Hi everyone, and welcome to all the new joiners!
As you may know, I’m currently a consultant at McKinsey & Co., and during my last project, I worked with the private equity division of a large pension fund. On one of our client calls, a managing director talked about cost structure, operating leverage, and contribution margin.
It inspired me to write this post, as I believe they are very important concepts in business and very useful to analyze and operate companies.
This is part 1 of 3, where I will cover the idea of cost structure. In my next posts, I will go over the concept of operating leverage and contribution margin.
Without further due, let’s dive into it!
Cost Structure
Every business incurs costs in order to operate and generate revenue. This is obvious and you all know this, but what’s interesting is that all costs are not created equal.
To better understand this, we must introduce the idea of “cost structure”, which refers to the various types of expenses a business incurs, and is composed of fixed and variable costs.
When you analyze or operate a business, you must have an understanding of where revenues are going, and how that will impact your margins as the company grows.
Cost structures differ across companies and industries, and can even differ within a company’s own product lines or business units.
Businesses aim to reduce their costs in order to increase their margins (i.e. Gross margin, EBITDA margin). That is essentially why this concept matters - you want to have a clear understanding of how your margins are impacted by your costs, and how they will behave as your revenue grows.
The cost structure is the proportion of Fixed & Variable costs to the total costs.
Variable Costs
Variable costs (VC) are dependent on the company’s outputs and revenues. They are directly linked to how much a company produces or sells - they rise as production increases and fall as production decreases.
Examples of variable costs include direct labor costs, direct material costs, utilities, bonuses and commissions, and marketing expenses.
Think about it this way: for every $1 of revenue you generate, or output your produce, what will be the cost associated with it?
Although they are called “variable” costs, they do not change on a “per unit” basis. VC will usually be the same amount on a per unit basis. The reason why they are called variable is because they vary proportionally to the total level of outputs / revenue.
The graph below illustrates this clearly. Take time to really understand this.
Fixed Costs
Fixed costs (FC) are not directly dependent on the company’s outputs and revenues. They are business expenses that don't change even when there's an increase or decrease in the number of goods and services produced or sold.
Examples of fixed costs include rent, salaries, utility bills, insurance, and loan repayments.
As you can tell from these examples, FC are generally indirect, in that they are not related to a company's production of any goods or services.
Think about it this way: if your business were to generate $0 in revenue and production were to fall to 0, what costs would you be incurring?
Although they are called “fixed” costs, they will vary on a “per unit” basis. FC per unit will decrease as your production level increases due to costs being spread across more units.
The graph below (2) illustrates the relationship between FC and total units produced.
How to think about this
All costs are not created equally.
As a business investor or operator, you must understand where the revenues are going, and how costs are split between fixed are variable.
Start thinking about cost this way from now on. Ask yourself: is this fixed or variable? Does it change with my total unit production or not? Make it an habit.
This was part 1 of 3 on my posts on costs. My next post, will cover the idea of operating leverage, where you will get a better sense of how the cost structure impacts margins.
More from us
If you found this newsletter insightful and want to learn more about business, strategy and investing, give us a follow on Twitter and sign up to our newsletter!