Optimal Cost Structure and Effective Scale Economies
How do firms choose their cost structure? What is the nature and function of scales of operation? What are sources of functional and dysfunctional scales of operation? These policy questions relate to the optimal overhead of a business enterprise-the appropriate mix of expenditures that maximizes the return on investment and shareholders’ wealth while minimizing the cost of operations, simultaneously.
Clearly, effective economies of scale (MES-Minimum efficiency scale) are correlated with optimal cost structure and critical to sound business strategies designed to maximize the wealth producing capacity of the enterprise. In these series on effective expenditure management, we will focus on the pertinent strategic overhead questions and offer some operational guidance. The overriding purpose of this review is to highlight some basic cost theory, strategic expenditures relationships, and industry best practices. For specific financial management strategies please consult a competent professional.
As we have already established, the optimal cost structure and appropriate scale of operation for each firm differs markedly based on overall industry dynamic, market structure-degree of competition, height of entry/exit barriers, market contestability, stage of industry life cycle, and its market competitive position. Indeed, as with most market performance indicators, firm-specific cost structure position in insightful only in reference to the industry expected value (average) and generally accepted industry benchmarks and best practices.
One of the most important contributions of economic science to management science is the principle of optimality-derivative of Bellmann Equation-the dynamic programming method which breaks decision problem into smaller sub-problems and early applications in economics by Beckmann, Muth, Phelps and Merton, and the resultant Recursive model. In practice, any optimization problem has some objectives often referred to as the objective functions such as maximizing output, maximizing profit, maximizing utility, minimizing total cost, minimizing cycle time, minimizing distribution cost, minimizing transportation cost, 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 despite the volume of goods or services produced within current scale of production. Examples may include salaries, rents, and physical manufacturing facilities. A number of high capital-intensive businesses, such as airlines and manufacturing companies, are characterized by a high proportion of fixed costs which may constitute effective barriers to entry for new industry entrants. Please note that effective exit barriers are effective entry barriers. When firms 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 frequently factor into 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 typically do not vary with the number of units produced. However, if production falls dramatically or reaches zero, then attrition may result. This is evidence that all costs are variable in the long run.
Finally, a firm with a large number of variable expenses (compared to fixed expenses) may exhibit more consistent per-unit costs and hence more predictable per-unit profit margins than a company with fewer variable costs. However, a company with fewer variable costs (and hence a larger number of fixed costs) may magnify potential profits (and losses) because revenue increases (or decreases) are applied to a more constant cost level.
Most business enterprises define cost structure in terms of costs incurred in relation to a cost object or activity. And because some expenditures can be difficult to define, we often implement an activity-based project to more closely assign expenses to the cost structure of the cost activity or object in question and use activity-based accounting. Note that 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 critical to minimize the time required to complete the activity or project. The following are examples of key elements of the cost structures of various expenditure objects:
Product cost structure: Under this structure there are fixed costs which may include direct labor and manufacturing overhead; and Variable expenses which may include direct materials, production supplies, commissions, and piece rate wages. Service cost structure: Under this cost structure there are fixed expenses which may include administrative overhead; and Variables costs which may include staff wages, bonuses, payroll taxes, travel and entertainment.
Product line cost structure: Under this structure there are fixed costs which 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 overhead for customer service, warranty claims; and Variable costs which may include costs of products and services sold to the customer, product returns, credits taken, early payment discounts.
The optimal Cost Structure is the combination of fixed and variable costs that minimizes the total operating overheads while maximizing net operating income simultaneously. The Cost Structure describes all 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 that a business enterprise incurs. In practice, the cost concept can be classified by region, product line, product item, customer group, department, or division, etc.
In cost-based pricing strategy, cost structure is used as a technique to determine effective prices, as well to identify areas in which expenses might potentially be reduced or at least subjected to better management control. Therefore, the cost structure concept is a useful management accounting tool that that has many financial accounting applications.
All business models have costs associated value creation- which occurs with the addition of actual 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 production chain. The objective function is to minimize total operating expenditures. Such overheads can be calculated relatively easily after isolating cost drivers, key activities, key inputs; key resources, and strategic partnerships.
It is our experience that operating costs can be minimized in every business model. Additionally, low cost structures are more important to some business models than to others. Therefore it is useful to distinguish between two broad categories of business models: Cost-driven and Value-driven (many business models fall in between these two extreme categories).
The DuPont model demonstrates that Return on Investment is calculated as the product of Profit Margin (Net Income/Sales) and Turnover Rate (Sales/Total Assets). DuPont 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) * Equity Multiplier (Assets/Equity).
Types of Business Models:
Cost-driven business model-Most Cost-driven business models focus on minimizing overheads wherever possible. This approach aims at standardization and least cost method by creating and sustaining the leanest possible Cost Structure, using low and dynamic 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 main focus is on value creation. Premium value propositions, customization and a high degree of personalized service often characterize value-driven business models.
Some Operational Guidance:
In practice, firms seeking to optimize cost management must optimize time management. One of the most significant revelations of Activity Based Accounting is the impact of time and activity in firms’ overall operating cost: Cost structure is activity driven and activity is time driven. Therefore, time is the most critical factor is effective cost management. Simply put, firms must reduce time required to execute specific activity to reduce cost associated with the specific activity, ceteris paribus.
Additionally, firms seeking to leverage and optimize scale economies must optimize cost savings derivative of specific scale of operation. Please note that scales of operation may be functional and log-run-cost reducing derivative of experience curve; learning effects; scope economies; division of labor; specialization; horizontal as well as vertical differentiation or dysfunctional and long-run-cost increasing derivative of reactive and entrenched management with musty and personality-driven vision; organizational inertia; adaptive and abusive supervision; increasing bureaucratic cost; lack of innovation; increasing internal and external transaction costs.
In sum, firms optimize cost structure through effective time management and optimizing scales of operation. Therefore, firms seeking to maximize the profit producing capacity of the enterprise must formulate and execute dominant efficient and effective cost management strategies based on appropriate combination of costs that maximizes the return on investment and shareholders’ wealth while minimizing the cost of operations, simultaneously. As we have already established, there is growing empirical evidence suggesting firms that opt for scale and volume tends to outperform those that opt for premium, ceteris paribus.