Kevin has edited encyclopedias, taught history, and has an MA in Islamic law/finance. He has since founded his own financial advice firm, Newton Analytical.
Depending on how you decide to structure your costs, there could be an impact on net income. In this lesson, we see how to not only affect the net income with cost structure, but also how to track it.
Different Cost Structures
When determining how to price their goods, companies use a variety of different cost structures. Cost structures allow a company to make sure that it is charging a high enough price for its goods to meet all variable costs for that unit and some amount of fixed costs, as well as making a profit.
You may be thinking it's odd that I made a point of saying all variable costs and some amount of fixed costs. The reason is simple - variable costs are those costs that are incurred in producing the unit. For example, if your variable cost to make an ice cream cone was a dollar, then you shouldn't sell it for less! Meanwhile, fixed costs refer to costs that have already been paid. Just because you paid $20,000 for an ice cream truck does not mean that you should make someone pay thousands of dollars for an ice cream sundae.
And, just because you've chosen a cost structure doesn't mean that you can't still influence your costs to be more beneficial. In this lesson we're going to look at how you can influence cost structures through business behavior as well as use a CVP (cost-volume-profit) statement to look at differences.
Influencing Cost Structures
Ultimately, you have to decide whether you want to maximize fixed costs or variable costs. If your cost structure favors the treatment of fixed costs, then you should work to maximize fixed costs while keeping variable costs to a minimum. This is especially true on variable cost pricing, where the final price of the unit can be set just above the variable cost.
Let's say that you run a company that takes travel reservations. Your fixed costs will be higher if you go with an automated system, but without having to pay wages for employees, your variable costs will be lower. As a result, you can set your price lower and hope for increased numbers of sales.
On the other hand, there are pricing strategies that are in place for having a higher variable cost and a lower fixed cost. This is especially true for pull production systems, where everything is custom made. If you run a custom widget company part time, then your variable costs are most of your costs. After all, you have little administrative overhead. As a result, your price will likely still be influenced by variable costs but won't require as much markup.
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We can see the results of this on a CVP statement. This is especially useful for checking to see if prices are set high enough. As a rule, your prices should always cover variable costs. To this end, you should always have a positive contribution margin, or the difference between sales and total variable costs.
However, that's not all. Let's say that you shifted some variable costs to have greater fixed costs. After all, that could result in lower prices. But did it work to get you a greater income? By using the CVP statement, we can compare net incomes between cost structures. If a smaller variable cost has been exchanged for a much larger fixed cost, we can use this sheet to see the difference in net income depending on the number of units sold.
In this lesson, we learned about the impact of a net income's cost structure, which allows a company to make sure that it is charging a high enough price for its goods to meet all variable costs for that unit and some amount of fixed costs, as well as making a profit.
We learned that different cost structures let us set prices depending on how we wanted to structure fixed costs (or costs that have already been paid) versus variable costs (or costs that are incurred in producing the unit). To some degree, companies have the ability to shape these costs, such as in pull production systems where everything is custom made. However, any efforts to manipulate the results are made apparent on the CVP statement, where an attempt to lower variable costs could manifest in lower profits if the fixed cost is still too high.
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