SLC | S21W6 | Costs for entrepreneurs - Cost structure

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What is a cost structure, and what is its importance for entrepreneurship?

The cost structure is information related to the costs of a business. It is the last step in the business model, but its importance is no less. The importance of cost structure for entrepreneurship is as follows.

Costs are constant factors in any business, while some business models are more cost-driven. Some businesses focus on their cost structure. For example, budget hotels keep their prices low to attract more customers.

However, luxury or posh hotels focus less on cost structure and more on amenities and personalized services. In entrepreneurship, to turn new ideas into reality, it depends on the ability to take risks and manage uncertainty, to identify opportunities, and how to take advantage of them.

Certainly, entrepreneurs increase their economic growth by introducing their products or services, solving problems, and creating new possibilities in the market.

Provide examples of businesses that use the cost structure methods explained; explain your answers.

My Answer

Businesses employ various cost structure methods to enhance their profitability and market positioning. Here are notable examples:

Value-Driven Structure

Advani Oerlikon Ltd. (ADOR): My former company, Advani Oerlikon Fon, operated on a value-driven structure, emphasizing quality and customer experience over low prices. The welding equipment and electrodes multinational invested heavily in premium materials and exceptional service, which justified their higher prices, and even their only international competitor, Larsen, and Toubro, had to follow suit because our customers expect not only the best but also products that gave the best results to their customers, making the cost less of a concern compared to the cheaper products available in the market.

Manufacturing Firm: Delta Communications Ltd

Delta Communications, a manufacturing company in the information technology sector where I used to work as marketing manager, utilized a hybrid cost system, combining fixed and variable costs. For instance, if they incurred fixed costs for their machines while facing variable costs because of fluctuations due to foreign exchange because they imported electronic components from China, Taiwan, and Korea. This flexibility allowed them to adjust according to market demands while maintaining stable operations, keeping control over both cost efficiency and responsiveness.

I guess these are a few examples that illustrate how different cost structures align with distinct business strategies and consumer expectations that can keep profits constant and prices competitive.

However, we can divide product cost based on the following structures:

Fixed Costs: These will always be constant regardless of production volume, including labor and manufacturing overheads.

Variable Costs: There are certain expenses that might fluctuate based on units' production levels, including material, fluctuation supplies, and mediators/commissions to different indirect sources.

Let's keep these points in mind that understanding all this helps us businesses manage production efficiency and keep the pricing strategies effective.

We have yet another point to keep in place, and that is:

Customer Cost Structure

This is important to outline costs related to serving customers, which again consists of:
Fixed Costs: Administrative overhead for customer service and warranty claims.
Variable Costs: Costs incurred for goods sold to customers, sales returns, and any credits issued.

Let's not forget that any business should analyze profitability per customer segment and optimize customer service costs.

Pricing strategies are essential for any business to determine how to price their products or services effectively.

Here are several key pricing strategies, along with explanations and real-world examples:

Cost-Plus Pricing

This strategy involves calculating the total cost of producing a product and adding a markup percentage to determine the selling price. For example, if Delta incurs $500 in production costs and wants a 25% profit margin, the selling price would be $625. This method is straightforward and commonly used in retail settings where costs are predictable.

Penetration Pricing by my former company Delta Communications Ltd.

In this case, a company sets its pricing low at the initial stage while launching a new product to attract customers quickly and gain market share. However, once its product is established and the company gets its desired share of customers, it gradually increases the prices within a competitive limit. Here is an example when my former company, Delta, launched its cash register at a lower price than competitors like TRIX Ltd., which helped it capture the market quickly.

Competitive Price Structure

This strategy involves setting a high price initially for a new product and lowering it over time so you can say it's the other way around as mentioned in penetration pricing.

Competitive Pricing as Adopted by "Make My Trip, the Tours and Travel Giant"

Competitive pricing is perhaps the most followed formula the businesses set their prices because they have to keep their competitors in account. They set their pricing strategies according to the market trend and frequently adjust their prices to remain competitive in the market. In a nutshell, competitive pricing is a strategy followed by companies dealing in seasonal business, for instance, the hospitality and travel industry. This pricing strategy allows businesses to adjust prices based on demand, competitor pricing, and other external factors.

Source

What are the elements of a cost structure? Provide examples

Understanding the elements of a cost structure is essential for businesses to manage expenses effectively and make informed financial decisions. A cost structure typically comprises fixed costs, variable costs, and overhead expenses, which can be analyzed across different dimensions such as product lines, customer segments, and services offered.

Key Elements of Cost Structure

Fixed Costs:

These are expenses that remain constant regardless of the production volume. Examples include:
Rent for office or manufacturing space.
Salaries of permanent staff.
Depreciation on equipment and machinery.

Variable Costs:

These costs fluctuate with the level of production or sales. Examples include:
Direct materials, such as raw materials used in manufacturing (e.g., steel for cars).
Production supplies, which vary depending on the output level.
Sales commissions, which are paid based on sales performance.

Overhead Costs:

These are indirect costs that support overall business operations but cannot be directly attributed to specific products or services. Examples include:
Utilities like electricity and water.

Every business sets a proper plan to keep their expenses within a reasonable limit to manage their business effectively and stay competitive in the market.

Every business has to study its cost structure, which mostly comprises fixed costs, overhead, and variable costs, besides sundry expenses, which no business knows beforehand. Still, they have to bear as per the demand of the occasion. Such expenses might come in the form of raised taxes, transportation hikes, and different other reasons.

I have already given the basic idea but to answer this segment I will keep it brief.

Let's discuss the basic cost structure:

Fixed Costs:

The expenses remain constant no matter the company's current output as long as it is not planning to downgrade its size or production volume.

These expenses might include rent of the establishment or installments/interests for the space owned by the company.

Salaries of permanent staff.

Depreciation on equipment and machinery.

Variable Costs:

In this case, the costs fluctuate according to the production capacity or increase or decrease in sales.

Cost of raw materials
Expenses incurred during transit, commissions
Overhead Costs

There are certain costs that a business needs to spend, but not fixed or indirectly attributed to specific services.

SuppStafftaff

Commission agents, outside taxation or legal consultants, or hired services or outsourcing.

Prepare the cost structure of a business dedicated to making cakes. It has a production of 5 cakes per day and expects to obtain a total profit margin of 25%.

Here is how I have the calculation to establish the cost structure for producing 5 cakes per day with a targeted profit margin of 25%.

I have to keep in account various factors like:

Cost of Goods

Ingredients: Flour, sugar, eggs, butter, frosting, etc.
Packaging:
Labor
Ingredients per cake: $15
Packaging per cake: $3
Labor direct and indirect per cake: $7.50
Overheads $1.50

The total cost for 5 cakes

Ingredients $75
Packaging $15
Labor $37.50
Overheads $7.5
Total Cost = $135
Price per cake = $27

Operating Expenses

Operating expenses are indirect costs that are necessary to run the business but are not directly tied to the production of cakes. These may include:
Rent: For the bakery space $100
Utilities: Electricity, water, gas. $200
Marketing: Advertising costs. $200
Miscellaneous Supplies: Cleaning supplies, maintenance, etc. $100
Total expenses: $600 for 30 days
Expenses per day = $20
We have to make 150 cakes at $27 = $4050

Now to achieve a 25% profit margin, the selling price will have to cover all the elements, the costs of raw material, expenses including overheads, and the profit margin

Revenue Target

Total costs $4050
Profit 25% of Revenue
Revenue Total costs ÷ (1 - Profit Margin)
Revenue $4050 ÷ 0.75 = $5433
Price per cakes = $5433 ÷ 150 = $36.22

Total manufacturing cost

Raw material $27+ Establishment $4 =31 +@25% profit per cake

Price per cakes = $36.22

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