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Cost structures are methods used by manufacturers to manage an operating budget for maximum profitability. There are three types: production site, process origin, and purchase structures. Fixed costs remain the same each month, while variable costs change. Managers must carefully align their budget to one of these structures to avoid strategic disadvantages.
Cost structures are the different ways a manufacturer can manage an operating budget so that the ratio of fixed costs to variable costs produces the greatest profitability. In general, there are three types of cost structures: production site, process origin, and purchase structures. Each of these cost structures focuses on an area of business where changing the allocation of expenses produces changes in operating efficiency. Generally, a certain type of cost structure is more appropriate for certain types of businesses.
A company’s operating budget is made up of fixed and variable costs. Fixed costs are expenses that stay the same every month. An example of a fixed cost is flat-rate rent paid at a facility under an agreement that spreads the full rent payment over 12 months in equal installments. This expense is known in advance and is contractually established. It cannot be easily changed to reduce costs.
By contrast, variable costs change every month. The company generally has some control over these expenses. For example, employee cell phone charges are a variable expense that changes each month based on usage. Managers have the ability to limit this cost by restricting usage, and it’s a change that can be made immediately.
The management decisions that allow a company to operate with costs that fall more or less in the fixed or variable categories involve its cost structure. There are three general types of cost structures that managers can adopt. Production site cost structures allocate fixed and variable expenses based on whether there are cost savings involved in moving a production site to another location, such as offshore. Process origination cost structures analyze fixed and variable expenses based on whether it is more profitable to keep manufacturing processes in-house or outsource them to a specialist third party.
Purchasing cost structures look at the fixed and variable expenses involved in purchasing raw materials. This is one of the most popular cost structures for manufacturers of consumer goods, with the cost of raw materials accounting for 60 to 80 percent of the total operating cost. Managers often need to be careful when aligning their operating budgets to fit one of these three frameworks. Making a move to reduce variable expenses can result in strategic disadvantages that come with their own expenses, such as losing efficiency by moving a plant to a foreign country or creating a more complex distribution system by outsourcing parts of the business.
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