Optimal cost structure and effective economies 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 scales of operation? These policy questions relate to the optimal overhead for 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) are correlated 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 will focus on the relevant strategic overarching questions and provide some operational guidance. The primary purpose of this review is to highlight some basic cost theory, strategic spending 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 based on the general dynamics of the industry, the structure of the market, the degree of competition, the height of entry / exit barriers. , market competition, the life cycle stage of the industry and its competitive position in the market. In fact, as with most market performance indicators, the position of the specific cost structure of the company is revealing only in reference to the expected value of the industry (average) and to the benchmarks and best practices of industry generally accepted.
One of the most important contributions of economics to management science is the optimization principle, derived from the Bellmann equation, the dynamic programming method that divides the decision problem into smaller subproblems and early applications in economics of Beckmann, Muth, Phelps, and Merton. and the resulting recursive model. In practice, any optimization problem has some objectives that are often referred to as objective functions, such as maximizing production, maximizing profit, maximizing profit, minimizing total cost, minimizing cycle time, minimizing cost. distribution, minimize the cost of transportation, etc.
Types of cost structure:
Cost structures consist of a combination of fixed costs, variable costs, and mixed costs. Fixed costs include costs that remain the same despite the volume of goods or services produced within the current scale of production. Examples can include salaries, rents, and physical manufacturing facilities. Several 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 those markets in the first place.
Variable costs vary proportionally with the volume of goods or services produced. Workforce-intensive companies focused on services such as banking and insurance are characterized by a high proportion of variable costs. In practice, variable costs often influence profit projections and the calculation of break-even points for a company or project.
Mixed cost items have fixed and variable components. For example, some managerial salaries generally do not vary with the number of units produced. However, if production drops dramatically or reaches zero, wear and tear can occur. This is evidence that all costs are variable in the long run.
Finally, a company with a large number of variable expenses (compared to fixed expenses) can 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 higher number of fixed costs) can magnify potential gains (and losses) because increases (or decreases) in revenue are applied at a higher cost level. constant.
Most companies define the cost structure in terms of 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 map 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 cost structures for various expense objects:
Product cost structure: Under this structure there are fixed costs that can include direct labor and manufacturing overheads; and Variable expenses that may include direct materials, production supplies, commissions, and piece rate wages. Service cost structure: Under this cost structure there are fixed expenses that can include administrative expenses; and Variable costs that may include staff salaries, bonuses, payroll taxes, travel, and entertainment.
Product line cost structure: Under this structure there are fixed costs that can include administrative overhead, manufacturing overhead, direct labor; y Variable costs that may include direct materials, commissions, production supplies; and Client 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 prepayment.
The optimal cost structure is the combination of fixed and variable costs that minimizes total operating overhead while simultaneously maximizing net operating income. The cost structure describes all the costs (fixed and variable) incurred to operate a business model. Further away, Cost structure refers to the types and relative proportions of fixed and variable costs incurred by a business enterprise. In practice, the concept of cost 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 prices, as well as to identify areas where expenses could potentially be reduced or at least put under better management control. Therefore, the concept of cost structure is a useful management accounting tool that has many financial accounting applications.
All business models have costs associated with the creation of value, which occurs with the addition of real or perceived value to a customer for a superior good or service; delivering value: 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 in the production chain. The objective function is to minimize total operating expenses. These overheads can be calculated relatively easily after isolating the cost drivers, key activities, key inputs; key resources and strategic partnerships.
In our experience, operating costs can be minimized across 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-driven and value-based (many business models fall between these two extreme categories).
The DuPont model shows that ROI is calculated as the product of profit margin (net income / sales) and turnover rate (sales / total assets). DuPont’s analysis indicates that ROE is affected by three factors: operating efficiency, which is measured by profit margin; Asset use efficiency, 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) * Capital multiplier (assets / equity).
Types of business models:
Cost-based business model-Most cost-driven business models focus on minimizing overhead whenever possible. This approach aims at standardization and the lowest-cost approach by creating and maintaining the lowest cost structure possible, using dynamic low-price value propositions, maximum automation, and strategic outsourcing.
Value-driven business model– Under this business model, most companies tend to be less concerned with the cost implications of a particular business model design and instead their primary focus is value creation. Superior value propositions, personalization, and a high degree of personalized service often characterize value-driven business models.
Some operational guidance:
In practice, companies seeking to optimize cost management must optimize time management. One of the most important revelations of activity-based accounting is the impact of time and activity on the overall operating cost of companies: the cost structure is based on activity and activity over time. Therefore, time is the most critical factor for effective cost management. Simply put, companies should reduce the time required to execute a specific activity to reduce the cost associated with the specific activity, ceteris paribus.
Additionally, companies seeking to leverage and optimize economies of scale must optimize cost savings derived from a specific scale of operation. Note that operating scales can be functional and a derivative of the experience curve that reduces the cost of logarithmic execution; learning effects; economies of scope; Division of labour; specialization; horizontal as well as vertical differentiation or dysfunctional and cost-increasing long-term derivative of ingrained, reactive management with a moldy, personality-driven vision; organizational inertia; adaptive and abusive supervision; increased bureaucratic costs; lack of innovation; increased internal and external transaction costs.
In short, companies optimize cost structure through effective time management and optimization of operating scales. Therefore, companies seeking to maximize the profit-producing capacity of the company must formulate and execute dominant efficient and effective cost management strategies based on an appropriate combination of costs that maximizes the return on investment and wealth of the assets. shareholders while minimizing the cost of operations, simultaneously. As we have already established, there is growing empirical evidence to suggest that companies that opt for scale and volume tend to outperform those that opt for premium, ceteris paribus.