Cost structure refers to the types and relative proportions of fixed and variable costs that a business incurs. The concept can be defined in smaller units, such as by product, service, product line, customer, division, or geographic region. Cost structure is used as a tool to determine prices, if you are using a cost-based pricing strategy, as well as to highlight areas in which costs might potentially be reduced or at least subjected to better control. Thus, the cost structure concept is a management accounting concept; it has no applicability to financial accounting.
To define a cost structure, you need to define every cost incurred in relation to a cost object. The following bullet points highlight key elements of the cost structures of various cost objects:
- Product cost structure
- Fixed costs. Direct labor, manufacturing overhead
- Variable costs. Direct materials, commissions, production supplies, piece rate wages
- Service cost structure
- Fixed costs. Administrative overhead
- Variable costs. Staff wages, bonuses, payroll taxes, travel and entertainment
- Product line cost structure
- Fixed costs. Administrative overhead, manufacturing overhead, direct labor
- Variable costs. Direct materials, commissions, production supplies
- Customer cost structure
- Fixed costs. Administrative overhead for customer service, warranty claims
- Variable costs. Costs of products and services sold to the customer, product returns, credits taken, early payment discounts taken
Some of the preceding costs can be difficult to define, so you may need to implement an activity-based costing project to more closely assign costs to the cost structure of the cost object in question.
You can alter the competitive posture of a business by altering its cost structure, not only in total, but between its fixed and variable cost components. For example, you could outsource the functions of a department to a supplier who is willing to bill the company based on usage levels. By doing so, you are eliminating a fixed cost in favor of a variable cost, which means that the company now has a lower break even point, so that it can still earn a profit at lower sales levels.
A knowledge of the capacity levels associated with the existing fixed cost structure can also allow a business to increase its profits by lowering prices sufficiently to maximize the utilization of a fixed cost item. For example, if a company has spent $100,000 on a high-capacity automated machine and it is currently only being utilized 10% of the time, a reasonable action would be to obtain more work to increase the amount of cash earned from that machine, even at prices that might normally be considered low. This type of pricing behavior is only possible if you have a detailed knowledge of the cost structure of a business.