# Cost Structure

Guide to Understanding Cost Structure

## Cost Structure in Business Model

The cost structure of a business model categorizes the total costs incurred by a company into two distinct types of costs, which are fixed costs and variable costs.

• Fixed Costs → Fixed costs remain relatively constant irrespective of the production volume (output).
• Variable Costs → Unlike fixed costs, variable costs fluctuate based on production volume (output).

If the ratio between fixed costs and variable costs is high, i.e. the proportion of fixed costs exceeds variable costs, high operating leverage characterizes the business.

In contrast, a business with a lower proportion of fixed costs in its cost structure would be considered to possess low operating leverage.

## Cost Structure Analysis: Fixed Costs vs. Variable Costs

The difference between fixed costs and variable costs is that fixed costs are independent of production volume in the given period.

Therefore, whether the business production volume increases to meet the higher-than-anticipated customer demand or its production volume is reduced (or maybe even halted) from lackluster customer demand, the amount of costs incurred remain relatively the same.

Fixed Costs Variable Costs
• Rental Expense
• Direct Labor Costs
• Direct Material Costs
• Interest Expense on Financial Obligations (i.e. Debt)
• Sales Commission (and Performance Bonuses)
• Property Taxes
• Shipping and Delivery Costs

Unlike variable costs, fixed costs must be paid regardless of output, resulting in less flexibility in the option to reduce costs and uphold profit margins.

For example, a manufacturer that rented equipment as part of a multi-year contractual agreement with a 3rd party must pay the same fixed amount in monthly fees, whether its sales outperform or underperform.

Variable costs, on the other hand, are output-dependent and the amount incurred is subject to change based on the production output each period.

## Cost Structure Formula

The formula to calculate the cost structure of a business is as follows.

Cost Structure = Fixed Costs + Variable Costs
To understand a company’s cost structure in a standardized format, i.e. percentage form, the following formula can be used to quantify the contribution.
Cost Structure (%) = Fixed Costs (% of Total) + Variable Costs (% of Total)

## Cost Structure and Operating Leverage (High vs. Low Ratio)

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 Risks: Product vs. Service Comparison

### 1. Manufacturing Company Example (Product Oriented Revenue Stream)

The effects discussed in the prior section were under favorable 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 relative to 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 with regard to 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 Revenue Stream)

Using a consulting firm as an example for a service-oriented company, the consulting firm has the option to 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 consideration, 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, and 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 might 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 off significantly, so the cost-cutting is done out of necessity for the firm to avoid collapsing into financial distress (and potential bankruptcy) during the recession.

## Profit Maximization and Earnings Volatility

• 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” at its disposal to support its profit margins and sustain operations, contrary to the manufacturer.

## Cost Structure Types: Cost-Based vs. Value-Based Pricing

The pricing strategy within a company’s business model is a rather complex topic, where variables such as the industry, the target customer profile type, and competitive landscape each contribute to the “optimal” pricing strategy.

But generally speaking, two common pricing strategies are cost-based pricing and value-based pricing.

1. 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 of the 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 a high number of sellers selling similar products.
2. 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 amount of value derived by the customer in order to price their products or services appropriately. 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.
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