Cost Structures

Learning Outcomes

  • Compare and contrast sample cost structures for company strengths and weaknesses

Your boss just stopped in your office with a flyer for a new piece of equipment that promises to replace ten of your manufacturing employees at a fraction of the cost you are paying now for labor. He is pretty excited about this opportunity and wants you to make the call and get it on order right away! You are hesitant for a few reasons, but the biggest is the huge price tag of $500,000! You need to do some analysis and put together a proposal for your boss showing the pros and cons of this big purchase, along with the effects it may have on your employees. This would be a shift from variable costs, those of the employees and the related costs, to a machine that has only one use. How are you going to prepare this proposal? Let’s first define cost structure and then look at some ideas and options.

How do we define cost structure? The percentage of sales that is related to fixed costs or variable costs is a component of cost structure. Let’s take a look at cost structure defined.

Cost structure refers to the proportion of fixed and variable costs within an organization. Managers may have some control over the proportion based on responsibilities. An example might be an investment in automated equipment that saves variable labor costs. This shifts the cost from a variable cost (labor for production) to a fixed cost (purchase and depreciation of equipment).

Let’s look at how a shift from labor to equipment may look.

Currently, an employee on your manufacturing floor can produce 800 items in a standard 8 hour shift. If your employee costs $25 an hour, then the variable labor cost per item is 25 cents. What if the automated equipment that costs $500,000 can produce 100 items per hour, and has a 10 year life? It can also operate 365 days per year, does not require paid time off, sick leave or insurance, and probably doesn’t complain about working conditions!

In 10 years, this piece of equipment can make 8,760,000 items. You think you are pretty smart because now the cost per item looks like 5.7 cents per item, rather than the 25 cents per item that your employee would cost. Oh, and your employee would probably want some wage increases over that time period as well. Essentially, the way you look at it, this machine will replace roughly 5 employees, and save a ton of money in the long run.

What flaws can you see in your plan? Well, one is a shift from the labor which is a variable expense (you can send your employee home if you aren’t busy), to a fixed cost (the machine is there, and will cost $50,000 a year, whether you make 1 item or 8,760,000 items).

Here are some things to consider as you contemplate a change in cost structure of this type:

  1. Will this machine be able to make a different item if the item it is designed to make becomes obsolete?
  2. What is the resale value of this machine if we determine we no longer need it?
  3. What is the maximum sales we can expect for this item? Just because the machine can make almost 9 million units, doesn’t mean we can sell that many!

Whether to invest in the expensive machine to make your item, or to keep paying the labor costs depend on many factors. Without having a crystal ball, it can be hard to make these decisions. As a manager, it is your job to look at various options and make the best decision for your company.

Practice Questions