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Optimal cost structure and effective savings of scale

How do companies choose their cost structure? What is the nature and function of the scales of operation? What are the sources of functional and dysfunctional operating scales? 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 minimizing the cost of operations, simultaneously.

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 the wealth-producing capacity of the firm. In this series on effective expense management, we’ll focus on the pertinent broad strategic issues and offer some operational guidance. The primary purpose of this review is to highlight some basic cost theory, strategic expense relationships, 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 the entry/exit barriers , market competition, the stage of the life cycle of the industry and its competitive position in the market. In fact, as with most market performance indicators, the position of the company-specific cost structure is revealing only by reference to industry expected value (average) and industry benchmarks generally. accepted and best practices.

One of the most important contributions of economics to management science is the optimization principle, derived from Bellmann’s equation, the dynamic programming method that divides the decision problem into smaller subproblems, and Beckmann’s early applications in 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 maximizing output, maximizing profit, maximizing profit, minimizing total cost, minimizing cycle time, minimizing distribution cost, minimizing the cost of transportation, etc.

Types of cost structure:

Cost structures consist of a mix 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. Keep in mind 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 both fixed and variable components. For example, some management salaries do not normally vary with the number of units produced. However, if production drops dramatically or goes to zero, then attrition can result. This is evidence that all costs are variable in the long run.

Finally, a company with a large amount of variable expenses (compared to fixed expenses) may exhibit more consistent unit costs and therefore more predictable unit profit margins than a company with fewer variable costs. However, a company with fewer variable costs (and therefore a greater amount of fixed costs) can magnify potential profits (and losses) because revenue increases (or decreases) are applied at a more constant cost level. .

Most business enterprises 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 more closely assign expenses to the cost structure of the activity or cost object in question and use activity-based accounting. Keep in mind 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 essential to minimize the time required to complete the activity or project. The following are examples of key elements of the cost structures of various spend 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 rates. Service cost structure: Under this cost structure there are fixed expenses that may include administrative overhead; and Variable costs which may include staff salaries, bonuses, payroll taxes, travel and entertainment.

Product line cost structure: Under this structure there are fixed costs that may include administrative overhead, manufacturing overhead, direct labor; and Variable costs which may include direct materials, commissions, production supplies; and Customer cost structure: Under this structure: Under this cost structure there are fixed costs; there are administrative overheads 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 prompt payment.

The optimal cost structure is the combination of fixed and variable costs that minimizes total operating overhead and simultaneously maximizes net operating income. The cost structure describes all the costs (fixed and variable) incurred to operate a business model. Further, cost structure refers to the types and relative proportions of fixed and variable costs incurred by a business enterprise. In practice, the cost concept 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 pricing, as well as to identify areas where expenses could potentially be reduced or at least brought under better management control. Thus, 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 with the addition of 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 productive chain. The objective function is to minimize total operating expenses. Such overheads 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. Also, low cost structures are more important for some business models than 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).

The DuPont model demonstrates that 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 for 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, personalization, 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 insights from activity-based accounting is the impact of time and activity on companies’ overall operating cost: 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.

In addition, 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 experience curve derivatives that reduce logarithmic costs; learning effects; range saving; Division of work; specialization; both horizontal and vertical differentiation or the dysfunctional and cost-increasing long-term byproduct of entrenched, reactive management with a musty, personality-driven vision; organizational inertia; adaptive and abusive supervision; increased bureaucratic cost; lack of innovation; increase in internal and external transaction costs.

In summary, companies optimize the cost structure through effective time management and optimization of operation scales. Therefore, firms seeking to maximize the profit-producing capacity of the firm must formulate and execute efficient and effective cost-management dominant strategies based on an appropriate mix of costs that maximizes return on investment and employee wealth. shareholders while minimizing the cost of operations, simultaneously. As we have already established, there is mounting empirical evidence to suggest that firms that opt ​​for scale and volume tend to outperform those that opt ​​for premium, ceteris paribus.

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