Underlying Profitability, a Sound Cost Structure
Every company seeking profitable, sustainable growth must have a sound cost structure. In the long-term, it is essential for any competitive business to stay competitive through achieving continuous cost reductions that enable costs to reach a level that is below the average of its competitors. It isn’t necessary to become the lowest cost provider, but it is necessary to be one of the lower-cost suppliers.
True profitability comes when a company is able to continuously reduce costs of producing and supplying products and services, even adjusting for inflation and other economic effects. The business that can be a lower cost producer has an advantage that provides flexibility in responding to other competitive pressures and actions.
The Growth Cycle: Balance Sheet and Income Statement
While cost isn’t the only consideration in profitability, the awareness and focus on cost structure in conjunction with sound pricing and other strategies enables the business to be cognizant of the connection between profits (the income statement side of the business) and the balance sheet (the investment side of the business). The utilization of resources to generate returns is, after all, what the business is engaged in. The business is using the long-term assets (balance sheet) to generate returns (sales and profits and cash–income statement) in the short term to reinvest and grow the business (balance sheet).
The cost and profit relationship is one that connects the balance sheet and the income statement, and the long-term investments and the short-term decisions. It requires the business to focus on productivity, use of existing capacity, volume and capacity investment decisions, incremental costs. These also require the business to focus on how each sale, pricing decision, and every other aspect of generating growth impacts the cost structure of the business. cycling back to impact the financial results: profits and what is available to invest back into the business for more growth.
Volumes Drive Cost Reductions?
The traditional view is that with volumes come cost reductions on a per-unit basis. The more sales you have, the more volume, so the lower the per-unit cost. Maybe; it depends upon your cost structure and the capacity of your operations. You may have limited critical capacity at one particular operation that would require additional capital investment. How will that capital investment impact costs? Will the added volumes be enough to offset the added costs? Understanding the capacity of the business, each business unit, and facility—the specific product mix that each facility can best produce—and the impact of what variations in product mix and volumes does to costs is important to understanding the cost structure and profitability potential of the business. Cost structures vary under different product mix and volumes because costs may be variable or fixed in nature. A fixed cost doesn’t change with volumes, so the more volume the lower the per-unit cost. A variable cost, however, varies with volumes, so its impact as its name implies will tend to follow volume.
Understand the Structure, Find the Opportunity
By understanding the nature of the costs and the underlying structure, where volumes have impact and what the impact is, where additional investment is required and its impact, where constraints on capacity exist and where investment may be required, the business is able to work to eliminate large segments of structured costs, design costs out of products and systems, improve efficiencies throughout the business (not just manufacturing or production areas), and invest in capital projects that have real impact and not over-invest.
Important Questions for Understanding Cost Structure:
• What are the direct and indirect costs for each product? Facility?
• What is the break-even point for each product? Product line? Account? Market Segment? Business unit?
• How does the break-even point change with capacity and volume?
• How does it relate to existing capacity and volume?
• What is the incremental cost and profit on each unit that is produce and sold over the current break-even point?
• How do costs move with volume changes?
• What costs remain regardless of volume decreases?
• How do the current cost structures, capacity utilization, and cost trends compare with competitors?
• What cost advantages or disadvantages exist versus competitors?
• What are the total costs to serve each account?
• Are some of the large accounts marginal or unprofitable?
• What do profits on the business look like without the unprofitable customers and associated sales and costs?
• Are there some market segments that are unprofitable?
• What does the business look like without those unprofitable market segments?
The Nature of Costs
The business is made up of costs. The larger and more complex the business, the more complex its cost structure becomes. As those costs are established and more business units are created, the debate rises as to what costs are controllable and what costs are uncontrollable at various levels of the organization. Part of the discussion arises from who is making the decisions about investing in capital projects (the buildings, equipment, and other major expenditures). Other aspects of the discussion come from functional responsibilities. For example, how much of a role does finance have in making a sale? How much of a role does the sales team have in setting credit policy?
All costs are controllable and variable over the long run. It is a matter of how long your planning horizon is. In the short term, many costs are fixed and “uncontrollable” because the decisions have already been made that will cause the cost to be incurred. Somewhere between variable and fixed, long term and short term, is where every decision and every business operates. This is where profits, growth, and sustainability of the business are created. For a business to succeed, the process of cost management has to take place in the day-to-day of the business to integrate the decision-making of what is controllable, preventing costs from getting into the structure unnecessarily, investing only where investment makes sense (e.g., at constrained resource points, where it gives a cost advantage), and addressing the total costs of the business. Focusing on cost management facilitates profitability, supports formulation of pricing strategy, enables financial analysis, and achieves long-term growth and sustainability objectives.
Some Cost Terms:
• Controllable costs: discretionary costs that can be incurred (or not) based upon spending decisions
• Uncontrollable costs: decision to incur cost has been made or is not affected at the level of the organization where cost is being charged
• Variable costs: costs that change with volumes
• Fixed costs: costs that remain unchanged with volumes, except when adding significant capacity, which may change the fixed cost base
• Direct costs: costs caused by a project or activity
• Indirect costs: costs not caused by a single activity, project, or event but a group of projects, events, or activities
• Overhead/Burden: another name for indirect cost or shared costs
• Infrastructure-fixed costs: the costs of physical capacity (e.g., buildings, property, plant, equipment)
• Managed fixed costs: discretionary costs related to people and structure providing supporting activities (e.g., accounting, human resources, sales)
• Variable direct costs: costs associated with the production of products and services (volume-driven costs)
• Shared costs: operating costs that benefit multiple activities or projects (usually associated with corporate headquarters, divisions, as well as managed fixed-cost groups listed above)