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Cost structures are the different ways a manufacturer can manage an operating budget so that the ratio of fixed costs to variable costs produces the highest profitability. Generally, there are three types of cost structures: production site, process origination, and purchasing structures. Each of these cost structures focuses on a business area where changing the allocation of expenses produces changes in operational efficiency. Typically, a certain type of cost structure is more appropriate for particular types of businesses.
A company's operating budget is made up of fixed and variable costs. Fixed costs are expenses that remain the same every month. An example of a fixed cost is the flat-rate rent paid on a facility under an agreement that spreads the total rent payment out over 12 months in equal installments. This expense is known in advance and is contractually set. It cannot be easily changed to cut costs.
Conversely, variable costs change every month. The company typically has some control over these expenses. For example, employee cell phone charges are a variable expense that changes every month based on use. Managers have the ability to limit this cost by restricting use, and it is a change that can be made immediately.
The management decisions that allow a company to operate with costs that are more or less in the fixed or variable categories comprise its cost structure. There are three general types of cost structures that managers can adopt. Production site cost structures allocate fixed and variable expenses based upon whether there are cost-savings involved in moving a production site to another location, such as offshore. Process origination cost structures look at fixed and variable expenses based upon whether it is more cost efficient to keep manufacturing processes in-house or to outsource them to a third-party specialist.
Purchasing cost structures analyze the fixed and variable expenses involved in the purchase of raw materials. This is one of the most popular cost structures for manufacturers of consumer goods, since the cost of raw materials represents 60 to 80 percent of total operating cost. Managers must often be careful when aligning their operating budgets to fit one of these three structures. Making a move to cut variable expenses can result in strategic disadvantages that have their own expenses attached, such as losing efficiency by moving a plant to a foreign country or creating a more complex distribution system by outsourcing parts of the business.
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