Cost Structure

Cost structure has traditionally been defined as the relative proportion of fixed and variable costs in an organization and how these costs behave in response to changes in production or sales volume. Additionally, cost structure is generally discussed in the context of long-run and short-run production, with an emphasis on a particular function. Modern definitions of cost structure, however, encompass a much more holistic definition, namely, rethinking business models to reduce costs across entire processes in order for organizations to remain competitive in the globalized business environment.

In economics, cost structure is defined as the relationship between costs and quantity. Embedded in this definition, firms have at least one fixed factor of production in the short run—all other costs are assumed to be variable. In the short run, fixed factors of production are assumed to have no impact on the firm's decisions since they cannot be changed over a short time period. For example, most products require raw materials, labor, machinery, and factory space. If demand increases for a particular product, it is generally quite easy to increase raw materials and labor in proportion to the increased demand. However, adding new machinery and a factory is not as easy since these are capital investments that generally require large financial outlays and a certain amount of time for completion.

In contrast to the short run, the long run is the period over which firms are assumed to be able to vary all factors of production. The implications therefore of the short run/long run at the industry level are that in the short run, firms can increase/decrease production in response to demand, while over the long run, firms can enter/exit the market.

A proper understanding of cost structure hinges on the fundamental distinction between fixed costs and variable costs. Fixed costs can be classified into two categories: (1) committed fixed costs, and (2) discretionary fixed costs. Committed fixed costs are costs associated with investments in basic organizational assets and structure (e.g., depreciation, insurance expenses, property taxes, and administrative salaries). Such costs are long term in nature (several years) and cannot be significantly reduced in the short term even during periods of diminished activity. In contrast, discretionary fixed costs (e.g., advertising, repairs and maintenance, research and development) are short term in nature (one year). Such costs can be altered by current managerial decisions with minimal damage to an organization's long-term goals. As a result, these costs are generally the first to be cut during bad times.

In terms of per unit and total comparisons, fixed costs that are expressed on a per-unit basis will vary inversely with the level of activity. In other words, unitized fixed costs will decrease as volume increases and vice versa. However, in total, fixed costs remain constant within the relevant range. For example, rent will not increase if a factory is working at full capacity or at minimum capacity, or if an outpatient clinic serves one patient or 20 patients daily. The relevant range is the range within which a factory, business, hospital, school, etc. can operate without increasing the size of its operations in the short run. Within this range, assumptions about variable and fixed cost behavior are reasonably valid.

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