Question

can you please explain to me what is the meaning of cost structure and profit stability? and the operating leverage? can you give an example to these two questions of mine? thank you.

Answer 1

Cost structure- This relates to how the cost of the organisation is split between fixed costs and variable costs. The relative proportion of these two (i.e. Fixed and variable) is referred to as cost structure of the firm. Fixed costs are those that don't increase with increase in revenue whereas variable costs are directly related to revenue of the firm

The cost structure affects the Profit stability by having an impact on the contribution margins and break-even points.

A company with higher fixed costs and lower variable costs would have a higher break-even point but in event of rising sales, the Operating income will also be higher as the per unit cost would be falling as the fixed cost remains the same despite increased production and sales.

On the other hand a company with higher variable costs would have a lower break-even point due to lower fixed costs, however its Operating income would also be lower when sales are rising as the per unit cost would also increase due to increase in variable costs.

Lets look at two scenarios :

1. When sales are rising, Company A is highly mechanised and Company B is depended on its labours.

	Company A		Company B
	Y1	Y2	Y1	Y2
Revenue	1000	1500	1000	1500
Fixed costs	150	150	50	50
Per unit variable costs	100	150	200	300
Operating Income	750	1200	750	1150
Operating income %	75%	80%	75%	76%

The Operating income is higher for company in Y2 as its Fixed costs are higher the increase in variable costs is not as much as that for Company B.

In a fall of sales scenario

	Company A		Company B
	Y1	Y2	Y1	Y2
Revenue	1000	700	1000	700
Fixed costs	150	150	50	50
Per unit variable costs	100	70	200	140
Operating income	750	480	750	510
Operating income %	75%	68.5%	75%	72.8%

Thus when the sales are falling a company which has more Variable costs is less prone to sever losses as the break-even point (which is 50 for Company B is lower) and the variable costs also fall due to lower production

2. Operating leverage

Operating leverage measures how much a firm can increase its operating by increasing its revenue based on the cost structure of the firm.

Formula for degree of operating leverage is :

= (Q * CM) / (Q* CM - Fixed operating costs)

where Q = unit quantity

CM = Contribution margin = Per unit revenue - Per unit variable cost

This will give us what 1% increase in revenue will give how much increase in operating income.

Example. Per unit revenue = $6,

Per unit variable cost= $1

Fixed costs= $1000

Number of units sold= 5000

Degree of operating leverage = 5000* (6-1)/ 5000*(6-1) - 1000

5000*5/ 5000*5 - 1000

= 25000/ 24000 = 1.04

1% increase in revenue will increase operating income by 1.04%

The more we increase fixed costs, the lower our base would be resulting in even higher degree of leverage