Cost Structure in a Business Plan

What is Cost Structure?

Financial projections need to take account of the cost structure of a business. Cost structure simply refers to the split between variable costs and fixed costs, but can have a significant impact on whether a new start up business is successful or not.

 

Fixed and Variable Costs

First a few definitions. A variable cost is a cost which changes in direct proportion to any production or selling activity, examples include, direct materials and labor used in manufacture, product cost, and sales commissions. On the other hand, a fixed cost is a cost which will occur whether or not a business has any production or selling activity. Fixed costs are a function of the passage of time, examples include rent, salaries, and insurance.

To identify a fixed or variable cost ask yourself the question does the cost vary if the business changes its level of production or selling activity? – if the answer is yes then the cost is a variable cost, if the answer is no then the cost is a fixed cost. Further details of variable, fixed and mixed costs can be found in our cost behavior post.

Low Fixed Cost Structure or High Fixed Cost Structure?

Although the cost structure of a business is to some extent fixed by the nature of the business and the type of industry in which it operates, decisions can be taken to directly influence the split between fixed and variable costs. It is important to understand that a business can have the same sales, total costs and therefore profit, but a completely different costs structure, as seen in the diagrams below.

cost structure
 

Both businesses have the same sales, total costs, and profit, however, the first business has a high fixed cost structure compared to the low fixed cost structure of the second business.

Business Plan Cost Structure and Break Even

You may be asking yourself if both businesses make the same profit on the same sales, why does the cost structure matter. The answer to that question can be found by analyzing what happens to the break even point of the business as the cost structure changes.

Consider as an example the two start up businesses shown in the table below. The financial projections of the first business show a high fixed cost structure. the business plans to start by investing heavily in production facilities, machinery and equipment to manufacture and distribute its own product. The consequence of this decision is high fixed costs but lower variable costs.

The second business proposes a lean start up. It plans to have the manufacture and distribution outsourced to a third party, its needs smaller premises and less investment in machinery and equipment and therefore has lower fixed costs but correspondingly higher variable costs, as payments need to be made to the third parties for manufacture and distribution.

Cost Structure Example
Item High Fixed Low Fixed
Product details
Selling price 12.00 12.00
Variable cost 4.80 9.60
Gross margin 7.20 2.40
Gross margin % 60% 20%
Units sold 6,000 6,000
Income Statement
Revenue 72,000 72,000
Variable costs 28,800 57,600
Gross margin 43,200 14,400
Fixed costs 36,200 7,400
Profit 7,000 7,000
Total cost summary
Variable cost 28,800 57,600
Fixed cost 36,200 7,400
Total cost 65,000 65,000

Effect of Cost Structure on Break Even Calculations

In each case, the number of units sold (6,000), selling price (12,00), total costs (65,000), and profits (7,000) are identical. Using this information and the break even formula, the break even point can be calculated for each of the start up businesses.

The break even formula is:

Break even sales = Fixed costs / Gross margin %

and the break even units are given by the formula:

Break even units = Break even sales / Selling price

The results of the calculations using the formulas are summarized in the table below.

Cost Structure and Break Even
Item High Fixed Low Fixed
Break even sales 60,333 37,000
Break even units 5,028 3,083

We can see that even though everything else is the same, the financial structure of the business has resulted in a completely different break even position.

For the low fixed cost structure business, only 3,083 units need to be sold at 12.00 to reach break even,

cost structure low fixed cost
Break even for the low fixed cost structure business

Whereas, for the high fixed cost business 5,028 units need to be sold to reach break even.

cost structure high fixed cost
Break even for the high fixed cost structure business

In order to break even, the high fixed cost business needs to sell 1,945 (63%) more units than the low fixed cost business.

Cost Structure and Break Even
Item High Fixed Low Fixed
Product details
Selling price 12.00 12.00
Variable cost 4.80 9.60
Gross margin 7.20 2.40
Gross margin % 60% 20%
Units sold 5,028 3,083
Income Statement
Revenue 60,333 37,000
Variable costs 24,133 29,600
Gross margin 36,200 7,400
Fixed costs 36,200 7,400
Profit Nil Nil

The conclusion is that when producing financial projections for a start up business, in order to reduce the break even point to an acceptable level, the cost structure should aim to keep the fixed costs as low as possible.

Last modified January 29th, 2019 by Michael Brown

About the Author

Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.

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