Cost Volume Profit (CVP) Consideration in Choosing a Cost Structure:

Definition and Explanation of Cost Structure:

Cost structure refers to the relative proportion of fixed and variable costs in an organization. An organization often has some latitude in trading off between these two types of costs. For example, fixed investment in automated equipment can reduce variable labor costs.

The purpose of management is to reduce the cost by choosing a blend of fixed and variable costs  that maximizes the ultimate objective i.e.; profit. In this section we discuss the choice of a cost structure.

Cost Structure and Profit Stability:

Which cost structure is better-high variable costs and low fixed costs, or the opposite? No single answer to the question is possible. It depends on specific circumstances that whichever is the ideal structure. For a detailed study about cost structure and profitability consider the example below.

Example:

Given below is the data for companies A and B:

 Company A Company B Amount Percent Amount Percent Sales \$100,000 100% \$100,000 100% Less variable expenses 60,000 60% 30,000 30% ——– ——- ——– —— Contribution margin 40,000 40% 70,000 70% ======= ====== Less fixed expenses 30,000 60,000 ——– ——- Net operating income \$10,000 \$10,000 ====== ======

Companies A and B  undertake agricultural activities. Company A is heavily depending on workers, where as company B is highly mechanized. Company A has high variable costs and company B has high fixed costs. The question that which company has the best cost structure depends on many factors including the long run trend in sales, year to year fluctuations in the level of sales, and the attitude of the owners toward risk. If the sales are expected to be above \$100,000 in future, then company B probably has the better cost structure. The reason is that its contribution margin (CM) ratio is higher, and its profit will increase more rapidly as sales increase. Assume that each company experiences a 10% increase in total sales and the new income statement would be as follows:

 Company A Company B Amount Percent Amount Percent Sales \$110,000 100% \$110,000 100% Less variable expenses 66,000 60% 33,000 30% ——– ——– ——– ——- Contribution margin 44,000 40% 77,000 70% ======= ======= Less fixed expenses 30,000 60,000 ——– ——– Net operating income \$14,000 \$17,000

Company B has experienced a greater operating income due to its higher CM ratio. Even though the increase in sales was the same for both companies. What if sales drop below \$100,000 from time to time? What are the break even points of two forms? What are their margin of safety. The computations needed to answer these questions are carried out below using the contribution margin method:

 Company A: Fixed cost = \$30,000 Contribution margin = 40% Break even in total sales dollars = \$30,000 ÷ 40% = \$75,000 Margin of safety = Total current sales − Break even sales Margin of safety = \$100,000 − \$75,000 = \$25000 Company B: Fixed cost = \$60,000 Contribution margin = 70% Break even in total sales dollars = \$60,000 ÷ 70% = \$85,714 Margin of safety = Total current sales − Break even sales Margin of safety = \$100,000 − \$85,714 = \$14286

This cost analysis makes it clear that company A is less vulnerable to downturns than company B. We can identify two reasons why it is less vulnerable. First, due to its lower fixed expenses, company A has a lower break even point and a higher margin of safety, as shown by the computations above. Therefore it will not incur losses as quickly as company B in periods of sharply declining sales. Second due to its lower contribution margin (CM) ratio, company A will not lose contribution margin as rapidly as company B when sales fall off. We can see a protection when sales decrease but a drawback when sales increase.

Without knowing the future, it is not obvious which cost structure is better. Both have advantages and disadvantages. Company B, with its higher fixed costs, will have wider swing in operating income as changes take place in sales with greater profits in good years and greater losses in bad years. Company A, with its lower fixed and higher variable costs, will enjoy greater stability in net operating income and will be more protected from losses during bad years, but at the cost of lower net operating income in good years.