontal and vertical differentiation or the long-term cost-increasing and dysfunctional by-product of entrenched, reactive management with a moldy, personality-driven vision; organizational inertia; adaptive and abusive supervision; increased bureaucratic cost; lack of innovation; increased internal and external transaction costs.
In short, companies optimize cost structure through effective time management and optimization of operation scales. Therefore, firms seeking to maximize the firm’s profit-producing capacity must formulate and execute efficient and effective cost-management dominant strategies based on an appropriate mix of costs that maximizes return on investment and asset wealth. shareholders while minimizing the cost of operations. As we have already established, there is growing empirical evidence to suggest that companies that choose scale and volume tend to outperform those that choose premium, ceteris paribus.