What Is a Cost Structure? (With Definition and Examples)
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Operating cost is an essential element of a company's financial statement. Companies may divide their operating costs into smaller units, such as service, product, customer division, and geographic location, to determine areas where they can reduce their expenses. Learning the various types of operating costs a company can incur can help you set prices for products to sell in an open or competitive market. In this article, we define what a cost structure is, explain its various types, highlight its key terms, and provide examples.
What is a cost structure?
A cost structure, or expenditure pattern, refers to the several types of expenses a company can incur. These expenses may include the cost of purchasing a raw material or packaging the product. Their major components include the fixed and variable costs that a business usually incurs. Fixed costs typically remain constant regardless of the amount of output a company produces, whereas variable costs change according to a production volume. It's a concept in management accounting that companies use to determine pricing strategies.
The structure of a company's cost can directly influence its product offerings and profit margin. Cost structures typically differ between service providers and retailers. This means that the expense account on a company's financial statement depends on its product, service, and business activity.
Types of expenditure pattern
Most modern businesses are a combination of the types of expenditure patterns because they aim to provide value to customers at the best possible price. The following are the two types of expenditure patterns:
Cost-driven business models focus on reducing costs in their daily operations. Companies that use this approach aim to make more profit by reducing costs, especially in ways their competition may not consider. Low-cost airlines are an example of businesses that use this expenditure pattern. Businesses with a cost-driven pattern often maintain low inventories, offer cheap propositions or services, and extensively outsource activities to control cost.
This category of business aims to provide maximum value to its customers. Here, companies typically offer premium or luxury goods and services to create the best experience for their customers. Value-driven businesses price their goods competitively to provide a degree of customization and offer personalized services to customers. Luxury hotels and exclusive airlines are examples of this business model.
Key terms relating to an expenditure pattern
Here are key terms that relate to an expenditure pattern:
Variable costs change proportionally with the volume of goods and services a company manufactures. They include all the expenses a business incurs when manufacturing a product or delivering a service. This means that these costs can directly affect a company's output. The variable cost may include commissions, piece-rate wages, and direct materials for companies selling products. It can comprise travel costs, bonuses, and wages for service providers.
Fixed costs typically remain the same regardless of the company's goods and services. They continue even if production activities stop. The fixed cost often has a static amount, but it may fluctuate over time. For example, the cost of renting a building is constant and permanently fixed, but it can change whenever the owner of the building increases the rent. Companies incur this cost regularly. Fixed costs include interest, rent, direct labour, property taxes, and utilities.
Economies of scope
This is a cost advantage companies can enjoy because it has a large scope of operation. In this economic concept, the unit cost a company uses to manufacture a product declines as the variety of the product increases. This means that the production of one good reduces the cost of producing another related good. Businesses typically use economies of scope to lower their production costs. Here's an example:
A shoe manufacturer produces women's and men's sneakers. To increase its profit and lower the cost of production, the manufacturer adds a children's line of sneakers. By doing this, the manufacturer has increased its economies of scope because it can use the same supplies, storage, production equipment, and distribution channels to make a new line of products.
Economies of scale
This refers to the cost advantage a company experiences when it increases its output level. In this economic concept, a company benefits more when it produces more goods. This means the greater the quantity of goods a company produces, the lower its per-unit fixed cost. A business' economies of scale can reduce its average cost per unit as output rises. A firm can implement this concept in its marketing department by hiring more professionals. Businesses may also adopt machine labour rather than human labour to increase production volume.
This is a strategy that companies use to identify the expenses individual departments or service sectors within the business incurred. The cost pool enables companies to determine their total expenses in manufacturing goods. Overhead, fixed, and maintenance costs are typical examples of cost pools. The cost pool makes cost allocation easy for businesses. For example, a business can accumulate the cost of maintaining a department in a cost pool before allocating resources to it. Businesses commonly use a cost pool for allocating factory overheads, such as rent, utilities, and salaries, to various production units.
Cost allocation is how businesses collect, identify, analyze, and assign expenses to cost objects, such as products, services, or departments. When a business allocates costs appropriately, it can trace the specific cost objects that are making profits or losses for the company. It can also help each unit in a company develop internal procedures or outsource necessary services to distribute the responsibility for spending and expenses equitably. Here's an example:
Pink's factory designs and manufactures handbags. In December, the factory produced 2,000 handbags with direct material costs of $5 and direct labour costs of $3 per handbag. Pink's factory also had $5,000 in overhead costs for December. Using the number of units it produced as the allocation method, the factory calculates its overhead cost at $2.5 per handbag. Adding this cost to the company's direct cost means that the factory allocates $10.50 to produce each handbag.
Examples of expenditure pattern
The following are examples of an expenditure pattern:
Here's an example of a value-driven business model:
Palm Luxury Wears Company specializes in manufacturing leather products, such as sandals, belts, and caps. It wants to offer customized items at a competitive price that recognizes direct labour. The company has fixed costs, including property taxes, rent, employee salaries, and utilities. It pays its employees a daily wage and has other variable costs. The business wants to determine how much expense it incurs in manufacturing its products in a year. It sells 200 belts within a year. To determine the cost of producing only belts, the company calculates its variable material cost and fixed overhead costs.
Then, it calculates the hourly labour costs for each item and adds the portion of the total overhead cost to the hourly labour cost. If the company wants to know the specific cost it allocates to each item, it can cost pool all its variable expenses per item. Suppose the company uses a more expensive leather material for a particular type of sandals. It can then create a cost pool for the expenses with the direct labour cost to determine the price of manufacturing that specific sandal type.
Here's an example of a cost-driven business model:
Green Rage is a clothing retail store specializing in selling clothes at the lowest possible price. To calculate the expenses it incurs on sales within the last six months, they calculate fixed costs, such as manager salaries, rent, and electricity bills. The company also calculates its variable costs, including the commission it pays to its sales employees. Green Rage adds the labour hours it spent in producing clothes by reviewing how much it paid each sales employee and their number of hours.
The fixed overhead expenses alongside its labour variable costs and other variable costs can show how much the retail store has spent within six months to produce clothes. Green Rage further divides these costs by the number of items it sells in each category, such as dresses, shirts, pants, and skirts. It may also specifically allocate the labour hours it pays each employee working in these departments. By doing this, Green Rage can assess if it's maintaining a low cost in manufacturing each item without producing low-quality goods.
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