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Optimal Cost Structure and Effective Scale Economies
How do firms choose their cost structure? What is the nature and function of operational scales? What are the functional and passive sources of scale of operations? These policy questions concern a business enterprise’s optimal overhead—the appropriate mix of expenditures that maximizes the return on investment and shareholders’ wealth while simultaneously minimizing operating costs.
Clearly, effective economies of scale (MES-minimum efficiency of scale) are related to optimal cost structure and are important for sound business strategies designed to maximize an enterprise’s ability to generate assets. In this series on effective expense management, we’ll focus on relevant strategic overhead questions and offer some operational guidance. The overriding purpose of this review is to highlight some basic cost theory, strategic expense relationships, and industry best practices. Please consult a competent professional for specific financial management strategies.
As we have already established, the optimal cost structure and appropriate scale of operations for each firm will vary markedly based on overall industry dynamics, market structure—degree of competition, height of entry/exit barriers, market competition, stage of the industry life cycle, and so on. Its market competitive position. Indeed, as with most market performance indicators, firm-specific cost structure positions are only insightful in terms of industry expected value (average) and generally accepted industry benchmarks and best practices.
The most important contribution of economics to management science is the optimality-derivation theory of the Bellman equation—a dynamic programming method that divides a decision problem into smaller subproblems and early applications in economics by Beckman, Muth, Phelps, and Merton, and the resulting recursive model. In practice, any optimization problem has some objectives often called objective functions such as maximizing production, maximizing profit, maximizing utility, minimizing total cost, minimizing cycle time, minimizing distribution cost, minimizing transportation cost, etc.
Types of Cost Structure:
Cost structures are a mix of fixed costs, variable costs and mixed costs. Fixed costs include costs that remain the same regardless of the quantity of goods or services produced within the current scale of production. Examples may include salaries, rent and physical building facilities. Many capital-intensive businesses, such as airlines and construction companies, are characterized by a high proportion of fixed costs that can 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 because of high exit barriers, they should not enter such markets in the first place.
Variable costs vary proportionally with the quantity 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 often factor into profit projections and calculations of break-even points for a business or project.
Mixed cost items have fixed and variable components. For example, some management salaries generally do not vary with the number of units produced. However, if the yield drops dramatically or reaches zero, then decay can result. This is evidence that all costs are variable in the long run.
Finally, a firm with a large number of variable costs (compared to fixed costs) may exhibit more consistent per-unit costs and thus a more predictable per-unit profit margin than a company with low variable costs. However, a company with fewer variable costs (and therefore a greater number of fixed costs) can increase potential profits (and losses) because revenue increases (or decreases) are applied to a more fixed cost level.
Most business enterprises define a cost structure in terms of costs incurred in relation to a cost object or activity. And because some expenses can be difficult to define, we often implement an activity-based project that uses activity-based accounting to assign expenses to the cost structure of the cost activity or item in question. Note that the time required to complete any activity is an important factor in cost management. Therefore, to minimize the overhead of any activity or project it is important to minimize the time required to complete the activity or project. Examples of key elements of the cost structure for various expenditure items are:
Product cost structure: Under this structure there are fixed costs which may include direct labor and manufacturing overhead; and variable expenses that may include direct materials, product supplies, commissions, and piece rate wages. Service Cost Structure: Under this cost structure there are certain expenses which may include administrative overhead; and variable costs which may include employee wages, bonuses, payroll taxes, travel and entertainment.
Product Line Cost Structure: Under this structure there are fixed costs which may include administrative overhead, construction overhead, direct labor; and variable costs which may include direct materials, commissions, product 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 the cost 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 total operating overheads while simultaneously maximizing net operating income. A cost structure describes all the costs (fixed and variable) involved in operating the business model. more, 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 area, product line, product item, customer group, department, or division, etc.
In a cost-based pricing strategy, cost structure is used as a technique to determine effective prices, as well as to identify areas that can potentially reduce costs or at least be subject to better management control. Therefore, the cost structure concept is a useful management accounting tool that has many financial accounting applications.
All business models involve cost-related value creation—that is, adding real or perceived value to the customer for a 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 across the good or service and production chain. The objective is to minimize total operating costs. Such overheads can be calculated relatively easily after isolating the cost drivers, key activities, key inputs. Key resources, and strategic partnerships.
It is our experience that operating costs can be reduced in every business model. Additionally, low cost structures are more important for some business models than others. It is therefore useful 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 analysis indicates that ROE is influenced by three factors—operating efficiency, which is measured by profit margin; asset utilization efficiency, which is measured by total asset turnover; and financial profitability, which is measured by the equity multiplier: ROE = Profit Margin (Profit/Sales) * Total asset turnover (Sales/Property) * Equity multiplier (assets/equity).
Types of business models:
Cost-driven business model– Most cost-driven business models focus on reducing overheads wherever possible. This approach aims to standardize and minimize cost methodology by creating a minimum cost structure using low and dynamic price value propositions, maximum automation, and strategic outsourcing.
Value-driven business model– Many companies under this business model 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, high levels of customization and personalized service often characterize value-driven business models.
Some operational instructions:
In practice, firms seeking to optimize cost management must optimize time management. One of the most important revelations of activity-based accounting is the effect of time and activity on firms’ overall operating costs: cost structure is activity driven and activity is time driven. Therefore, time is the most important factor in effective cost management. Simply put, firms must reduce the time required to execute specific activities in order to reduce the costs associated with that specific activity, ceteris paribus.
In addition, firms seeking to leverage and optimize economies of scale must optimize the cost savings derivative of the specific scale of operations. Please note that scales of operations can be derived from functional and log-run-cost reduction experience curves; learning effects; economies of scope; division of labor; expertise; Derivation of management with horizontal as well as vertical differentiation or passive and long-term cost-increasingly reactive and robust and personality-driven approaches; organizational inertia; adaptive and abusive supervision; rising bureaucratic costs; lack of innovation; Increase in internal and external transaction costs.
In essence, firms optimize cost structure by effective time management and optimizing scale of operations. Therefore, firms seeking to maximize the profit-generating capacity of the enterprise must develop and implement efficient and effective cost management strategies based on the proper combination of costs that maximize return on investment and shareholders’ wealth while minimizing operating costs. As we have already established, there is growing empirical evidence that firms choosing for scale and volume outperform those choosing for premium, ceteris paribus.
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