Investors, managers, analysts, and entrepreneurs alike face one of the most difficult aspects of an investment: forecasting the future profitability of a given company. It is not enough to simply increase revenues; in fact, companies with high volumes of sales often experience problems and even bankruptcy because expenses grow at a disproportionate rate compared to revenue. The power of cost structure analysis comes from understanding how costs behave for a given company and utilizing that information to determine expected margins, identify potential for risk, and project future profitability under various assumptions and conditions (for example, seasonal fluctuations).
Analyzing a company’s cost structure entails more than just identifying and summarizing expense items. A cost structure analysis is able to determine the composition of costs as well as their trends over time, identify influences/impacts on income, and how costs and revenues affect each other. When applied correctly, an analysis of a company's costs will provide insight as to the scalability of its business model, the stability of its business in times of economic challenge, and its ability to produce long-term profitability. This article will discuss how a company’s cost structure analysis is a critical component in predicting the future profitability of the company, along with examples of the application of cost structure analysis.
Understanding Cost Structure
A company's cost structure determines how much money it will have to pay for each type of expense in relation to its total operating cost. All types of expenses can be categorized into two broad categories:
Fixed Costs - These are the same amount every month regardless of the volume of production or sales made by the company. Examples of fixed costs are: rent, salary, insurance, depreciation, and long term leases.
Variable Costs - These types of expenses will increase or decrease based on the volume of production or sales made by the company. Variable costs include: raw materials, direct employee wages and commissions, shipping fees and transaction fees.
In addition to fixed and variable costs, there are also mixed costs. Mixed costs contain both fixed and variable cost elements. Examples of mixed costs are: utility bills and performance based compensation to employees.
A company's cost structure has a direct effect on how much profit it will earn as revenue increases or decreases. Two different companies with the same total revenue can have very different amounts of profit due to the way they list their cost structure.
The Link Between Cost Structure and Profitability
Profitability is calculated by subtracting total sales revenue from total expenses. The amount of expenses is relevant, but how those expenses will fluctuate over time is just as important.
A business whose primary expenses are fixed will likely not be able to make a profit (or might even incur losses) until it reaches its sales goals. However, once sales reach that threshold, such businesses can see a rapid increase in profits. A business with a high percentage of variable costs, on the other hand, will usually have more predictable profit margins with limited potential to increase profit margins.
By studying a company's cost structure, analysts can identify:
· Break-even point
· Operating leverage
· Profit margin fluctuations
· Sensitivity to changes in the marketplace
· Ability to grow over time
With this information, analysts can predict not only if a company will be able to realize profit or profit growth, but also the conditions under which that realization will take place.
Fixed Cost and Operating Leverage
The most important aspect of analysing a company’s cost structure is Operating Leverage. Operating Leverage refers to the extent to which operating income is affected by revenue changes.
A company with high fixed costs and low variable costs (e.g., software companies, airlines, manufacturing plants) will generally have a high level of Operating Leverage. That is, when fixed costs are covered, every dollar of revenue increases the company’s profit significantly.
For example:
As part of its business model, a software company would invest substantial amounts in Development and Infrastructure before they generated any revenue. Because serving one more customer incurs almost no cost, an increase in revenue allows for a large increase in profit during the subsequent periods of growth through increasing Margins.
Cost Structure Analysis allows for estimates of a firm’s future profits (i.e., either an expoenntial increase or an incremental increase) and highlights the risk associated with high fixed costs versus the potential for large returns in down economic environments.
Variable Cost and Margin Stability
Retailers, consultants, and transportation companies may have substantially lower Operating Leverage compared to Businesses with a Higher proportion of Fixed Cost; however, since most are structured around Variable Costs, they will have increased Flexibility and, therefore, experience less Risk associated with potential changes in Economic Conditions.
The main characteristics of these types of Businesses are:
- The Cost of doing Business fluctuates with the Volume of Product sold;
- Profitability remains relatively consistent regardless of the amount of Product sold;
- If there is a chance that Sales are going to be lower than originally anticipated, Operating Costs (expenses) can be quickly adjusted accordingly;
- Understanding your Cost Structure is a helpful indicator of Profitability because you can see how your Margin will be resilient during trying times of Economic Distress. Although there may not be Significant Growth in Profits when your Business is experiencing Growth Periods, generally you will be much Better Protected from the Negative Effects of Economic Downturns.
Break -Even Analysis : A Core Predictive Tool
Cost Structure Analysis is the direct application of Break-Even Analysis to determine the point when Total Revenue will match Total Cost. The Break-Even point is where sales equal total costs. A Break Even Analysis allows us to calculate how much revenue the company needs to make a profit, how far away from that point they are currently, and if they change selling prices or variable costs, how it will impact their bottom line.
This information is critical for new businesses or start-ups. A new business may seem unprofitable now, but if they are close to Breaking Even and have a strong cost structure to support their growth, they could become attractive to investors.
Cost Structure and Business Model Quality
The quality and sustainability of a company's business model are represented by its cost structure. Typically, companies with strong business models have at least one of the following characteristics:
• Economies of scale
• High gross margins
• Decreasing unit costs as time goes on
• Good use of fixed expenses to create efficiency
Cost structure analysis can help you determine whether or not the profitability of a company is a result of its structure or if it's simply due to short-term profits as a result of cutting costs. For example, if a company is significantly cutting costs to increase short-term profits, then it may be negatively impacting its ability to compete in the long run. On the other hand, if a company is investing heavily in fixed infrastructure, then it may not appear to be as profitable in the present, but it is likely to expand its margins in the future.
Predicting Profitability Across Growth Stages
Companies' cost structures change as they become more established, and knowing how those cost structures change can help understand how much profit a company may eventually make.
At the pre-startup stage, early-stage companies tend to have higher fixed costs in relation to their revenue than any other type of company; hence, most startups will operate at a loss until their cost structure can be determined. Understanding the cost structure of an early-stage company can help answer key questions such as:
· Are fixed costs building scalable capabilities?
· Will variable costs decline with increased volume?
· Is the break-even point a realistic target?
As revenue increases for established companies, their margins are improving, and as such, companies need to conduct cost structure analysis to determine if they are experiencing the same increase in profitability or if it is the result of increasing costs and declining margins.
For mature companies, performing cost structure analyses is all about controls, efficiencies, and sustaining margins. The information gathered through the analysis will allow us to make reasonable predictions regarding whether mature companies will be able to maintain or improve their profits even in a slowing revenue growth environment.
Cost Structure and Competitive Advantages
A business's cost structure is a powerful source of competitive advantage. A business can achieve an advantage in the marketplace based on their ability to have lower costs per unit, and therefore have the ability to:
- Be more aggressive in pricing
- Withstand competitive pressure
- Invest more in innovation or marketing
- Have the ability to remain profitable in downturns
By analysing the cost structure of competitors, you can understand which competitors are positioned to be profitable over time. Additionally, in highly competitive industries, a small cost advantage can lead to significant profit differentials.
Industry-Specific Cost Structures
Each sector within a given industry has distinct cost structures that can help predict profits accurately; therefore, it is important to understand how each sector's cost structure compares with others'.
The cost structures of various sectors include:
- Technology and Software: High fixed costs, low marginal costs, high scalability.
- Manufacturing: Significant capital expenditures and high levels of fixed and variable costs.
- Retail: High variable Costs; small margins; very reliant on high quantites sold.
- Service Industry: Cost of labor; variable and semi-variable; and costs are largely dependent on each type of service offered.
The analysis of cost structures allows for more even comparison of expectations among sectors, as some types of companies will have higher margins than others depending upon their industry sector.
Forecasting Under Different Scenarios
Scenario planning is a major benefit of analyzing Cost Structures. You can build scenarios that show how costs change with various revenue assumptions, and therefore you can ascertain the expected Profitability with each of those outcomes.
For Example:
What will happen to Profit or Loss if my sales
increase by 20%?
If my revenue declines by 10%, how healthy is my company?
If my input costs increase, by how much do my Margins decrease?
This information is vital to investors and lenders, as well as executives developing strategies under uncertainty.
Cost Structure Analysis for Investors
The Cost Structure Analyse allows Investors to separate companies that earn profits through the superficial appearance of "profit" versus those that have continuing earnings potential.
Investors look at several aspects to understand how to rank an investor on their overall potential for profitability based on the cost structure of that company.
Some of those aspects include:
- Quality of earnings and sustainability durability
- Downside Investment risk exposure through the Economic cycle
- Ability to Expand Margins
- Inflation and Wage Pressure Sensitivity
The stronger a company's Cost Structure is, the more likely Investors will view that company at a higher Premium because its future profits are more predictable and scalable than that of its competition.
Cost Structure Analysis for Management
The cost structure analysis is used by management teams, not merely as a forecasting tool, but rather as a strategic guiding tool for decision-making with respect to: Pricing Strategy, Outsourcing or In-House Production; Capital Investment; Hiring Plan; New Market Expansion. Management can identify the relationship between cost behaviour and desired outcomes (profitability) and establish their plans and expectations in advance of any financial "surprises."
Common Pitfalls in Cost Structure Analysis
While cost structure analysis is a helpful tool, there are a number of ways in which it can be misapplied. Some of the most common pitfalls of cost structure analysis include:
- Not distinguishing between fixed and variable costs is common experience.
- Ignoring long-term cost obligations.
- Ignoring indirect or hidden costs.
- Focusing on short-term cost reductions only.
Dynamic, forward-looking analysis of cost structure is essential for accurate profitability forecasts due to the ways in which costs change over time.
The Strategic Value of Cost Transparency
Companies with a thorough understanding of their own cost structure are more easily able to adapt to changing circumstances. The visibility of their cost structure provides:
An ability to respond quickly to market changes.
Greater confidence when making investment decisions.
A better alignment between a company's strategy and execution.
In addition, from the perspective of those evaluating a company externally, a visible cost structure will provide greater comfort to an analyst or investor regarding the reliability of reported profitability and forecasted profitability.
Conclusion
A cost structure analysis, which displays the cost and revenue streams associated with running a company, is one of the most effective ways to understand the basic economics of your business and to help you predict profitability through understanding how your costs will behave in relation to revenue. In addition, this analysis gives you a deeper understanding of your company's ability to be scalable, the risk you assume in order to achieve such scalability, the potential profit margins available for your Company, and the long-term sustainability of your company's operations.
Your revenue provides an indication of the total amount of sales that your company generates. The
cost structure indicates whether the revenue that you generate translates into long-term profits for your company. Understanding your company's cost structure should be a key component of the decision-making processes for all investors, managers, and entrepreneurs who are evaluating investment or building a business.
In an environment where competition is expanding and the uncertainty is high, the interpretation of Profitability is not only dependent on growth or increasing sales volume but also on how that growth is achieved. An analysis of the cost structure will give you the clarity that you need to forecast, safeguard, and/or improve the profitability of your company.
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