Fixed and variable costs
A cost structure entails fixed and variable costs, and people need to know the differences between each. A fixed expense is one that doesn't change with the company's output. Conversely, variable costs fluctuate, and they typically go up with a company's production levels.
Some common examples of fixed costs include a building's lease, utilities and insurance. However, fixed costs could be things like labor and materials expenses. One straightforward method of calculating variable expenses is to add them up and divide that number by the production volume.
Ongoing and one-off costs
Gathering your figures for a complete cost structure will likely require calculating ongoing and one-off costs associated with the business. Ongoing expenses are the continual ones, while one-off costs represent single expenses.
Many of your ongoing costs will likely be fixed. For example, building rent is both a fixed and an ongoing expense. However, equipment maintenance is variable and ongoing. It's something you may need to invest in each month, though the amount won't stay the same. A one-off cost might involve office furniture or hiring someone to design a website.
Cost-driven vs. value-driven cost structure
Beyond figuring out the kinds of costs mentioned above, businesses need to figure out if the enterprise has a cost-driven or value-driven structure.
In a cost-driven structure, the business strives to keep prices as low as possible. It often figures out how low it can set prices while remaining profitable, and also sets the cost ceiling, which is the maximum price the market tolerates. Walmart is an example of a brand that uses a cost-driven structure. People expect low prices when shopping there. If a business wants to capitalize on a customer’s desire to save money, it’ll likely choose a cost-driven model.
A value-driven cost structure focuses on the benefits a product or service provides. If a person walks into a Tiffany & Co. store to buy accessories, they expect top-notch service and luxurious goods. The cost might come into the equation to some extent, but people who shop there aren't primarily concerned with price. If a business wants to focus on personalized service or luxury, a value-driven cost structure usually makes sense.
In addition to determining whether a company should operate with a cost-driven or value-driven structure, businesses must realize that models differ depending on the nature of the enterprise. For example, an entity that needs manufacturing equipment or a huge warehouse space would have a different cost structure model than one operating solely online, or that plans to outsource many of its needs.
Creating your cost structure
The first step to make a cost structure requires breaking down all expenses into categories. They might include product-related costs, customer-related costs and employee-related costs, as a start. Then, within each group, calculate the associated fixed, variable, ongoing and one-off expenses. Some companies may create several cost structures: one for the whole company, another for a product line and one for a single product.
Cost structure is also often brought up when people discuss the business model canvas, which is a one-page option for profiling the company. No matter if professionals use this or another way of showing cost structure, the methods of illustrating expenses are similar.
The best approach is to use a color-coded system that differentiates each kind of expense. This example from Equity Residential, a real estate investment trust company, does that. However, it's even better to show whether the costs listed are fixed or variable.
Another option is to create boxes of various sizes, each one representing the relative amount you spend on something. Make the boxes different colors depending on if the expenses are fixed or variable.
Consider the example of this design firm, which has mostly fixed costs:
The goal is to come up with a format that's easy to read. Company representatives should find that choosing what kind to use is simpler once they add up all the expenses and categorize them correctly.
Closing thoughts about cost structures
Thanks to the definitions and examples here, you should feel that it's not difficult to create a cost structure. Just remember that accuracy is crucial. One incorrect calculation could affect the entire cost structure, making it unreliable.
While striving to make the most accurate cost structures, businesses should also realize they’ll change over time. It's smart to create a new cost structure when a company goes through major changes, and ideally, even more often to ensure relevancy.
Staying on top of your expenses will make it easier to determine if the company is financially sound or needs to make some spending tweaks to avoid future catastrophes.