Cost Structure: Definition, Key Components and Examples
By Deepti Sharma
Updated September 23, 2022 | Published March 1, 2021
Updated September 23, 2022
Published March 1, 2021
Deepti Sharma spent nine years in the corporate world before starting her own human resources consultancy. Her experience includes accounts, HR and statistics.
Cost structure is how costs related to selling a product or service are categorized for business purposes. It has several variables that define it and allow a business to determine operating costs on a broad, company-wide level or an individual product level.
In this article, we explain what cost structure is, define key terms and provide examples of how businesses might use cost structure.
What is cost structure?
Cost structure involves all the costs that are associated with selling a product or service and how those costs are categorized. There are varying ways of discussing cost structure, and not every business or expert will refer to cost structure the same way. The most important thing is that you understand how your business approaches cost structure and the relevant terms.
Cost structure varies most between different types of businesses. Some variables that can affect how a business refers to cost structure are cost objects, like products, services, customers, projects and business activities. Additionally, cost structure might vary even within one business depending on product lines, business units or divisions.
Types of cost structure
There are two primary types of cost structure:
Cost-driven businesses specialize in low-cost products and services. These businesses want to offer their customers the lowest cost possible and use a variety of systems and cost-saving methods to keep costs low. Cost-driven businesses, like most businesses, still want to make a profit, and so they must reduce costs in every way, especially in ways their competitors haven't considered. Examples of cost-driven businesses are discount airlines, retail stores that focus on selling low-cost items and service providers that charge less than similar services.
Value-driven businesses are those that want to give their customers the best value for their money, but they may not have the cheapest goods or services. They might be priced competitively, but the most important thing for a value-driven business is that they believe they are offering their customers a good value for what they are spending. Examples of this might be an exclusive airline, a high-end retailer selling luxury goods or a highly trained service provider.
Terms related to cost structure
Many terms are related to cost structure, including:
Fixed costs are those business costs that do not change, no matter how many products or services the company sells. Fixed costs might include rent, utilities, property taxes and salaries. These expenses might fluctuate a bit from month to month, however, they do not change based on the number of goods or services the business sells.
Related: How To Calculate Fixed Cost
Variable costs are those that change depending on how many products or services a business sells. As a business grows, offers new products or increases sales of any product, these costs will increase. These include direct labor costs (especially hourly wages), bonuses and commissions, travel expenses, direct material costs, payroll taxes and marketing costs.
Economies of scale
Economies of scale are products or services a business buys or sells where the price per unit goes down if more units are purchased.
For example: A business needs to buy 10 boxes of materials to create their product and the cost is $100 per box, but if they buy 25 or more boxes, the price goes down to $90 per box. With economies of scale, businesses that buy more get per-unit savings, while the businesses selling the goods under economies of scale find they sell more in bulk because of offering savings.
Cost allocation is a way of tracking business expenses so that the business can assign those expenses to a specific product or service to determine if it is profitable. An example of this might be assigning relevant employees and their wages to a particular product line and then dividing them based on each product offered. That way, the business can see how the income from each product affects the costs of the employee wages and vice versa.
Businesses use a cost pool to group fixed expenses together so that they can be divided later on a per-project or product basis. The cost pool is a part of cost allocation. Some expenses that might be grouped in a cost pool include overhead expenses like salaries, rent, utilities and other fixed expenses that are the same no matter how many products the business sells.
Economies of scope
Economies of scope is a financial benefit when a business purchases a good or service that can apply to multiple areas of their business for the same cost. This might include software that has multiple features to take the place of different types of software the business paid for previously. Economies of scope is another way of lowering costs for a business.
Examples of cost structure
Here are two examples of cost structure:
Snyder Electronics is a retail store that specializes in selling electronics at the lowest possible cost. They are calculating the expenses that go into their sales for the last year. First, they cost pool to add up fixed costs like rent, manager salaries and utilities as overhead expenses. They also add up the variable costs from the last year as a cost pool, which includes marketing expenses and commissions paid to sales employees.
Then they add up the labor hours that went into the previous year's sales by reviewing how many hours each hourly sales employee worked and how much they are paid by the hour. Those labor variable costs, along with the fixed overhead expenses and the other variable costs, are how much the business has spent in the last year to do business.
The business then divides these costs by the number of products sold in each category they offer, such as cell phones, computers, printers and video game systems. They may go a step further and specifically allocate labor hours paid for each employee in each of those departments if employees stay in one area. This allows Snyder Electronics to assess if they are keeping their costs as low as possible in each area so that they can keep prices low for their customers without damaging their ability to stay in business.
Jasmine's Knit Goods is a small company specializing in producing high-quality handmade knit goods such as sweaters, socks, scarves and hats. Jasmine wants to offer high-value items at a reasonable but fair cost that recognizes the labor involved. Jasmine has fixed costs including a mortgage payment, property taxes, utilities and her own salary. She pays her employees an hourly wage and also has other variable costs, including yarn and knitting tools.
Jasmine wants to know how much it cost the company to produce its products over the last quarter. First, she calculates her fixed overhead costs as well as the variable material costs and divides them across the four primary product lines. Then, she calculates the hourly labor costs for each type of item. Adding the portion of overall costs to the hourly labor costs for the 125 sweaters sold in the last quarter, Jasmine can see how much it cost the company to produce those sweaters. She does the same for each of the other item categories as well.
If Jasmine wants to get even more specific with the costs for each item, she could cost pool all variable expenses per item. This would mean if the company uses a higher-cost yarn or more expensive knitting tool for one particular type of hat, she could create a cost pool of those expenses with the direct labor costs to find the costs for that specific hat type when added into a percentage of the overhead costs.
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