Optimal cost structure and effective economies of scale

How do companies choose their cost structure? What is the nature and function of operational scales? What are sources of functional and dysfunctional surgical scales? These policy questions relate to a commercial enterprise’s optimal overhead — the appropriate mix of expenses that maximizes return on investment and shareholder wealth while minimizing operating expenses.

Effective economies of scale (MES-Minimum Efficiency Scale) clearly correlate with an optimal cost structure and are critical to sound business strategies designed to maximize the wealth generation capacity of the organization. In this series on effective spend management, we focus on the relevant strategic overhead issues and offer some operational guidance. The overall purpose of this review is to highlight some key cost theories, strategic spend 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 scope of operation for each company differs significantly based on general industry dynamics, market structure, level of competition, level of entry/exit barriers, market competitiveness, stage of Industry life cycle and its competitive position in the market. As with most market performance indicators, the company-specific cost structure is only revealing in relation to the expected value of the industry (average) and generally accepted industry benchmarks and best practices.

One of economics’ most important contributions to management science is the principle of optimality – derivation of Bellmann’s equation – the method of dynamic programming that breaks down decision problems into smaller sub-problems, and early applications in economics by Beckmann, Muth, Phelps and Merton. and the resulting recursive model. In practice, every optimization problem has some objectives, often referred to as objective functions, such as

Types of cost structure:

Cost structures consist of a mixture of fixed costs, variable costs and mixed costs. Fixed costs include costs that remain the same despite the volume of goods or services produced at the current scale of production. Examples can be salaries, rents and physical production facilities. A number of very capital-intensive companies, such as airlines and manufacturers, are characterized by high proportions of fixed costs, which can present effective barriers to entry for new entrants. Please note that effective exit barriers are effective entry barriers. If 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. Labour-intensive companies that focus on services, such as banks and insurance companies, are characterized by a high proportion of variable costs. In practice, variable costs often go into profit forecasting and the calculation of break-even points for a business or project.

Mixed cost items have both fixed and variable components. For example, some managerial salaries typically do not vary with the number of units produced. However, when production drops dramatically or reaches zero, it can cause fluctuation. This is evidence that all costs are variable over the long term.

Finally, a company with a large number of variable costs (relative to fixed costs) may have 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 thus a greater number of fixed costs) can magnify potential gains (and losses) as sales increases (or decreases) are applied to a more constant level of costs.

Most business organizations define cost structure in terms of costs incurred in relation to a cost object or activity. And because some expenses are difficult to define, we often conduct a performance-based project to more accurately map the expenses to the cost structure of the cost activity or object in question, and use performance-based accounting. Note that the time it takes to complete a given activity is the critical factor in cost management. Therefore, in order to minimize the overhead of an activity or project, it is crucial to minimize the time required to complete the activity or project. The following are examples of key elements of the cost structures of various expense objects:

product cost structure: There are fixed costs in this structure, which may include direct labor and manufacturing overheads; and variable expenses, which may include direct materials, production materials, commissions, and piecework wages. Service cost structure: Under this cost structure there are fixed costs which may include administrative overheads; and variable expenses, which may include wages, bonuses, payroll taxes, travel and entertainment.

Product line cost structure: Under this structure there are fixed costs, which may include administrative overheads, manufacturing overheads, direct labor; and variable costs, which may include direct materials, commissions, production supplies; and Customer cost structure: Under this structure: This cost structure includes fixed costs of administrative expenses for customer service, warranty claims; and variable costs, which may include costs of products and services sold to customers, product returns, credit drawn, early payment discounts.

The optimal cost structure is the combination of fixed and variable costs that minimizes total operating expenses while maximizing net operating income. The cost structure describes all costs (fixed and variable) that are incurred for operating a business model. Further, cost structure refers to the types and relative proportions of fixed and variable costs incurred by a business. In practice, the cost concept can be classified by region, product line, product item, customer group, department or line of business, and so on.

The cost-based pricing strategy uses cost structure as a technique to determine effective pricing, as well as to identify areas where spending could potentially be reduced or at least come under better managerial control. Therefore, the cost structure concept is a useful management accounting tool that has many financial accounting applications.

All business models have cost-related value creation that occurs with the addition of actual or perceived value to a customer for a superior good or service; value-adding and maintaining effective, mutually beneficial and satisfying customer relationships; and value capture – which occurs through changes in the distribution of value in the goods or services and production chain. The objective is to minimize the total cost of ownership. Such overheads can be calculated relatively easily after isolating cost drivers, key activities, key inputs; Key resources and strategic partnerships.

In our experience, operating costs can be minimized in every business model. In addition, low cost structures are more important for some business models than for others. Therefore, it makes sense to distinguish between two broad categories of business models: cost-driven and value-driven (many business models fall between these two extreme categories).

The DuPont model shows that return on investment is calculated as the product of profit margin (net income/sales) and turnover rate (sales/total assets). DuPont’s analysis shows that ROE is affected by three factors: operational efficiency, which is measured by profit margin; Asset Use Efficiency, which is measured by Total Asset Turnover; and financial leverage, measured by equity multiple: ROE = Profit margin (profit/sales) * total asset turnover (sales/assets) * Equity Multiplier (Assets/Equity).

Types of business models:

Cost-oriented business model-Most cost-oriented business models focus on minimizing overhead wherever possible. This approach aims for standardization and lowest cost method by creating and maintaining the leanest possible cost structure using low and dynamic price-value propositions, maximum automation and strategic outsourcing.

Value-based business model– With this business model, most companies are often less concerned with the cost implications of a particular business model design and instead focus primarily on value creation. Value-oriented business models are often characterized by premium value propositions, individualization and a high degree of personalized service.

Some operating notes:

In practice, companies that want to optimize cost management must optimize time management. One of the most significant findings of activity-based accounting is the influence of time and activity on the total cost of ownership of companies: the cost structure is activity-driven and the activity is time-driven. Therefore, time is the most critical factor for effective cost management. Simply put, organizations need to reduce the time it takes to perform a specific activity in order to reduce the costs associated with that specific activity, all things being equal.

Additionally, companies that want to leverage and optimize economies of scale need to optimize the cost savings derivation of a given scale of operations. Please note that operational measures can be functional and log-run cost-reducing derivatives of the experience curve; learning effects; scale savings; division of labor; Specialization; horizontal as well as vertical differentiation or dysfunctional and long-term cost-increasing derivation from reactive and deadlocked management with musty and personality-driven vision; organizational inertia; adaptive and abusive oversight; increasing bureaucracy; lack of innovation; rising internal and external transaction costs.

In summary, companies optimize the cost structure through effective time management and optimization of operational scales. Therefore, companies that want to maximize the company’s profit-generating capacity must formulate and implement dominant, efficient and effective cost management strategies based on an appropriate combination of costs that maximizes return on investment and shareholder wealth while minimizing operating expenses. As we’ve previously noted, there is growing empirical evidence that companies that choose size and volume tend to outperform those that choose premium, all things being equal.