cost structure assignment

Cost Structure: Business Model Canvas Explained

The cost structure is a fundamental component of the business model canvas, a strategic management and entrepreneurial tool that allows businesses to describe, design, challenge, invent, and pivot their business model. The cost structure refers to the total cost a company must incur to operate its business model, create value, deliver value, and generate revenue. This concept is crucial to understanding the financial sustainability and profitability of a business.

Understanding the cost structure of a business model requires a comprehensive analysis of the costs associated with the business's key activities, key resources, and key partnerships. This analysis allows businesses to identify the most cost-intensive areas and to strategize on cost optimization and efficiency . In this article, we will delve into the various aspects of the cost structure, its importance, and how it fits into the business model canvas .

Understanding Cost Structure

The cost structure of a business refers to the types and amounts of costs that a company incurs to operate its business model. These costs can be categorized into fixed costs, variable costs, economies of scale, and economies of scope. Fixed costs are costs that do not change with the level of output or sales, such as rent or salaries. Variable costs, on the other hand, change with the level of output or sales, such as raw materials or direct labor costs.

Economies of scale refer to the cost advantages that a business can achieve by increasing its scale of production, leading to a decrease in per-unit costs. Economies of scope refer to the cost advantages that a business can achieve by producing a wide variety of products or services, leading to a decrease in per-product or per-service costs. Understanding these cost categories allows businesses to strategically manage their costs and improve their profitability.

Fixed Costs

Fixed costs are costs that do not change with the level of output or sales. These costs are incurred regardless of the business's level of activity and are often considered sunk costs because they cannot be recovered once they are incurred. Examples of fixed costs include rent, salaries, insurance, and depreciation. These costs must be paid regardless of the business's revenue or profit levels, making them a critical factor in the business's financial sustainability.

Managing fixed costs is a crucial aspect of strategic cost management . Businesses must carefully consider their fixed costs when designing their business model and pricing their products or services. High fixed costs can create a high break-even point, requiring the business to achieve high sales volumes to cover its costs and become profitable. On the other hand, low fixed costs can allow a business to be profitable at lower sales volumes, providing greater flexibility and resilience.

Variable Costs

Variable costs are costs that change with the level of output or sales. These costs increase as the business's level of activity increases and decrease as the level of activity decreases. Examples of variable costs include raw materials, direct labor costs, and utilities. These costs are directly tied to the business's production or sales volume, making them a critical factor in the business's profitability.

Managing variable costs is another crucial aspect of strategic cost management. Businesses must carefully consider their variable costs when designing their business model and pricing their products or services. High variable costs can erode the business's profit margins, requiring the business to achieve high sales prices to cover its costs and become profitable. On the other hand, low variable costs can allow a business to be profitable at lower sales prices, providing greater competitiveness and profitability.

Cost Structure in the Business Model Canvas

The cost structure is one of the nine building blocks of the business model canvas. It is located on the left side of the canvas, representing the financial aspects of the business model. The cost structure is directly linked to the business's key activities, key resources, and key partnerships, which are also located on the left side of the canvas. This positioning highlights the interdependencies between these building blocks and the cost structure.

The cost structure allows businesses to identify and quantify their most cost-intensive areas, providing a basis for cost optimization and efficiency strategies. By understanding their cost structure, businesses can design a business model that aligns with their strategic objectives and financial capabilities. This alignment is crucial for the business's financial sustainability and profitability.

Link to Key Activities

The cost structure is directly linked to the business's key activities, which are the most important actions a company must take to operate its business model. These activities can include production, problem-solving, platform/network, and more. The cost of these activities constitutes a significant portion of the business's total costs and directly impacts the cost structure.

By understanding the cost of their key activities, businesses can identify cost-intensive areas and strategize on cost optimization and efficiency. This understanding can also inform the business's pricing strategy, as the cost of key activities must be covered by the revenue generated from selling the business's products or services.

Link to Key Resources

The cost structure is also directly linked to the business's key resources, which are the most important assets a company must have to operate its business model. These resources can include physical, intellectual, human, and financial resources. The cost of acquiring, maintaining, and utilizing these resources constitutes a significant portion of the business's total costs and directly impacts the cost structure.

By understanding the cost of their key resources, businesses can identify cost-intensive areas and strategize on cost optimization and efficiency. This understanding can also inform the business's investment strategy, as the cost of key resources must be justified by the value they bring to the business.

Link to Key Partnerships

The cost structure is also directly linked to the business's key partnerships, which are the network of suppliers and partners that make the business model work. These partnerships can include strategic alliances, joint ventures, buyer-supplier relationships, and more. The cost of establishing and maintaining these partnerships constitutes a significant portion of the business's total costs and directly impacts the cost structure.

By understanding the cost of their key partnerships, businesses can identify cost-intensive areas and strategize on cost optimization and efficiency. This understanding can also inform the business's partnership strategy, as the cost of key partnerships must be justified by the value they bring to the business.

Importance of Cost Structure

The cost structure is a critical component of a business's financial health and strategic direction. It determines the business's profitability, competitiveness, and sustainability. A well-understood and well-managed cost structure can provide a business with a competitive advantage, allowing it to offer competitive prices, achieve high profit margins, and sustain its operations in the long term.

The cost structure also provides a basis for strategic decision-making . By understanding their cost structure, businesses can make informed decisions about their business model, pricing strategy, investment strategy, and more. These decisions can have a significant impact on the business's financial performance and strategic direction.

Profitability

The cost structure directly impacts a business's profitability. A business becomes profitable when its total revenue exceeds its total costs. Therefore, managing costs is as important as generating revenue for achieving profitability. By understanding and managing their cost structure, businesses can control their costs, improve their profit margins, and increase their profitability.

Profitability is a key indicator of a business's financial health and success. It is also a key factor in attracting investors, as profitable businesses can provide a return on investment. Therefore, understanding and managing the cost structure is crucial for a business's profitability and financial success.

Competitiveness

The cost structure also impacts a business's competitiveness. Businesses with a low cost structure can offer competitive prices, attracting more customers and gaining market share. On the other hand, businesses with a high cost structure may need to charge higher prices to cover their costs, which can make them less competitive.

Competitiveness is a key factor in a business's market success and growth. It is also a key factor in attracting customers, as competitive businesses can offer better value for money. Therefore, understanding and managing the cost structure is crucial for a business's competitiveness and market success.

Sustainability

The cost structure also impacts a business's sustainability. Businesses with a sustainable cost structure can cover their costs and generate a profit in the long term, ensuring their financial sustainability. On the other hand, businesses with an unsustainable cost structure may struggle to cover their costs and generate a profit, threatening their financial sustainability.

Sustainability is a key factor in a business's long-term success and survival. It is also a key factor in attracting investors, as sustainable businesses can provide a long-term return on investment. Therefore, understanding and managing the cost structure is crucial for a business's sustainability and long-term success.

Strategies for Managing Cost Structure

Managing the cost structure is a strategic task that requires a comprehensive understanding of the business's costs and a strategic approach to cost management. There are several strategies that businesses can use to manage their cost structure, including cost leadership, differentiation, and focus. These strategies can help businesses control their costs, improve their profitability, and achieve their strategic objectives.

Cost leadership involves achieving the lowest cost structure in the industry, allowing the business to offer competitive prices and achieve high profit margins. Differentiation involves offering unique and superior products or services, allowing the business to charge premium prices and achieve high profit margins. Focus involves targeting a specific market segment, allowing the business to optimize its cost structure and pricing strategy for that segment.

Cost Leadership

Cost leadership is a strategy that involves achieving the lowest cost structure in the industry. This strategy requires a focus on efficiency, scale, and cost control. By achieving a low cost structure, businesses can offer competitive prices, attract more customers, and achieve high profit margins.

Cost leadership requires a comprehensive understanding of the business's cost structure and a strategic approach to cost management. This involves identifying cost-intensive areas, implementing cost-saving measures, and monitoring cost performance. By mastering cost leadership, businesses can gain a competitive advantage and achieve financial success.

Differentiation

Differentiation is a strategy that involves offering unique and superior products or services. This strategy requires a focus on innovation, quality, and customer value. By offering differentiated products or services, businesses can charge premium prices, attract more customers, and achieve high profit margins.

Differentiation requires a comprehensive understanding of the business's cost structure and a strategic approach to value creation. This involves identifying value-creating activities, investing in key resources, and delivering superior customer value. By mastering differentiation, businesses can gain a competitive advantage and achieve financial success.

Focus is a strategy that involves targeting a specific market segment. This strategy requires a focus on customer understanding, market insight, and strategic positioning. By targeting a specific market segment, businesses can optimize their cost structure and pricing strategy for that segment, attracting more customers and achieving high profit margins.

Focus requires a comprehensive understanding of the business's cost structure and a strategic approach to market segmentation. This involves identifying profitable market segments, understanding their needs and preferences, and positioning the business to meet those needs and preferences. By mastering focus, businesses can gain a competitive advantage and achieve financial success.

The cost structure is a critical component of the business model canvas and a key factor in a business's financial health and strategic direction. By understanding and managing their cost structure, businesses can control their costs, improve their profitability, and achieve their strategic objectives. This requires a comprehensive understanding of the business's costs and a strategic approach to cost management.

Whether a business chooses to pursue cost leadership, differentiation, or focus, understanding and managing the cost structure is crucial. It allows businesses to make informed decisions about their business model, pricing strategy, investment strategy, and more. Therefore, mastering the cost structure is a key factor in a business's financial success and strategic direction.

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43 Cost Structures

Learning Objectives

• Compare and contrast sample cost structures for company strengths and weaknesses

Your boss just stopped in your office with a flyer for a new piece of equipment that promises to replace ten of your manufacturing employees at a fraction of the cost you are paying now for labor. He is pretty excited about this opportunity and wants you to make the call and get it on order right away! You are hesitant for a few reasons, but the biggest is the huge price tag of $500,000! You need to do some analysis and put together a proposal for your boss showing the pros and cons of this big purchase, along with the effects it may have on your employees. This would be a shift from variable costs, those of the employees and the related costs, to a machine that has only one use. How are you going to prepare this proposal? Let’s first define cost structure and then look at some ideas and options.

How do we define cost structure? The percentage of sales that is related to fixed costs or variable costs is a component of cost structure. Let’s take a look at cost structure defined.

Cost structure refers to the proportion of fixed and variable costs within an organization. Managers may have some control over the proportion based on responsibilities. An example might be an investment in automated equipment that saves variable labor costs. This shifts the cost from a variable cost (labor for production) to a fixed cost (purchase and depreciation of equipment).

Let’s look at how a shift from labor to equipment may look.

Currently, an employee on your manufacturing floor can produce 800 items in a standard 8 hour shift. If your employee costs $25 an hour, then the variable labor cost per item is 25 cents. What if the automated equipment that costs $500,000 can produce 100 items per hour, and has a 10 year life? It can also operate 365 days per year, does not require paid time off, sick leave or insurance, and probably doesn’t complain about working conditions!

In 10 years, this piece of equipment can make 8,760,000 items. You think you are pretty smart because now the cost per item looks like 5.7 cents per item, rather than the 25 cents per item that your employee would cost. Oh, and your employee would probably want some wage increases over that time period as well. Essentially, the way you look at it, this machine will replace roughly 5 employees, and save a ton of money in the long run.

What flaws can you see in your plan? Well, one is a shift from the labor which is a variable expense (you can send your employee home if you aren’t busy), to a fixed cost (the machine is there, and will cost $50,000 a year, whether you make 1 item or 8,760,000 items).

Here are some things to consider as you contemplate a change in cost structure of this type:

• Will this machine be able to make a different item if the item it is designed to make becomes obsolete?
• What is the resale value of this machine if we determine we no longer need it?
• What is the maximum sales we can expect for this item? Just because the machine can make almost 9 million units, doesn’t mean we can sell that many!

Whether to invest in the expensive machine to make your item, or to keep paying the labor costs depend on many factors. Without having a crystal ball, it can be hard to make these decisions. As a manager, it is your job to look at various options and make the best decision for your company.

Business Finance Copyright © by Nicolet College and Ellen Mathein is licensed under a Creative Commons Attribution 4.0 International License , except where otherwise noted.

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What Is The Cost Structure Of A Business Model And Why It Matters

The cost structure is one of the building blocks of a business model . It represents how companies spend most of their resources to keep generating demand for their products and services. The cost structure together with revenue streams, help assess the operational scalability of an organization.

Table of Contents

Why it’s important to know how companies spend money

There are two elements to understand about any company:

• How it makes money.
• How it spends money.

While most people focus on how companies make money. A few truly grasp how those same companies spend money.

However, understanding how companies spend money can give you insights into the economics of their business model .

Thus, once you grasp those two – seemingly simple – elements you’ll understand a good part of the logic behind the company’s current strategy .

Defining and breaking down the cost structure

In the  business model canvas by Alexander Osterwalder , a cost structure is defined as:

What are the most cost in your business? Which key resources/ activities are most expensive?

In other words, the cost structure comprises the key resources a company has to spend to keep generating revenues.

While in accounting terms, the primary costs associated with generating revenues are called COGS (or cost of goods sold).

In business modeling , we want to have a wider view.

In short, all the primary costs that make a business model viable over time are good candidates for that.

Therefore, there is not a single answer.

For instance, if we look at a company like Google, the cost structure will be primarily comprised of traffic acquisition costs, data center costs, R&D costs, and sales and marketing costs.

Why? Because all those costs help Google’s business model keep its competitiveness.

However, if we had to focus on the main cost to keep Google making money we would primarily look at its traffic acquisition costs (you’ll see the example below).

This ingredient is critical as – especially in the tech industry – many people focus too much on the revenue growth of the business.

But they lose sight of the costs involved to run the company and the “price of growth .”

Defined as the money burned to accelerate the rate of growth of a startup.

Too often startups burn all their resources because they’re not able to create a balanced business model , where the cost structure can sustain and generate enough revenues to cover the major expenses and also leave ample profit margins.

Companies like Google have been pretty successful in building up a sustainable business model thanks to their efficient cost structure.

Indeed, from a sustainable cost structure can be built a scalable business model .

Operational scalability

In the Blitzscaling business model canvas , to determine operational scalability, Reid Hoffman asks:

Are your operations sustainable at meeting the demand for your product/service? Are you revenues growing faster than your expenses? 

Blitzscaling is a particular process of massive growth under uncertainty that prioritizes speed over efficiency and focuses on market domination to create a first-scaler advantage in a scenario of high uncertainty.

Reid Hoffman uses the term operational scalability as the ability of a company at generating sustainable demand for its products and services while being profitable.

Indeed, lacking the ability to build operational scalability represents a key growth limiter, and the second key element (together with lack of product/market fit ).

While most startups’ dream is to grow at staggering rates. Growth isn’t easy to manage either.

As if you grow at a fast rate, but you also burn cash at a more rapid rate, chances are your company or startup might be in jeopardy.

That is why a business model that doesn’t make sense from the operational standpoint is doomed to collapse over time!

Cost structure and unit economics

A cost structure is an important component of any business model, as it helps to assess its sustainability over time.

While a startup’s business models, trying to define a new space might not be able to be profitable right away, it’s important to build long-term unit economics.

Google cost structure case study

I know you might think Google is too big of a target to learn any lessons from it.

However, the reason I’m picking Google is that the company (besides its first 2-3 years of operations) was incredibly profitable.

Many startups stress and get hyped on the concept of growth . However, it exists a universe of startups that instead managed to build a sustainable business model .

Google is an example of a company that came out of the ashes of the dot-com bubble thanks to a hugely profitable business model :

To appreciate Google’s business model strength, it is critical to look at its TAC rate .

TAC stands for traffic acquisition costs, and that is a crucial component to balance Google’s business model sustainability.

More precisely the TAC rate tells us the percentage of how Google spends money to acquire traffic, which gets monetized on its search results pages.

For instance, in 2017 Google recorded a TAC rate on Network Members of 71.9% while the Google Properties TAX Rate was 11.6%.

Over the years, Google managed to keep its cost structure extremely efficient, and that is why Google has managed to scale up!

Part of Google’s cost structure is useful for keeping together the set of processes that help the company generate revenues on its search results pages, comprising:

• Server infrastructure: back in the late 1990s when  Google was still in the very initial stage at Stanford, it brought down its internet connection several times, causing several outages. That allowed its founders to understand they needed to build up a robust infrastructure on top of their search tool. Today Google has a massive  IT infrastructure made of various  data centers  around the world.
• Another element to allow Google to stay on top of its game is to keep innovating in the search industry. Maintaining, updating, and innovating Google‘s algorithms isn’t inexpensive. Indeed, in 2021 Google spent billions on R&D .
• The third element is the acquisition of continuous streams of traffic that make Google able to create virtuous cycles and scale up.

How do we judge the ability of Google’s advertising machine ? 

I envisioned a metric called traffic monetization multiple, which is the ability of the company to monetize its traffic: 

As you can notice from the above, this is a purely financial metric, which needs to be balanced out with a qualitative analysis of why the metric increased in the first place. 

Indeed, it’s critical to keep into account these questions: 

• Has monetization increased thanks to an improved UX?  Or is monetization worsening the UX?
• Has monetization improved thanks to an increased customer base? Or has it increased due to higher prices per ad?
• Lastly, how is monetization balanced with legal risks posed by increased tracking? 

All these questions are critical to answer, because, financially Google’s advertising machine seems as strong as ever.

There are hidden risks underlying it, which might, all of a sudden threaten its overall business model. 

• On a positive note, Google has managed to further scale, as a consequence of the pandemic. Thus, bringing its products to hundreds of millions of new users. Yet. this further scale (especially on mobile devices) has created new challenges for the company. Which is finding it harder and harder to properly index a web made of billions and billions of pages, and growing. This poses a threat in the long term, as it might reduce the quality of organic search results.
• To monetize this expanded user base, Google is serving more ads. This might work in the short term to squeeze the advertising machine. But it might make the overall experience bad in the long term. So it’s critical to balance these things out. 
• To further expand its revenues, the company has also increased the price per ad. While, in the short-term, the strategy works, in the long-term, this might substantially reduce the customer base. 

The points above, are some of the things you want to look at, qualitatively, to really understand what’s going on, with the changing cost structure of the company. 

Netflix cost structure case study

When we look at the overall Netflix business model it’s important to understand a couple of things in order to frame its cost structure: 

• The Netflix revenue model .
• And the Netflix capital expenditure. 

Netflix runs an on-demand streaming platform, on top of a subscription service.

Members pay a fixed subscription monthly or yearly price, in exchange for having access to a library of content that continuously updates. 

If Netflix revenues are higher than the cost that it takes to run the platform, then the platform is profitable. 

Is Netflix profitable? It is indeed. However, to understand its cost structure we need to have a deeper look at Netflix’s capital expenditure.

In short, in order for Netflix to keep generating revenues in the long-term, it needs to have a library of content that is guaranteed in the coming 5-10 years.

How can the company do that? 

It can do that by either licensing or producing content.

Those mechanisms have two different dynamics. 

In fact, for most of its life, Netflix has been spending a massive amount of resources to license content and make it available on its platform.

This is the epitome of a platform business model . 

Thus, Netflix invested capital to guarantee a continuous flow of content on top of its platform.

This advanced capital would be repaid back, with revenues coming from memberships.

This also means that for most of its history Netflix run at a negative cash flow cost structure.

Meaning that Netflix had to advance the money needed to license the content.

This money would be recouped many times over, in the long run, as the platform kept growing its members’ base. 

On the other hand, starting in 2013, Netflix started to invest more and more into produced content.

What we know today as “Netflix Originals” or a library of content exclusive to paying members. 

This sort of investment, while similarly, to licensing content, makes Netflix advance the costs of content, which would be recouped over the years.

It also gives the company the ability to freely distribute this content and dispose of this content over the years. 

In conclusion, even though the content production investment doesn’t change the Netflix cost structure in the short term, it will change it in the long run.

Thus, we might expect Netflix to move from a cash flow negative cost structure, to a cash flow positive cost structure as it moves from the platform (investing primarily in licensed content) to a media powerhouse (as investments in produced content pass those in licensed content). 

Thus, what I like to call “the mediafication” of Netflix, will be a key component of its business model advantage, in the long term.

How do we assess the evolution in this process?

This process of “mediafication” started in 2013. And while today, 66% of the content investments on Netflix are still about licensed content, the company is ramping up its investments in owned content, further. 

From a formal standpoint, when new content investments in produced content will pass the license ones, we can officially call Netflix a Media Powerhouse! 

And for now, it’s critical for the company to keep “arbitrating content:”

Amazon cost structure case study

When we look at the overall Amazon business model it’s important to understand a couple of things in order to frame its cost structure: 

• The Amazon revenue model .
• And Amazon’s capital expenditure. 

When it comes to Amazon, in particular, understanding its cost structure is a bit trickier, as the company runs a business model with many moving parts, business units, and cost structures. 

In fact, it’s important to look at Amazon’s business model, according to two perspectives: 

• Amazon e-commerce platform (everything that runs on top and adjacent to Amazon e-commerce).
• And Amazon Enterprise/B2B platform (Amazon AWS). 

When it comes to the Amazon e-commerce platform, its primary mission is to enable variety, low costs, and a great customer experience. 

Thus, Amazon runs it (as a choice) with very tight profit margins. However, this doesn’t give us a complete picture of its e-commerce cost structure.

Indeed, while the Amazon e-commerce platform has tight profit margins, it still runs with a widely positive cash flow structure. 

How? Through its cash conversion cycle:  

In short, Amazon is able to turn its inventories very quickly, get paid quickly by customers, and pay back suppliers with a wider term, thus enabling the company to generate wide cash margins, in the short-term, invested back into the business. 

When instead, we look at Amazon’s Enterprise/B2B platform, Amazon AWS , we need to frame this in a different light:

You can see how over the years Amazon AWS profitability has been running at wide margins. As the infrastructure costs are well paid for, from its revenues. 

This is true also today (2021), where Amazon AWS contributed to 55.5% of the overall Amazon operating margins.

This means, that if you were to spin off Amazon AWS from Amazon’s operations, you would get a much lower operating profit figure. 

Amazon AWS, while also requiring substantial technological investments, for now, it enjoys market dominance (In 2021 Amazon AWS had revenues of over $62 billion, whereas Microsoft Intelligent Cloud, for over $60 billion, and Google Cloud, for over $19 billion) and wide margins, which might last over the next 5 years, as more startups move to AI, as a core paradigm of software companies (Amazon AWS is becoming the leading infrastructure powering up the AI and software industry). 

Spotify’s Cost Structure Analysis Case Study

When we look at Spotify’s cost structure, it’s important to emphasize the difference between the two main revenue streams: 

• Ad-supported:  free users can get unlimited music for free, but they have limited options and features. For instance, before they can skip listening to new songs or podcasts they will have to listen to the advertising. Thus advertising amortized the cost of Spotify to run the platform for free users.
• Premium:  free users are channeled through a self-serving funnel that prompts them to subscribe to the paid service. Thus, enabling Spotify to monetize at wide margins the free platform, once free users become paid subscribers. 

When it comes to cost structure, therefore, it’s worth noticing: 

• The ad-supported business runs at tight margins, and its cost gets amortized with advertising. However, the free platform is used as a self-serving funnel to prompt free users to become paid members. In fact, chances are – if you are a paid member – you were a free user before. In short, being a free user widely increases the chances of becoming a paid member. 
• The premium business, while it has a lower subscriber count, it has much wider margins. Thus, the premium platform widely pays off for the free platform. 

In other words, in this specific case, the cost structure analysis helps us frame the importance of the free platform. 

As if we were to analyze that from the perspective of revenues along, the free platform would not be justified.

In fact, the free platform has tight margins, and it generates costs the more it widens up.

In fact, the more free users on the platform, the more royalties Spotify has to pay back to creators for the streamed content. 

Instead, the free platform needs to be judged beyond revenue generation along. And the cost structure analysis of the premium members helps us assess that. 

The free users’ platform is critical to enhancing Spotify’s sales model, thus increasing the chances of free users becoming paid members.

And it plays a key role to enhance the brand and visibility of Spotify, as a consumer platform. 

In short, chances are that if to become a premium member, you were a free member first.

Therefore, on the one hand, the ad-supported business is key to amplifying the brand of the company.

On the other hand, the ad-supported business is critical to funneling free users into premium members. 

That is why, it’s important to perform bot a revenue model analysis, combined with a cost structure analysis. 

To understand the reasons for running certain business segments, that go beyond revenues alone. 

Apple: how much does an iPhone cost?

Another incredible example, of how a cost structure changes according to a business model, it’s Apple. 

Apple has been among the few companies that managed to build one of the most incredible business platforms of the last fifteen years. 

Indeed, we can argue, that Apple is the major business platform of the last fifteen years (since on Stage, in 2008, Steve Jobs announced the App Store, after having announced it almost a year before the iPhone). 

Of course, when it comes to Apple we can easily argue that its business model depends too much on its iPhone sales and that the company managed to keep its manufacturing costs for the iPhone, by outsourcing most of the manufacture in China, while keeping the design in-house. 

And those are all true facts. 

Yet, Apple is the only company that managed to build such a massive business, at scale, on a device, which turned into a platform. 

This completely affected the company’s cost structure. 

First, let me explain what’s the difference between a product and a platform. 

A product is simply a physical/digital thing that can be exchanged from the company to the customer. 

A platform, instead, is something that goes beyond the physical/digital product itself, and it gains value based on the utility that can grow exponentially, of the underlying product. 

This utility comes from the fact, that other people (developers, and entrepreneurs) can extend and expand the capability of the product to design features and a whole set of applications that final users find compelling.

When the iPhone transformed from a product (in 2007) to a platform (in 2008), that was the turning point. 

You no longer get a commodifiable good, which over time would depreciate. 

Instead, thanks to the fact that the iPhone became de facto the dominating mobile platform of the last fifteen years, it enabled Apple to use a reverse razor strategy . 

In other words, other players had to gain market shares by decreasing the price of their products. 

Apple could keep growing by increasing the price of the iPhone, as its utility (thanks to the App Store) grew. 

This deeply affected Apple’s cost structure. 

Where the company managed to keep its cost of making the iPhone low, while keep increasing its prices, as utility grew.

In addition to that, Apple successfully built a service business, on top of the iPhone, thanks to its market strength. 

The service business further expanded on top of the iPhone dominance and it’s now become among the most important revenue streams for Apple. 

For that, it’s critical to look at the evolution of Apple’s business model . 

Today the App Store represents a 30% tax on the mobile web, which Apple is able to keep cashing out on, thanks to the success of hardware + software (Operating System) + Marketplace (App Store) what today we know as a Business Platform!

Key takeaway

You need to understand two key elements to have insights into how companies  “think” in the current moment.

The first is how they make money.

The second is how they spend money.

When you combine those two elements, you can understand the following:

• How a company really makes money (where is the cash cow, and how and if a company lowers its margins to generate more cash flow for growth ).
• Whether that company is operationally scalable.
• Where the company is headed in the next future and whether it will make sense for it to invest in certain areas rather than others!

In this article, we focused on operational scalability and cost structure, and we saw how Google managed to build an extremely efficient cost structure.

Additional Cost structure examples

Here are some more cost structure examples from a few well-known companies.

According to Statista, Walmart has a total of almost 11,000 stores around the world with a sophisticated and optimized supply chain.

The company benefits from a cost-driven structure characterized by economies of scale and scope, but it nevertheless must meet numerous expenses.

One of the main costs Walmart must absorb is labor. This is no surprise since the company at one point was the third largest employer in the world after the United States and Chinese armed forces.

Employee wages are the main component of the labor costs, but the company’s strong anti-union stance means it is frequently embroiled in various legal disputes over worker rights.

The company also spent $107.1 billion on selling, general, and administrative expenses in 2019 (around 20.5% of total revenue).

Cost of sales for the same period was $385.3 billion, which includes the cost of product transportation, warehousing, and import distribution .

As a premium manufacturer of sports cars, Ferrari utilizes a value-driven cost structure.

While it is difficult to compare exact data, manufacturing relatively bespoke vehicles by hand is more expensive than churning out thousands of the same model on a production line.

Nevertheless, estimates suggest Ferrari only makes about $6,000 in profit for each car that sells for an average price of $200,000.

Ferrari’s main costs are incurred from:

• Raw materials and parts.
• Research and development – this was the company’s most significant expense in 2016 because of expenses associated with its Formula 1 racing team.
• Labor – relatively high compared to less prestigious car brands.
• Advertising, and
• Other – which includes depreciation, overheads, markups, logistics, etc.

Wizz-Air is a Hungarian ultra-low-cost airline carrier that unsurprisingly employs a cost-driven structure to provide the most value to travelers.

Like Walmart, Wizz Air can undercut the vast majority of competition by using economies of scale.

In 2020, for example, it was offering two-hour flights for as little as $21 each way .

Wizz Air can offer these extremely low ticket prices because it chooses to collect a smaller profit from more passengers rather than earning a larger profit on fewer passengers.

This means populating each of the company’s Airbus A320s with as many seats as possible and removing business class altogether.

The aircraft themselves are also turned around as quickly as possible to ensure they spend the maximum amount of time in the air.

The company also minimizes costs with the following initiatives:

• A fleet comprised of one type of aircraft. With staff only required to be trained on one model, costs are reduced.
• Continuous leasing. This means Wizz Air has access to only the most reliable and fuel-efficient models.
• Undesirable flight times. Many of Wizz Air’s flights take off early in the morning or very late at night.
• Basic airport services. Scheduled services also operate in satellite or budget terminals that do not contain lounges or other creature comforts.

Key Highlights

• Cost Structure Overview: The cost structure of a business is a crucial aspect that defines how the company allocates resources to produce and deliver its products or services. It includes both fixed and variable costs that impact the company’s profitability.
• Revenue and Cost Relationship: Understanding how a company makes money (revenue generation) and how it spends money (cost structure) is essential for assessing its financial health and sustainability. The balance between revenue and expenses is a key determinant of profitability.
• Business Model Canvas: The Business Model Canvas, created by Alexander Osterwalder, is a popular tool used to visualize and analyze a company’s business model. It breaks down various components, including cost structure, to provide a holistic view of the business.
• Primary Cost Components: Cost structure comprises several primary cost components, such as labor, materials, overhead, marketing , research and development (R&D), and administrative expenses. These costs can vary significantly across industries and business models.
• Cost of Goods Sold (COGS): COGS represents the direct costs associated with producing or delivering a company’s products or services. It’s a critical cost component in many businesses, particularly in manufacturing and retail.
• Operational Scalability: Operational scalability is the ability of a company to handle increased demand for its offerings without incurring proportionately higher costs. Achieving operational scalability is vital for sustainable growth .
• Balancing Growth and Costs: While rapid growth is a goal for many startups, it’s important to balance growth with cost management. Uncontrolled growth can lead to financial challenges if expenses outpace revenue.
• Unit Economics: Analyzing unit economics involves examining the profitability of each unit (product or service) a company sells. Positive unit economics indicate that a company can generate profits at the unit level, contributing to overall profitability.
• Case Studies: Real-world examples of companies like Google, Netflix, Amazon, Spotify, and Apple are used to illustrate how their unique cost structures have played a critical role in shaping their business models and success.
• Platform Business Models: Some companies, like Apple, have transitioned from traditional product-centric models to platform-centric models. These platforms create ecosystems that drive additional revenue streams, such as app stores and services.
• Long-Term Strategy: Building a sustainable cost structure is essential for long-term success. Companies must ensure that their cost-to-revenue ratios allow for consistent profitability and adapt to changes in the business landscape.
• Market Dominance: Achieving dominance in a specific market, as seen with Amazon Web Services (AWS), can lead to wide profit margins and strong financial performance. Companies that can leverage their market position effectively can enjoy sustainable success.
• Industry-Specific Cost Factors: Different industries and sectors have unique cost factors that impact their cost structures. For instance, airlines like Wizz Air focus on cost optimization to offer low-cost flights to customers.
• Value-Driven and Cost-Driven Models: Businesses can adopt either a value-driven or cost-driven cost structure. Value-driven models emphasize delivering premium products or services, while cost-driven models focus on cost efficiency and affordability.
• Continuous Analysis: Companies should regularly assess their cost structures and adjust them as needed to remain competitive and adapt to changing market conditions.
• Importance of Free Services: Free or freemium services, like Spotify’s ad-supported platform, can serve as acquisition funnels to convert free users into paying customers. These free offerings have costs but contribute to overall revenue.
• Financial Metrics: Key financial metrics like gross margin, net profit margin, and return on investment (ROI) are essential for evaluating the effectiveness of a company’s cost structure.
• Strategic Decision-Making: Cost structure analysis informs strategic decisions, including resource allocation, pricing strategies, and investments in innovation and growth .
• Marketplace and Ecosystems: Building marketplaces and ecosystems, as seen with Apple’s App Store, can create additional revenue streams beyond core product sales.
• Customer Acquisition Costs: Understanding the cost of acquiring new customers is vital for assessing the efficiency of marketing and sales efforts.

Alternatives to the Business Model Canvas

Fourweekmba squared triangle business model.

This framework has been thought for any type of business  model , be it digital or not. It’s a framework to start mind mapping the key components of your business or how it might look as it grows. Here, as usual, what matters is not the framework itself (let’s prevent to fall trap of the  Maslow’s Hammer ), what matters is to have a framework that enables you to hold the key components of your business in your mind, and execute fast to prevent running the business on too many untested assumptions, especially about what customers really want. Any framework that helps us test fast, it’s welcomed in our  business strategy .

An effective  business model  has to focus on two dimensions: the people dimension and the financial dimension. The people dimension will allow you to build a product or service that is 10X better than existing ones and a solid  brand . The financial dimension will help you develop proper  distribution channels  by identifying the people that are willing to pay for your product or service and make it financially sustainable in the long run.

FourWeekMBA VTDF Framework For Tech Business Models

This framework is well suited for all these cases where technology plays a key role in enhancing the  value proposition  for the users and customers. In short, when the company you’re building, analyzing, or looking at is a tech or  platform  business  model , the template below is perfect for the job.

A tech  business model  is made of four main components:  value   model  ( value  propositions,  mission ,  vision ), technological  model  (R&D management),  distribution   model  (sales and  marketing   organizational structure ), and financial  model  (revenue modeling, cost structure, profitability and  cash  generation/management). Those elements coming together can serve as the basis to build a solid tech business  model .

Download The VTDF Framework Template Here

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Additional Resources:

• Successful Types of Business Models You Need to Know
• Business Strategy: Definition, Examples, And Case Studies
• What Is a Business Model Canvas? Business Model Canvas Explained
• Blitzscaling Business Model Innovation Canvas In A Nutshell
• What Is a Value Proposition? Value Proposition Canvas Explained
• What Is a Lean Startup Canvas? Lean Startup Canvas Explained
• What Is Market Segmentation? the Ultimate Guide to Market Segmentation
• Marketing Strategy: Definition, Types, And Examples
• What Is Product-Market Fit? Product-Market Fit In A Nutshell

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Cost Structure

The types and proportions of fixed and variable costs incurred by the business are referred to as a cost structure . Fixed costs are costs that do not fluctuate depending on how much output a company creates, whereas variable costs change depending on how much output it creates. The idea can be clarified in more modest units, for example, result, administration, client, product offering, division, or geographic district. Cost structure is utilized as an apparatus to decide costs, if associations are utilizing an expense based evaluating procedure, just as to feature regions in which expenses may conceivably be diminished or if nothing else exposed to more readily control.

Whether you’re a retailer or a service provider, you’ll have to pay certain expenses to run your firm. As a result, the cost structure idea is only applicable to management accounting and not to financial accounting. Cost structures contrast among retailers and specialist organizations, accordingly the business ledgers showing up on a budget report rely upon the expense objects, like an item, administration, venture, client, or business movement. 

Even inside a corporation, cost structures might differ due to the different sorts of operations performed by product lines, divisions, and business units. The costs of those items that remain constant regardless of the number of goods and services are known as fixed costs. Then again, the variable expenses are such costs which change in relation to the volume of products or administrations. To characterize an expense structure, associations need to characterize each cost brought about comparable to an expense object.

The key elements of the cost structures are as follows:

Product cost structure:

• Fixed costs: Direct labor and manufacturing overheads
• Variable costs: Direct materials, production supplies, commissions, and piece-rate labor

Product line cost structure:

• Fixed costs: Administrative overheads, manufacturing overheads, and direct labor
• Variable costs: Direct materials, production supplies, and commissions

Customer cost structure:

• Fixed costs: Administrative overheads for customer service and warranty claims
• Variable costs: Costs of goods and services sold to customers, as well as sales returns and credits

Service cost structure:

• Fixed costs: Administrative overheads
• Variable costs: Staff wages, bonus, tax deducted at source, travel, and entertainment

A portion of the first expenses can be hard to characterize, so firms may have to execute a movement-based costing undertaking to all the more intently allot expenses for the expense design of the expense object being referred to. The distinction between fixed and variable costs varies by industry. A service provider may have various forms of fixed and variable costs than a manufacturing unit.

• Fixed Costs: Fixed costs occur on a regular basis and are unlikely to change over time. Overhead expenditures like as rent, interest expenditures, property taxes, and depreciation of fixed assets are examples of fixed costs. One special example of a fixed cost is direct labor cost. While direct labor costs vary depending on the number of hours a person works, they are nevertheless reasonably steady and can be categorized as a fixed cost, even if hourly workers are more frequently classed as a variable cost.
• Variable Costs: Variable costs are expenses that change depending on the amount of product produced. Direct labor costs, direct material costs, utilities, bonuses and commissions, and marketing expenses are all examples of variable costs. Fixed costs are more uniform than variable expenses. For organizations selling items, variable expenses may incorporate direct materials, commissions, and piece-rate compensation. For specialist organizations, variable costs are made out of wages, rewards, and travel costs. Costs such as salary and other project expenses are determined by the amount of hours invested in each project in project-based businesses.

For a service provider, a fixed cost for a production unit may become variable. For a manufacturing unit with a set production premise, rent, for example, may be a fixed expense. A service provider, on the other hand, may change offices and godowns based on its needs and requirements. Thus, its lease payout may change each month. The expense structure discloses all expenses brought about to make a plan of action utilitarian. Such expenses can be processed effectively subsequent to deciding distinct advantages, exercises, and organizations. The design can be either cost-driven or esteem driven.

The process of detecting costs spent and then accumulating and assigning them to the appropriate cost objects (e.g., product lines, service lines, projects, departments, business units, and consumers) on a measurable basis is known as cost allocation. Legitimate expense portion is fundamental to recognize and compute the benefits with every item and product offering. An expense pool is a gathering of individual expenses, from which cost designations are made later. Overhead expense, support cost, and other fixed expenses are run of the mill instances of cost pools.

Overpricing will hurt sales and force the company’s items off the market. As a result, the company will lose business to its rivals. Underpricing may boost sales temporarily, but it will eventually cut into earnings. Hence it will lead to erosion of capital. An organization ordinarily utilizes a solitary expense allotment premise, for example, work hours or machine hours, to dispense costs from cost pools to assigned expense objects. Recognizing the expense design and its appropriate assignment additionally helps in discovering which items are generally productive and which are less beneficial.

Knowing the capacity levels associated with the present fixed cost structure can also help a company enhance profits by lowering prices enough to maximize the use of a fixed cost item. Cost-driven plans of action limit costs at every possible opportunity, frequently through a low-value incentive, most extreme computerization, and broad re-appropriating. Though, esteem driven organizations center around a superior incentive regularly with a serious level of customized administration.

Businesses must discover every conceivable opportunity to cut costs in order to increase earnings. While some fixed expenditures are necessary to keep the firm functioning, a financial analyst should always check the financial records to look for potentially excessive spending that add no value to the core business operations. In this manner, a business can then adequately distribute its assets to the creation and offer of more beneficial items. Likewise, an organization can get bits of knowledge on the most proficient method to improve its benefit. It will likewise assist with recognizing the degree to reduce expenses, and it can take restorative choices.

When an analyst understands a company’s whole cost structure, he or she can uncover cost-cutting options that don’t compromise the quality of the items sold or the service provided to customers.  The financial analyst should also maintain a close eye on the cost trend to verify that cash flows are constant and that there are no unexpected expense increases. Businesses can be divided into two groups based on their cost structures:

• Cost-driven: To stay ahead of the competition, some company models only work and prosper by reducing expenses on a regular basis in their day-to-day operations. A good example of this type of business model is low-cost airlines. To keep expenses under control, such organizations minimize costs wherever possible, retain the smallest feasible inventory, offer low-cost services and proposals, and outsource a large number of operations.
• Value-driven: The other type of company believes in offering maximum value to its clients, with price being a secondary consideration. A good illustration of this type of business model is luxury hotels. They provide high-end services and products, as well as luxury and style, as well as a high level of personalization and personalized service.

The part of a monetary examiner is to ensure costs are effectively credited to the assigned expense objects and that proper expense portion bases are picked. Both the fixed expenses, for example, the startup and procurement expenses and variable expenses, for example, the month to month working expenses should be represented. It’s worth noting that the majority of firms throughout the world use a combination of the two cost structures described above. The basic goal of most businesses is to provide value to customers at the lowest possible price.

Information Sources:

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• corporatefinanceinstitute.com
• cleartax.in

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Cost structure: Building a Solid Foundation: Understanding Cost Structures

1. the importance of understanding cost structures, 2. differentiating the two, 3. understanding the difference, 4. finding the right approach, 5. identifying factors that impact costs, 6. maximizing efficiency and minimizing expenses, 7. evaluating the relationship between costs, volume, and profit, 8. exploring variations and trends.

Cost structures are an integral part of any business, regardless of its size or industry. It refers to the breakdown of costs incurred in the production, distribution, and sale of goods or services. Having a clear understanding of cost structures is crucial for businesses as it allows them to make informed decisions about pricing, profitability, and resource allocation. In this section, we will delve deeper into the importance of understanding cost structures and explore some examples, tips, and case studies to highlight its significance.

2. Examples

To better grasp the concept of cost structures, let's consider a few examples. Imagine a small bakery that produces and sells various types of bread. The cost structure of this bakery would include expenses such as ingredients, labor, packaging, utilities, rent, and marketing. By analyzing these costs, the bakery owner can determine the price at which each loaf of bread should be sold to ensure profitability while remaining competitive in the market.

Similarly, let's think about a software development company that creates and sells mobile applications. In this case, the cost structure would involve expenses like salaries for developers, designers, and testers, software licenses, server costs, marketing, and customer support. understanding the cost structure enables the company to assess the viability of each project, allocate resources effectively , and set prices that cover both the development costs and generate a profit.

3. Tips for Understanding Cost Structures

Now that we have explored some examples, let's discuss a few tips to help businesses gain a better understanding of their cost structures:

- Categorize Costs: Start by categorizing costs into fixed and variable . Fixed costs, such as rent or salaries, remain constant regardless of the level of production, while variable costs, like raw materials or shipping fees, fluctuate with production volume. This categorization allows businesses to identify areas where cost reduction or optimization is possible.

- analyze Cost drivers : identify the key factors that drive costs within your business. For instance, in a manufacturing company , the cost of raw materials and labor could be significant drivers. By understanding these cost drivers , businesses can focus on optimizing these areas to improve overall cost efficiency .

- Monitor and Review Regularly: Cost structures are not static and can change over time. It is essential to regularly monitor and review your cost structure to identify any deviations or inefficiencies. This ongoing analysis enables businesses to make necessary adjustments and improvements to maintain profitability.

4. Case Studies

To illustrate the importance of understanding cost structures, let's look at a couple of case studies:

Case Study 1: Company A, a retail clothing store, analyzed its cost structure and identified that the cost of inventory storage and unsold products was a significant expense. By implementing a more efficient inventory management system and offering targeted promotions to clear excess inventory, Company A was able to reduce costs and increase profitability .

Case Study 2: Company B, a consulting firm, realized that the cost of marketing and client acquisition was eating into its profits. By analyzing the cost structure , Company B identified that a significant portion of its marketing budget was being spent on ineffective advertising channels. By reallocating the marketing budget to more successful channels and leveraging referral programs , Company B was able to reduce costs while attracting more high-quality clients.

In conclusion, understanding cost structures is vital for businesses to make informed decisions, optimize resource allocation , and ensure profitability. By categorizing costs, analyzing cost drivers , and regularly monitoring and reviewing the cost structure, businesses can identify areas for improvement and implement strategies to enhance their financial performance .

The Importance of Understanding Cost Structures - Cost structure: Building a Solid Foundation: Understanding Cost Structures

Understanding the different types of costs that make up a company's cost structure is essential for effective financial management . Two key components of cost structure are fixed costs and variable costs. While both types of costs contribute to a company's overall expenses, they differ in nature and behavior, and understanding the distinction between the two is crucial for making informed business decisions .

2. Fixed Costs:

Fixed costs are expenses that remain constant regardless of the level of production or sales volume. These costs are incurred regardless of whether a company is operating at full capacity or not. fixed costs are usually associated with long-term commitments and are not easily influenced by short-term changes in business activity.

Examples of fixed costs include rent or lease payments for office or manufacturing space, salaries of permanent employees, insurance premiums, property taxes, and depreciation of fixed assets. For instance, a manufacturing company with a monthly rent of $5,000 will have to pay that amount regardless of whether it produces 100 units or 1,000 units.

3. Variable Costs:

In contrast to fixed costs, variable costs fluctuate in direct proportion to changes in production or sales volume. These costs vary as the level of business activity changes. Variable costs are typically associated with the direct costs of producing and delivering goods or services .

Examples of variable costs include raw materials, direct labor costs (hourly wages, commissions), packaging materials, transportation costs, and sales commissions. For instance, a bakery's variable costs may include the cost of flour, sugar, eggs, and other ingredients, which increase or decrease based on the number of pastries produced.

4. Tips for managing Fixed and Variable costs :

- Analyze and understand the cost structure of your business: Conduct a thorough analysis of your company's expenses to identify fixed and variable costs . This understanding will help you make strategic decisions regarding cost control and pricing.

- Focus on cost reduction for fixed costs : Since fixed costs are not influenced by short-term changes in business activity, it is crucial to find ways to reduce these costs . Negotiating better lease terms, optimizing staffing levels , or exploring cost-sharing opportunities can help in minimizing fixed costs .

- Monitor and control variable costs : As variable costs directly relate to production or sales volume, closely monitor and control these expenses. Implementing efficient inventory management systems , negotiating better supplier contracts, or exploring automation opportunities can help reduce variable costs .

5. Case Study: XYZ Manufacturing Company

XYZ Manufacturing Company produces electronic components. Its fixed costs include factory rent, salaries of permanent employees, and equipment depreciation, totaling $50,000 per month. On the other hand, variable costs include raw materials, direct labor, and packaging materials, which amount to $10 per unit produced.

To increase profitability, XYZ Manufacturing Company decides to analyze its cost structure . By identifying the fixed and variable costs, the company realizes that reducing the fixed costs could have a significant impact on its bottom line . After renegotiating the factory rent and optimizing staffing levels, XYZ Manufacturing Company successfully reduces its fixed costs by 20%. This cost-saving measure leads to improved profitability and increased competitiveness in the market.

By understanding the difference between fixed costs and variable costs and effectively managing both, businesses can make informed decisions to optimize their cost structure , improve profitability, and achieve long-term financial stability .

Differentiating the Two - Cost structure: Building a Solid Foundation: Understanding Cost Structures

1. Direct Costs:

Direct costs are expenses that can be directly attributed to a specific product, project, or service. These costs are easily identifiable and can be measured accurately. They are directly related to the production or provision of a good or service and are necessary for its completion. Examples of direct costs include raw materials, labor costs directly associated with production, and any costs specifically incurred for a particular project or service.

For instance, let's consider a bakery that produces cakes. The cost of flour, sugar, eggs, and other ingredients used in making the cakes would be considered direct costs. Additionally, the wages paid to the bakers who directly work on the cake production line would also be classified as direct costs.

2. Indirect Costs:

Indirect costs, also known as overhead costs, are expenses that cannot be directly attributed to a specific product or service . These costs are necessary for the overall operation of a business but are not directly tied to the production process. Indirect costs are usually shared among multiple products or services and require allocation methods to be assigned to each.

Some common examples of indirect costs include rent, utilities, administrative salaries, marketing expenses, and general supplies. These costs are incurred to support the overall functioning of a business and are not directly linked to the production or provision of a specific product or service.

3. Understanding the Difference:

Distinguishing between direct and indirect costs is crucial for businesses to accurately assess their cost structures and make informed decisions. By understanding the difference, companies can better allocate resources, determine product pricing, and evaluate profitability.

One useful tip is to categorize costs based on their relationship to the product or service. Direct costs should be directly linked to the production process, while indirect costs should support the overall operation of the business. This classification will provide clarity when analyzing cost structures .

Case Study:

Let's take the example of a software development company. The salaries of the software developers directly involved in building a specific software product would be considered direct costs. On the other hand, the salaries of the HR department or the utilities cost for the office space would be categorized as indirect costs since they support the overall functioning of the company.

Understanding the difference between direct and indirect costs allows the software development company to accurately determine the cost of producing a specific software product and make pricing decisions accordingly. It also helps in identifying areas where cost-saving measures can be implemented, such as reducing indirect costs without compromising the quality of the products or services .

In conclusion, distinguishing between direct and indirect costs is essential for businesses to build a solid cost structure foundation. By accurately categorizing expenses, companies can better allocate resources, evaluate profitability, and make informed decisions to optimize their operations.

Understanding the Difference - Cost structure: Building a Solid Foundation: Understanding Cost Structures

Cost allocation is a crucial aspect of managing a business's finances. It involves distributing expenses across different products, services, or departments to accurately determine their costs. By implementing effective cost allocation methods, businesses can gain insights into their cost structure, make informed decisions, and improve overall profitability. In this section, we will explore various approaches to cost allocation and discuss how businesses can find the right method for their specific needs.

1. direct Cost allocation :

Direct cost allocation involves assigning expenses directly to specific cost objects , such as products or services. This method is relatively straightforward as it attributes costs based on a cause-and-effect relationship. For example, if a manufacturing company produces two different products, the direct costs, such as raw materials and labor, can be easily allocated to each product based on their usage.

2. Step-Down Cost Allocation:

Step-down cost allocation, also known as the sequential method, considers the interdependencies among different departments or cost centers within an organization. It begins by allocating costs from one department to another, followed by further allocations to subsequent departments. This method recognizes that some costs are shared among multiple departments and aims to distribute them in a fair and logical manner. For instance, a hospital may allocate overhead costs from the maintenance department to various patient care departments based on their utilization of maintenance services.

3. activity-Based costing (ABC):

Activity-Based costing is a more complex cost allocation method that takes into account the activities involved in producing a product or delivering a service. It identifies the cost drivers, which are the activities that consume resources, and allocates costs accordingly. ABC provides a more accurate cost allocation by considering the specific factors that influence costs . For example, a software development company using ABC may allocate costs based on the number of lines of code written for each project, as it correlates directly with the effort and resources required.

Tips for choosing the Right Cost allocation Method:

- Understand your business: Analyze your business operations, cost drivers, and objectives to determine which cost allocation method aligns with your needs. Consider factors such as the complexity of your operations, the nature of your products or services, and the availability of data for accurate allocation.

- Balance accuracy and simplicity: While accuracy is crucial, it is important to strike a balance between the complexity of the cost allocation method and its practicality. A highly complex method may consume excessive resources and time, outweighing the benefits gained. evaluate the trade-offs and choose an approach that provides reasonable accuracy without being overly burdensome.

Case Study: XYZ Corporation

XYZ Corporation, a multinational manufacturing company, faced challenges in accurately allocating costs across its numerous product lines. They initially used a direct cost allocation method, but it failed to account for the shared costs among different departments. As a result, some products appeared more profitable than others, leading to suboptimal decision-making.

To address this issue, XYZ Corporation implemented the step-down cost allocation method. By considering the interdependencies among departments, they were able to allocate shared costs more fairly and accurately . This allowed them to make informed decisions regarding product pricing, resource allocation, and profitability analysis. The step-down cost allocation method significantly improved their understanding of the cost structure and helped streamline their operations.

In conclusion, cost allocation methods play a vital role in understanding a business's cost structure and making informed decisions . By choosing the right approach, businesses can allocate costs accurately, gain insights into their operations, and optimize profitability. Whether it's through direct cost allocation, step-down cost allocation, or activity-based costing, finding the most suitable method requires careful analysis of the business's specific needs and objectives.

Finding the Right Approach - Cost structure: Building a Solid Foundation: Understanding Cost Structures

Understanding the various factors that contribute to costs is essential for any business looking to build a solid foundation for its cost structure. By identifying these cost drivers , organizations can gain valuable insights into the root causes of their expenses and make informed decisions to optimize their operations. In this section, we will explore five common cost drivers and discuss how they can impact costs.

1. Volume of Production:

The volume of production is a significant cost driver for many businesses. As the quantity of goods or services produced increases, so do the associated costs. This can be due to higher material and labor requirements, increased energy consumption, or additional overhead expenses. For example, a manufacturing company that experiences a surge in demand may need to invest in more raw materials , hire additional workers, and run production lines for longer hours, all of which can drive up costs.

2. Economies of Scale:

Economies of scale occur when the average cost per unit decreases as production volume increases. This cost driver is particularly relevant for businesses that can benefit from spreading fixed costs over a larger output. For instance, a software development company may need to invest in expensive equipment and infrastructure. However, as they produce more software licenses, the cost per license decreases, resulting in higher profitability.

3. Input Costs:

Input costs refer to the expenses associated with the materials, labor, and resources required to produce goods or services. Fluctuations in input costs can significantly impact a company's overall expenses. For instance, a restaurant heavily reliant on seafood may experience increased costs if there is a shortage in the seafood market or a rise in fuel prices affecting transportation costs. Monitoring and managing input costs is crucial for maintaining a stable cost structure.

4. Technology and Automation:

Technological advancements and automation can both drive costs up and lower them. While the initial investment in technology and automation can be substantial, it can lead to long-term cost savings through increased efficiency and reduced labor requirements. For example, a company that adopts automated machinery can streamline its production processes, minimize human error, and lower labor costs over time.

5. External Factors:

External factors such as changes in government regulations, economic conditions, or market trends can significantly impact costs. For instance, a sudden increase in minimum wage laws can raise labor costs for businesses. Similarly, a recession or inflation can drive up prices of raw materials and utilities. By staying informed about external factors and their potential impact on costs, businesses can proactively adapt their cost structures to mitigate risks.

Tips for Identifying Cost Drivers:

- Regularly review and analyze financial data to identify trends and patterns in expenses.

- conduct thorough cost analysis to determine the specific factors driving costs in different areas of your business.

- Use benchmarking to compare your costs with industry standards and identify areas for improvement.

- Engage with suppliers and negotiate better deals to manage input costs effectively.

- Stay informed about industry-specific trends, economic indicators, and regulatory changes to anticipate potential cost impacts.

Case Study: XYZ Manufacturing Company

XYZ Manufacturing Company, a leading automotive parts manufacturer, identified labor costs as a significant cost driver impacting their profitability. To address this, they implemented lean manufacturing principles and invested in training programs to improve employee efficiency. By streamlining their operations and reducing labor-intensive processes, XYZ Manufacturing Company successfully lowered their labor costs by 15% within a year, significantly improving their cost structure and overall competitiveness in the market.

In conclusion, understanding the various cost drivers that impact a company's expenses is crucial for building a solid cost structure . By identifying factors such as volume of production, economies of scale, input costs, technology, automation, and external influences, businesses can make informed decisions to optimize their operations and enhance profitability. Regular analysis, benchmarking, and proactive management of cost drivers are essential for maintaining a sustainable and competitive cost structure.

Identifying Factors that Impact Costs - Cost structure: Building a Solid Foundation: Understanding Cost Structures

1. identify and eliminate unnecessary expenses : One of the first steps in reducing costs is to thoroughly analyze your business operations and identify any unnecessary expenses. This could include subscriptions or services that are no longer used, excessive office supplies, or inefficient processes that waste time and resources. By eliminating these unnecessary expenses, you can instantly reduce your overall costs.

2. negotiate better deals with suppliers : building strong relationships with your suppliers can often lead to favorable deals and discounts. Regularly review your supplier contracts and negotiate better terms, such as lower prices or longer payment terms. Additionally, consider consolidating your purchasing power by partnering with other businesses to increase your bargaining leverage.

3. Implement energy-efficient practices: Energy costs can be a significant portion of a company's expenses. implementing energy-efficient practices can help reduce these costs while also benefitting the environment. Simple measures such as switching to LED lighting, turning off equipment when not in use, or optimizing temperature control can result in substantial savings over time.

4. automate repetitive tasks : Many businesses waste valuable time and resources on repetitive tasks that could easily be automated. By investing in automation software or tools , you can streamline your operations, reduce human error, and free up your employees' time to focus on more strategic tasks. This can lead to increased productivity and cost savings in the long run.

5. Embrace remote work and flexible schedules: The COVID-19 pandemic has shown us that remote work is not only possible but often more efficient and cost-effective . By allowing employees to work remotely or implementing flexible schedules, you can reduce office space requirements and associated expenses such as rent, utilities, and maintenance. This strategy also increases employee satisfaction and reduces turnover.

6. Conduct regular cost-benefit analyses: It's essential to regularly assess the cost-effectiveness of your business practices. By conducting cost-benefit analyses, you can identify areas where costs can be reduced without sacrificing quality or customer satisfaction. For example, you might find that outsourcing certain functions or investing in new technology can lead to significant cost savings over time.

Case Study: XYZ Company

XYZ Company, a manufacturing firm, implemented several cost reduction strategies to maximize efficiency and minimize expenses . They started by analyzing their operations and identified wasteful processes, such as excessive inventory levels. By implementing just-in-time inventory management , they were able to reduce storage costs and minimize waste. Additionally, they negotiated better deals with their suppliers, resulting in significant cost savings on raw materials.

Furthermore, XYZ Company embraced automation by investing in robotic systems for their production line. This not only increased productivity but also reduced the need for manual labor, leading to substantial cost savings in the long run. They also implemented energy-efficient practices, such as installing solar panels and optimizing their HVAC systems, resulting in lower energy bills.

Overall, these cost reduction strategies allowed XYZ Company to improve their bottom line and remain competitive in the market.

Tips for Success:

- Regularly review your expenses and identify areas for potential cost reduction.

- Foster strong relationships with suppliers to negotiate better deals.

- Embrace technology and automation to streamline operations and reduce human error.

- Encourage a culture of cost-consciousness among employees to identify wasteful practices.

- Continuously monitor and adjust your cost reduction strategies to adapt to changing market conditions .

Remember, cost reduction is an ongoing process that requires constant evaluation and adjustment. By implementing these strategies and continuously seeking opportunities for improvement, you can build a solid foundation for your business's cost structure and ensure long-term success .

Maximizing Efficiency and Minimizing Expenses - Cost structure: Building a Solid Foundation: Understanding Cost Structures

In order to build a solid understanding of cost structures, it is essential to evaluate the relationship between costs, volume, and profit. cost-Volume-profit (CVP) analysis provides a powerful tool for businesses to assess the impact of changes in these variables on their financial performance. By analyzing the interplay between costs, volume of production or sales, and resulting profits, organizations can make informed decisions and optimize their operations. In this section, we will delve into the key aspects of CVP analysis and explore its practical applications.

1. understanding Fixed and Variable costs :

One of the fundamental concepts in CVP analysis is distinguishing between fixed and variable costs. Fixed costs remain constant regardless of the volume of production or sales, such as rent, insurance, and salaries. On the other hand, variable costs fluctuate in direct proportion to the volume, such as raw materials, direct labor, and commissions. By identifying these cost components, businesses can estimate their breakeven point and assess the impact of changes in volume on profitability.

Example: Let's consider a manufacturing company that incurs fixed costs of $10,000 per month and a variable cost per unit of $5. If the selling price per unit is $15, the breakeven point can be calculated as follows: Breakeven Point (in units) = Fixed Costs / (Selling Price per Unit - Variable Cost per Unit) = $10,000 / ($15 - $5) = 1,000 units. This means the company needs to sell 1,000 units to cover all its costs and start generating a profit.

2. contribution Margin and profitability :

The contribution margin is a crucial metric in CVP analysis, representing the amount of revenue available to cover fixed costs and contribute to profit. It can be calculated by subtracting variable costs per unit from the selling price per unit. understanding the contribution margin allows businesses to evaluate the profitability of different products or services and make informed pricing decisions.

Example: Suppose a company sells a product for $50, with variable costs per unit of $30. The contribution margin per unit would be $50 - $30 = $20. If the company sells 1,000 units, the total contribution margin would be $20 * 1,000 = $20,000. This means that the company has $20,000 to cover fixed costs and generate profit.

3. Sensitivity analysis and Decision-making :

CVP analysis provides a framework for conducting sensitivity analysis , which helps businesses understand the impact of changes in cost, volume, or price on their financial results. By performing "what-if" scenarios, organizations can assess the potential outcomes of different decisions and identify the most favorable course of action.

Example: A retail business is considering reducing the selling price of a product from $100 to $80. By using CVP analysis, the company can evaluate the impact on its breakeven point , contribution margin, and overall profitability. If the analysis shows that the decrease in price would result in a significant increase in sales volume , the decision might be favorable despite a potential decrease in profit margin.

Tips for Effective CVP Analysis:

- Ensure accurate cost classification: Properly categorizing costs as fixed or variable is essential for accurate CVP analysis. Review your cost structure regularly to ensure correct allocation.

- Consider multiple scenarios: Conducting sensitivity analysis by exploring various scenarios helps identify risks and opportunities, enabling better decision-making.

- Monitor actual performance: Regularly compare actual results with projected figures to assess the accuracy of your CVP analysis and make necessary adjustments.

Case Study: The success story of a manufacturing company that used cvp analysis to optimize its cost structure and pricing strategy, resulting in increased profitability and market

Evaluating the Relationship between Costs, Volume, and Profit - Cost structure: Building a Solid Foundation: Understanding Cost Structures

The manufacturing industry typically has a high cost structure due to the need for raw materials, labor, and equipment. Companies in this sector often have significant fixed costs, such as factory rent and machinery maintenance, which need to be spread over a large production volume to achieve profitability. Additionally, the cost of sourcing raw materials and transportation can greatly impact the overall cost structure . For example, automobile manufacturers have high fixed costs associated with their production facilities and assembly lines, while also incurring variable costs for components and logistics.

2. Service Industry:

In contrast to the manufacturing industry, the service industry generally has a lower cost structure. service-based businesses , such as consulting firms or software companies, may have minimal raw material costs and lower overhead expenses. Instead, their main costs are often related to employee salaries and professional development. For instance, a consulting firm primarily relies on the expertise and time of its consultants, making labor costs a significant part of their cost structure. However, it's important to note that some service-based businesses may have higher costs due to specialized equipment or technology investments.

3. Retail Industry:

The retail industry encompasses a wide range of businesses, from small local shops to large multinational chains. In this industry, the cost structure can vary depending on the type of retail business. For brick-and-mortar stores , fixed costs such as rent, utilities, and store maintenance can be substantial. On the other hand, e-commerce retailers often have lower fixed costs but higher variable costs associated with website maintenance, online advertising, and shipping. For example, a traditional clothing retailer may have high fixed costs for leasing a prime location, while an online clothing retailer may incur significant marketing expenses to drive traffic to their website .

4. Tech Industry:

The tech industry is known for its unique cost structure, heavily influenced by research and development (R&D) expenses. Companies in this sector invest a significant portion of their revenue into R&D to develop innovative products and stay competitive. These R&D costs can include salaries of engineers, designers, and scientists, as well as prototyping and testing expenses. Tech companies also incur costs related to intellectual property protection and licensing fees. For instance, a software development company may allocate a substantial portion of its budget to R&D activities, while also incurring costs for patent filings and licensing technologies from third parties.

Tips for Analyzing Cost Structures:

1. Conduct a thorough cost analysis: Break down your costs into fixed and variable components to understand the impact of each on your business's profitability.

2. Benchmark against industry peers: Compare your cost structure to that of similar companies in your industry to identify areas where you may be overspending or underutilizing resources.

3. Lean towards automation: Consider automating repetitive tasks or implementing technology solutions to reduce labor costs and improve efficiency.

4. Continuously monitor and adjust: Regularly review your cost structure and make adjustments as needed to adapt to market changes and optimize your operations.

One example of a company with a unique cost structure is Tesla Inc. The electric vehicle manufacturer incurs significant costs related to R&D for its innovative battery technology and autonomous driving features. Additionally, Tesla operates its own network of charging stations, leading to substantial infrastructure and maintenance costs. Despite these high costs, Tesla aims to achieve economies of scale and reduce its cost structure over time by increasing its production volume and improving manufacturing efficiency.

Understanding the cost structure in different industries is crucial for businesses to make informed decisions about pricing , resource allocation, and overall financial sustainability. By analyzing and adapting to industry-specific cost trends, companies can build a solid foundation for long-term success.

Exploring Variations and Trends - Cost structure: Building a Solid Foundation: Understanding Cost Structures

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What Is a Cost Breakdown Structure (CBS) In Project Management?

Manufacturing a product or constructing a building is a complicated process, which in turn makes determining the price for that product equally difficult to discern. There are many factors that must be considered, and project managers use a cost breakdown structure to help them determine the cost of that product.

Using a cost breakdown is essential to developing a sound cost breakdown analysis and selling that product or delivering the project at a profit. This requires an understanding of what a cost breakdown analysis is, what’s included in a cost breakdown structure and how to make one.

What Is Cost Breakdown Analysis?

Cost breakdown analysis is the process of identifying what will determine the price of a product, service or any final project deliverable. Some refer to it as a should-cost analysis. Whatever it’s called, the process finds all the elements that make up the final deliverable and from that determines what it should cost.

This business economics tool allows organizations to tag the price of their product or service by its cost drivers, or the components that make up that final deliverable. This process is part of a larger cost-reduction strategy and provides opportunities for businesses to remain viable and profitable.

The price for the product or service is then developed by using a cost breakdown analysis to figure out how much the product or service costs and then adds the profit margin. This is further broken down into direct and indirect costs. Businesses can’t influence the latter but can have some influence on the former, which includes labor, raw materials and subcontracting.

Once a cost breakdown analysis is complete, it’s important that you stick to that calculation as you execute your project to attain the profitability you figured out. ProjectManager is award-winning project management software with powerful Gantt charts that manage and track your resources and costs to help you keep on budget. Once you set a baseline, your plan is captured and compared to your actual progress. This allows you to track project variance in real time. If there’s a discrepancy, you can respond quickly and stay on track. Get started with ProjectManager today for free.

What Is a Cost Breakdown Structure?

To conduct a cost breakdown analysis, you need a cost breakdown structure (CBS), which is a hierarchical map of the costs in your project. The cost breakdown structure works off a work breakdown structure (WBS) , which is also a hierarchical chart, but it maps project deliverables and tasks, by determining the costs of those deliverables and tasks.

A cost breakdown structure is a vital tool when managing the financial aspects of a project and helps to not only create a project estimate but also how to create measurable cost controls. Project managers use this tool to help them manage the project’s life cycle, specifically the financial elements.

Oddly, cost breakdown structures often aren’t included in project management and scheduling, while the WBS is a fundamental part of project scheduling. But the two are complementary and should be used together to identify all project deliverables and costs. Using a CBS allows project managers to track change orders , revisions and transfers, contingencies, variance and more.

What Costs Might Be Included in a Cost Breakdown Structure?

In general, there are four types of costs essential to creating a thorough cost breakdown structure: labor, material, equipment and overhead costs. Let’s explore each and why they’re important to CBS.

Labor Costs

Labor costs are the money spent on the people who will execute the project . These are direct costs in that they’re costs that can be directly tied to the production of a product or service. Labor costs are broken down into categories such as service or manufacturing. A rate is then attributed to each category of labor as well as the hours worked. Labor costs are easy to identify and, therefore, the first focus of cost reduction.

Material Costs

Any materials that are bought by the business fall under material costs. Some examples of material costs include raw materials, parts and components and manufacturing supplies. But it isn’t only tangible items that fall under material costs; also included are expenses for insurance and freight. When accounting, separate direct from indirect material costs by thinking of direct materials as having one cost objective, while indirect materials have multiple cost objectives.

Equipment Costs

While some fold equipment costs in with material costs, it’s better to separate them as a distinct line item as you’re working on your cost breakdown structure. Yes, parts and components are considered material costs, but the actual equipment that you’re using falls under this cost category. If you prefer, you can pull out the parts and components that are directly related to the equipment and list them here, leaving the parts and components used in manufacturing your products under materials.

Overhead Costs

Overhead costs are considered hidden costs as they’re ongoing expenses that aren’t directly allocated to a specific cost. While they might not contribute to profits, they’re part of the larger project activities. Overhead costs are those costs that are part of running the business or organization such as office space, utilities, benefits, taxes and so on.

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Cost Breakdown Structure vs. Work Breakdown Structure

We’ve already touched on the difference between a cost breakdown structure and a work breakdown structure , but it’s an important distinction that requires more detail. Clearly, the cost breakdown structure represents the costs of all the parts of the work breakdown structure.

The work breakdown structure defines the project deliverables and in so doing decomposes the work that must be completed by the project team. The work breakdown structure is done by the project team, but the cost breakdown structure is within the purview of the finance or commercial department of an organization.

The cost breakdown structure and the work breakdown structure are used together, as noted, but the work breakdown structure is project-specific and a cost breakdown structure can be used across a portfolio of projects.

Cost Breakdown Structure vs. Resource Breakdown Structure

We’ve explained a cost breakdown structure, but how does it compare to a resource breakdown structure (RBS) ? For one, a resource breakdown structure is a list of resources, not costs. It identifies all the resources that will be needed to execute the project.

A resource breakdown structure defines each resource by its function and types. This includes the people who will execute the project. In fact, resources tend to be anything that costs money in a project.

Therefore, there’s a common link between the cost breakdown structure and the resource breakdown structure in that the RBS collects resources such as people (labor), management tools (equipment), materials and more.

How to Make a Cost Breakdown Structure

It should be clear that a cost breakdown structure is an important part of your project planning and scheduling process. The work isn’t overly difficult and you’re already doing much of it with other breakdown structures that are part of normal project management techniques. Follow these steps to make a cost breakdown structure.

1. Create a Work Breakdown Structure (WBS)

As noted, the work breakdown structure is part of creating a cost breakdown structure. You’re probably already making one to identify your deliverables and tasks that are necessary to complete them. Use the work breakdown structure to see the entire project on one chart . Everything you have to do is outlined so determine which of those pieces are going to contribute to the cost of the project.

Related: Free Work Breakdown Structure Template for Excel

2. Identify Costs for Each Project Task

Once you’ve outlined the project activities, you need to estimate how much they’ll cost. You can break these costs into labor or direct costs, as well as materials, equipment, overhead, etc. To get the most accurate estimate possible, you’ll want to use cost estimation techniques . Once you have accurately estimated the costs of all these items then you’ll have the final cost for your project.

3. Define a Contingency Margin

No matter how careful you are, estimates are just that, estimates. You need to build in a cushion if your estimates are off and factor in changes that could impact the project costs. That’s called a contingency margin. Take into account your overhead, direct and indirect costs, and administrative costs and provide enough wiggle room to get through the project without negatively impacting your budget .

This free project budget template for Excel allows you to list down all the costs related to project resources such as labor, materials, equipment rental and other cost categories you might need to add. The best part is that you can compare your cost estimates against actual costs once the execution phase starts.

Cost Breakdown Structure Example

Let’s look at a more concrete cost breakdown structure by applying it to an example. Suppose we’re making a dog house for a friend who said they would pay us for the work. The first thing we’d have to do is create a work breakdown structure with the finished dog house on top and the assembling of lumber, use of nails, hammers, glue and other materials.

Once we have those items listed, we can start to estimate costs . We figure the wood costs $20, the nails and glue another $5, and the equipment we have, so that’ll get folded into our labor. It should take us two hours from getting the materials to finish the project. Our labor is $25 an hour. We’ll add an extra $5 for our contingency margin. That gives us a total of $80, plus a $20 profit for a grand total of $100.

ProjectManager Helps With Cost Tracking

Naturally, your projects are going to be vastly different and more complicated than the cost breakdown example above. That’s why you need project management software. ProjectManager is award-winning project management software that helps you manage and track your project costs in real time. Our robust Gantt charts help you plan and schedule your resources with a work breakdown structure that adjusts automatically as you create tasks and summary tasks.

Get a High-Level View of Project Costs

Once you’ve done all the work with a cost breakdown structure, you want to make sure those costs are sticking to the plan. The only way to do this is by monitoring and controlling your project. You can toggle to our real-time dashboard at any time to get a high-level view of the project’s progress and performance. Our software collects the data automatically and displays metrics such as cost, workload and more in easy-to-read graphs and charts. Unlike lightweight software, there’s no time-consuming setup. It’s ready when you need it.

Generate Customizable Reports for More Details

When you need more information than you can get from the live dashboard, use our reporting features . You can create a report with a keystroke on project status or portfolio status if you’re managing more than one project. There are also reports on timesheets, tasks and more. All reports can be filtered to show only the data you want to see. Then they can be easily shared in a variety of formats with stakeholders to keep them updated.

More than just monitoring your costs, you can manage them, too. Our software gives you task management, resource management and risk management features that help you control your costs to deliver a successful project.

ProjectManager is online project management software that empowers teams to plan, manage and track projects in real time. Our resource and cost-tracking tools make it easier for you to keep to your budget and deliver a project on time. Join teams at companies as diverse as Avis, Nestle and Siemens who use our software to deliver success. Get started with ProjectManager today for free.

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Cost becomes one of the essential elements in a company’s financial statements. Understanding the concept of cost structure is very important for the company. If the business can be controlled well, the industry’s impact will get maximum profit.

Of course, product development, product sales, customer relationships, and after-sales service all cost money. You can easily calculate the costs if you understand the primary resources, the main activities, and the primary partnerships. 

Costs usually include fixed and variable costs. No matter how many products are produced, fixed costs are understood as fixed costs. For example, fixed costs are building rent, permanent employee salaries, and more.

In addition, this cost structure is commonly known as the method of controlling production costs. The primary purpose of this structure is to obtain planning and decision-making in a business.

Understand more in terms, types, and elements, of how to allocate cost structure below. After understanding more, refine cost components and improve more efficient business control. For example, you can control your company’s procurement costs with HashMicro’s Purchasing System .

Table of Contents

What is cost structure, types of cost structure analysis, what are the elements of cost structure, cost structure-function for the company, examples of cost structure allocation.

The cost structure incurred in producing and marketing goods and services. The cost structure will explain all the business’s costs to operate.

Companies in cost structure refer to the different costs incurred, generally consisting of fixed and variable costs. Fixed costs remain constant regardless of the amount of output a company produces, whereas variable costs vary according to production volume.

Therefore, expenses in a company’s financial statements depend on the products or services sold, projects or activities held, company customers, and other business activities. Even within a company, the spending pattern can vary between product lines, divisions, or business units, because the types of activities that businesses do are different.

Different types of cost activities occur in the cost structure; Here are some types of cost structures:

Fixed types of cost

A flat fee is a type of cost that does not change in proportion to the number of goods or services a company produces. In other words, these costs will remain constant regardless of the number of goods or services produced.

The fixed cost has a fixed amount, but that amount will not always be the same. These costs may change in the future. A simple illustration is the cost of renting a building. Although this cost is arguably fixed and constant, it can change at any time based on the building owner’s wishes.

This means that costs will remain constant over the current period and may increase or decrease in the next period. However, these changes usually occur over a more extended period.

Examples of fixed costs are depreciation, insurance, salaries, rental, and more.

Variable costs

Unlike fixed costs, variable costs change as the number of products produced changes. The higher the production, the higher the variable cost. Also, the lower the production, the lower the number of variable costs.

Examples of variable costs are raw materials, product packaging costs, shipping cargo costs, wholesale employee wage costs, etc. 

Allocating costs

Cost allocation is analyzing and collecting costs that arise to perform cost objects more precisely. Examples include well-structured products, projects, departments, business units, and consumers.

After that, the company will generally use this cost allocation to perform those costs according to the activities of different cost objects to achieve calculations and profits. 

A cost pool is a distinct set of costs for which the company must make the next cost allocation. Simple examples of collecting these costs include overheads, maintenance, and other flat expenses. Typically, businesses allocate costs from the cost pool to a designated cost object using a single cost allocation basis, such as working hours or machine hours.

Optimize inventory levels, monitor stock transfer processes, estimate inventory needs, and effective stock management with HashMicro’s integrated Inventory Management System .

The following are some examples of production expenditure structure elements:

Customer cost structure

• A flat fee is an additional administrative fee for customer service and warranty claims. 
• Variable costs are the cost of the goods and services you sell to customers, the return on sales, and the credit notes you receive.

Product cost structure

• Fixed costs are divided into direct labor costs and factory overhead costs. 
• Variable costs are divided into direct materials, production equipment, costs, and cutwork.

Service cost structure

• Fixed costs, including additional management fees.
• Variable costs include employee salaries, bonuses, tax credits withholding taxes, travel, and entertainment.

The cost structure of the product line

• Fixed costs have administrative costs, production costs, and direct labor. 
• Variable costs include direct materials, manufacturing equipment, and commissions. You may need to map these costs from various activities to the cost structure of a specific object.

The business’s cost structure is fundamental, especially for the finance division. Generally, determine this cost by using fixed and variable cost elements.

Given that this is related to the business’s financial health, then it should be that every company can make a cost structure. Because, by utilizing an expenditure structure, the company will be able to control various divisions and make efficient spending efforts in the future.

After discussing the cost structure of a business, you now have a basic understanding of financing and its various forms. Arrange and choose the rules for multiple activities intelligently and carefully. Budget management can help your business become more efficient and reduce the risk of loss.

With the collection of costs, the production overhead cost uses direct working hours to calculate cost allocation.

At first, the business will undoubtedly accumulate the company’s overhead costs over time.

For example, in one year, the total overhead costs are divided by the total hours worked to determine overhead costs, i.e., cost per hour or allocation rate.

Thus, the business will double the hourly cost by the number of hours worked in producing the product to arrive at a specific overhead cost.

To optimize the company’s revenue, you should look for as many steps as possible to minimize cost structure. In addition, since fixed costs are essential for a company’s operations, a person with financial analytical skills should monitor financial statements.

The financial statements should show whether there is a possibility of high costs and whether an economic activity is making a profit or not. Meanwhile, a financial analyst familiar with the structure of production costs must find a way to reduce costs without implying product quality.

Thus, businesses can use this analysis to monitor cost trends to ensure that stable cash flow and unexpected cost increases do not occur or are minimal. The cost allocation function can help an analyst to be able to calculate the cost per unit based on some product, business unit, or department, until knowing the profit per unit.

Automate cash flow management, financial statement generation, bank reconciliation, adjustment journals, invoice creation, and more with our accounting software . Whether you’re a large enterprise or a small business, HashMicro’s accounting software is tailored to scale alongside your business. Our budget management feature efficiently handles budget management tasks and establishes approval matrices based on available budgets. Click here to explore our free demo today!

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What Is Cost Accounting?

Understanding cost accounting.

• Cost vs. Financial Accounting
• Cost Accounting FAQs

The Bottom Line

• Corporate Finance

Cost Accounting: Definition and Types With Examples

Yarilet Perez is an experienced multimedia journalist and fact-checker with a Master of Science in Journalism. She has worked in multiple cities covering breaking news, politics, education, and more. Her expertise is in personal finance and investing, and real estate.

• Accounting Explained With Brief History and Modern Job Requirements
• Accounting Equation
• Current and Noncurrent Assets
• Accounting Theory
• Accounting Principles
• Accounting Standard
• Accounting Convention
• Accounting Policies
• Principles-Based vs. Rules-Based Accounting
• Accounting Method
• Accrual Accounting
• Cash Accounting
• Accrual Accounting vs. Cash Basis Accounting
• Financial Accounting Standards Board (FASB)
• Generally Accepted Accounting Principles (GAAP)
• International Financial Reporting Standards (IFRS)
• IFRS vs. GAAP
• US Accounting vs. International Accounting
• Understanding the Cash Flow Statement
• Breaking Down The Balance Sheet
• Understanding the Income Statement
• Financial Accounting
• Financial Accounting and Decision-Making
• Financial vs. Managerial Accounting
• Cost Accounting CURRENT ARTICLE
• Certified Public Accountant (CPA)
• Chartered Accountant (CA)
• Accountant vs. Financial Planner
• Tax Accounting
• Forensic Accounting
• Chart of Accounts (COA)
• Double Entry
• Closing Entry
• Introduction to Accounting Information Systems
• Inventory Accounting
• Last In, First Out (LIFO)
• First In, First Out (FIFO)
• Average Cost Method

Cost accounting is a form of managerial accounting that aims to capture a company's total cost of production by assessing the variable costs of each step of production as well as fixed costs, such as a lease expense.

Cost accounting is not GAAP-compliant , and can only be used for internal purposes.

Key Takeaways

• Cost accounting is used internally by management in order to make fully informed business decisions.
• Unlike financial accounting, which provides information to external financial statement users, cost accounting is not required to adhere to set standards and can be flexible to meet the particular needs of management.
• As such, cost accounting cannot be used on official financial statements and is not GAAP-compliant.
• Cost accounting considers all input costs associated with production, including both variable and fixed costs.
• Types of cost accounting include standard costing, activity-based costing, lean accounting, and marginal costing.

Investopedia / Theresa Chiechi

Cost accounting is used by a company's internal management team to identify all variable and fixed costs associated with the production process. It will first measure and record these costs individually, then compare input costs to output results to aid in measuring financial performance and making future business decisions. There are many types of costs involved in cost accounting , each performing its own function for the accountant.

Types of Costs

• Fixed costs are costs that don't vary depending on the level of production. These are usually things like the mortgage or lease payment on a building or a piece of equipment that is depreciated at a fixed monthly rate. An increase or decrease in production levels would cause no change in these costs.
• Variable costs are costs tied to a company's level of production. For example, a floral shop ramping up its floral arrangement inventory for Valentine's Day will incur higher costs when it purchases an increased number of flowers from the local nursery or garden center.
• Operating costs are costs associated with the day-to-day operations of a business. These costs can be either fixed or variable depending on the unique situation.
• Direct costs are costs specifically related to producing a product. If a coffee roaster spends five hours roasting coffee, the direct costs of the finished product include the labor hours of the roaster and the cost of the coffee beans.
• Indirect costs are costs that cannot be directly linked to a product. In the coffee roaster example, the energy cost to heat the roaster would be indirect because it is inexact and difficult to trace to individual products.

Cost Accounting vs. Financial Accounting

While cost accounting is often used by management within a company to aid in decision-making, financial accounting is what outside investors or creditors typically see. Financial accounting presents a company's financial position and performance to external sources through financial statements , which include information about its revenues , expenses , assets , and liabilities . Cost accounting can be most beneficial as a tool for management in budgeting and in setting up cost-control programs, which can improve net margins for the company in the future.

One key difference between cost accounting and financial accounting is that, while in financial accounting the cost is classified depending on the type of transaction, cost accounting classifies costs according to the information needs of the management. Cost accounting, because it is used as an internal tool by management, does not have to meet any specific standard such as  generally accepted accounting principles (GAAP) and, as a result, varies in use from company to company or department to department.

Cost-accounting methods are typically not useful for figuring out tax liabilities, which means that cost accounting cannot provide a complete analysis of a company's true costs. 

Types of Cost Accounting

Standard costing.

Standard costing assigns "standard" costs, rather than actual costs, to its cost of goods sold (COGS) and inventory. The standard costs are based on the efficient use of labor and materials to produce the good or service under standard operating conditions, and they are essentially the budgeted amount. Even though standard costs are assigned to the goods, the company still has to pay actual costs. Assessing the difference between the standard (efficient) cost and the actual cost incurred is called variance analysis.

If the variance analysis determines that actual costs are higher than expected, the variance is unfavorable. If it determines the actual costs are lower than expected, the variance is favorable. Two factors can contribute to a favorable or unfavorable variance. There is the cost of the input, such as the cost of labor and materials. This is considered to be a rate variance.

Additionally, there is the efficiency or quantity of the input used. This is considered to be a volume variance. If, for example, XYZ company expected to produce 400 widgets in a period but ended up producing 500 widgets, the cost of materials would be higher due to the total quantity produced.

Activity-Based Costing

Activity-based costing (ABC) identifies overhead costs from each department and assigns them to specific cost objects, such as goods or services. The ABC system of cost accounting is based on activities, which refer to any event, unit of work, or task with a specific goal, such as setting up machines for production, designing products, distributing finished goods, or operating machines. These activities are also considered to be cost drivers , and they are the measures used as the basis for allocating overhead costs .

Traditionally, overhead costs are assigned based on one generic measure, such as machine hours. Under ABC, an activity analysis is performed where appropriate measures are identified as the cost drivers. As a result, ABC tends to be much more accurate and helpful when it comes to managers reviewing the cost and profitability of their company's specific services or products.

For example, cost accountants using ABC might pass out a survey to production-line employees who will then account for the amount of time they spend on different tasks. The costs of these specific activities are only assigned to the goods or services that used the activity. This gives management a better idea of where exactly the time and money are being spent.

To illustrate this, assume a company produces both trinkets and widgets. The trinkets are very labor-intensive and require quite a bit of hands-on effort from the production staff. The production of widgets is automated, and it mostly consists of putting the raw material in a machine and waiting many hours for the finished good. It would not make sense to use machine hours to allocate overhead to both items because the trinkets hardly used any machine hours. Under ABC, the trinkets are assigned more overhead related to labor and the widgets are assigned more overhead related to machine use.

Lean Accounting

The main goal of lean accounting is to improve financial management practices within an organization. Lean accounting is an extension of the philosophy of lean manufacturing and production, which has the stated intention of minimizing waste while optimizing productivity. For example, if an accounting department is able to cut down on wasted time, employees can focus that saved time more productively on value-added tasks.

When using lean accounting, traditional costing methods are replaced by value-based pricing  and lean-focused performance measurements. Financial decision-making is based on the impact on the company's total value stream profitability. Value streams are the profit centers of a company, which is any branch or division that directly adds to its bottom-line profitability.

Marginal Costing

Marginal costing (sometimes called cost-volume-profit analysis ) is the impact on the cost of a product by adding one additional unit into production. It is useful for short-term economic decisions. Marginal costing can help management identify the impact of varying levels of costs and volume on operating profit. This type of analysis can be used by management to gain insight into potentially profitable new products, sales prices to establish for existing products, and the impact of marketing campaigns.

The  break-even point —which is the production level where total revenue for a product equals total expense —is calculated as the total fixed costs of a company divided by its contribution margin. The contribution margin , calculated as the sales revenue minus variable costs, can also be calculated on a per-unit basis in order to determine the extent to which a specific product contributes to the overall profit of the company.

History of Cost Accounting

Scholars believe that cost accounting was first developed during the  industrial revolution  when the emerging economics of industrial supply and demand forced manufacturers to start tracking their fixed and variable expenses in order to optimize their production processes.

Cost accounting allowed railroad and steel companies to control costs and become more efficient. By the beginning of the 20th century, cost accounting had become a widely covered topic in the literature on business management.

How Does Cost Accounting Differ From Traditional Accounting Methods?

In contrast to general accounting or financial accounting, the cost-accounting method is an internally focused, firm-specific system used to implement  cost controls . Cost accounting can be much more flexible and specific, particularly when it comes to the subdivision of costs and inventory valuation. Cost-accounting methods and techniques will vary from firm to firm and can become quite complex.

Why Is Cost Accounting Used?

Cost accounting is helpful because it can identify where a company is spending its money, how much it earns, and where money is being lost. Cost accounting aims to report, analyze, and lead to the improvement of internal cost controls and efficiency. Even though companies cannot use cost-accounting figures in their financial statements or for tax purposes, they are crucial for internal controls.

Which Types of Costs Go Into Cost Accounting?

These will vary from industry to industry and firm to firm, however certain cost categories will typically be included (some of which may overlap), such as direct costs, indirect costs, variable costs, fixed costs, and operating costs.

What Are Some Advantages of Cost Accounting?

Since cost-accounting methods are developed by and tailored to a specific firm, they are highly customizable and adaptable. Managers appreciate cost accounting because it can be adapted, tinkered with, and implemented according to the changing needs of the business. Unlike the  Financial Accounting Standards Board (FASB)-driven financial accounting, cost accounting need only concern itself with insider eyes and internal purposes. Management can analyze information based on criteria that it specifically values, which guides how prices are set, resources are distributed, capital is raised, and risks are assumed.

What Are Some Drawbacks of Cost Accounting?

Cost-accounting systems ,and the techniques that are used with them, can have a high start-up cost to develop and implement. Training accounting staff and managers on esoteric and often complex systems takes time and effort, and mistakes may be made early on. Higher-skilled  accountants  and  auditors  are likely to charge more for their services when evaluating a cost-accounting system than a standardized one like GAAP.

Cost accounting is an informal set of flexible tools that a company's managers can use to estimate how well the business is running. Cost accounting looks to assess the different costs of a business and how they impact operations, costs, efficiency, and profits. Individually assessing a company's cost structure allows management to improve the way it runs its business and therefore improve the value of the firm. These are meant to be internal metrics and figures only. Since they are not GAAP-compliant, cost accounting cannot be used for a company's audited financial statements released to the public.

Fleischman, Richard K., and Thomas N. Tyson. "The Economic History Review: Cost Accounting During the Industrial Revolution: The Present State of Historical Knowledge." Economic History Review , vol. 46, no. 3, 1993, pp. 503-517.

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8.15: Assignment- Cost Volume Profit Analysis

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This assignment is available for download as a Word Document .

Read the following scenario and complete the questions and tasks below.

Mirabel Manufacturing is a small but growing company that manufactures and sells marine sonar equipment. They employee a national sales force and their primary customers are marine retailers and boat dealerships. The company has expanded over the last 5 years and Paul Mirabel, the founder and CEO has become concerned that he no longer has a clear picture of their cost structure. He calls his CFO, Mary Jane Montgomery in for a meeting.

“Mary Jane, I am concerned that I am not current on our cost structure and how that is impacting our bottom line,” Paul begins.

“Well, Paul, the company has grown considerably over the past 5 years, so I’m not surprised that you feel a little disconnected with how things are going,” Mary Jane replied. She continued “In fact, I’ve been meaning to talk to you about a couple of big items such as increasing the sales commission to 15%. We’ve lost two of our best account managers in the last 9 months. It seems like we are behind the curve paying only 12% on gross sales.”

“What do you mean we are behind the curve,” Paul replied angrily. “We have always been the leader in every aspect of our business.”

“Well, that may have been the case in the past, Paul, but frankly we need to step up our compensation package to stay competitive,” Mary Jane replied. She continued, “And that’s not everything. I met with Frank Jacobs from marketing and he said we need to have a bigger presence at the trade show in March. He told me he would need about $650,000 added to the marketing budget to support new marketing materials.”

“Come on, Mary Jane, how can we do that when we are going to have to increase commission?” He continued, “I spoke with Dan Clark in production and he indicated that we have two pieces of equipment that need to be replaced by the end of the quarter and that’s going to set us back almost $1.2 million.”

Mary Jane shook her head. “Paul, I hate to bring this up but while we are talking costs, but Bob in purchasing stopped by the office and dropped off some revised cost information – it looks like several of our suppliers are talking about significant price increases by the end of the year.”

Paul slumped in his chair. “This is a mess, Mary Jane. Increasing commissions, new equipment, materials price increases and marketing expenses all at once. Even if Frank Mallow is correct that we should see a 10% increase in sales for the coming year, I just don’t see how we can make this work. We have to maintain enough profit to keep the shareholders happy and I can’t sleep when we dip below that $2 million margin of safety.”

Mary Jane gathered up her papers. “Before you get too distressed, let me put together some figures and let’s see what this looks like on paper. I’ll get back to you by the end of the week. In the meantime, stay positive, we’ll find the best solution.”

The following income and cost data for Mirabel is provided:

(Note: Each of the following questions is independent of the others)

• What is Mirabel’s over-all break-even point in sales dollars?
• Assume that sales revenue remains constant, what is the impact on break-even and the margin of safety if Paul takes Mary Jane’s advice and increases sales commission to 15%?
• If Mirabel purchases the new equipment for $1,200,000, it will increase fixed costs by 10% but will decrease the variable cost per unit for all 3 models by 5%. What will Mirabel’s new break-even point be?
• If Mirabel invests the additional $650,000 in fixed marketing expenses, sales of the Model 301 are expected to increase by 8%. What is the break-even and margin of safety under these circumstances?
• If the projection is that sales will increase by 10% in the coming year, can the company afford to also increase commission from 12% to 15%? Why or why not.
• Assume that sales volume remains fixed but there is a 5% increase in variable expenses (materials cost) for the Model 101 and 301, and a 10% increase in variable expenses for Model 201. What is the new break-even?

Prepare a report from Mary Jane to Don explaining how these changes will affect Mirabel’s overall cost structure. For those changes that are controllable, make a recommendation considering the uncontrollable cost changes. Be certain to consider not only the company’s break-even point, but also the desired margin of safety.

The Ultimate Guide to Project Cost Management with Templates

By Kate Eby | April 25, 2017

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Your organization’s projects are critical to its future. Sound cost management enables you to make optimal use of your resources (time, personnel, equipment, and materials), make data-driven decisions about projects and their risks, measure financial performance, and provide key metrics to senior management.   This definitive guide to project cost management includes templates for key activities like cost estimating and creating a cost management plan. You’ll learn important terms, best practices, and subtle distinctions (such as the difference between cost management and strategic cost management), as well as how cost management works in specialized cases, like construction and IT projects.

What Is Project Cost Management?

Whether you are developing a new product, designing a facility, or changing a key process, it’s challenging to forecast and manage project costs effectively.   In fact, the job is so challenging that half of all large IT projects massively blow their budgets , running on average 45 percent over budget and seven percent over time, according to consultants McKinsey & Co. and the University of Oxford. For projects in other sectors, the news is no better. The Project Management Institute (PMI) reported in 2016 that companies were completing only 53 percent of projects within their original budget. However, strong cost management helps you avoid that fate. So what exactly is cost management?   Cost management refers to the activities concerning planning and controlling a project’s budget. Effective cost management ensures that a project is completed on budget and according to its planned scope. Since you assess the success of a project at least in part by its cost performance, cost management is a prime determinant of project outcome.   Cost management activities are conducted throughout the project life cycle, from planning and budget allocation to controlling costs during project execution and assessing a project’s cost performance upon completion.   Although cost management includes a whole ensemble of activities, it is sometimes referred to in terms of more specific functions, such as spend management, cost accounting, and cost transparency. Cost managers sometimes use these terms as loose synonyms for the broad cost management function.

Cost Management: Four Major Steps

The Project Management Body of Knowledge (PMBOK), the bible of project management theory, says cost management is made up of four processes. These generally adhere to the sequence that follows — as a project goes from the planning board to reality.

• Resource Planning: Part of the initiation stage of a project, resource planning uses a work breakdown structure — a hierarchical representation of all project deliverables and the work required to complete them — to calculate the full cost of resources needed to complete a project successfully. Managers typically determine required resources for each work breakdown structure component and then add them to create a total resource cost estimate for all project deliverables.
• Cost Estimating: Cost estimating is an iterative process that uses a variety of estimating techniques to determine the total cost of completing a project. Cost estimating techniques vary widely in their approaches to computing project costs, and stretch from conceptual techniques that draw mainly from historical experience and expert judgment to determinative techniques that estimate costs on a component-by-component basis. We will discuss these techniques in detail later, as they vary in their levels of accuracy. Determinative techniques are the most accurate; however, while the estimator’s job is always to create the most accurate estimate possible, determinative estimating techniques are only an option if you’ve reasonably finalized a project’s scope and deliverables. As such, you use the less accurate estimating techniques during the earliest stages of project planning, and then revise and update estimates as the project continues to be defined. To learn more about cost estimating, read The Ultimate Guide to Project Cost Estimating . 
• Cost Budgeting: Once you’ve created satisfactory estimates, you can finalize and approve the project’s budget. Cost managers typically release budgeted amounts in stages according to the level of a project’s progress. These allocations include contingencies and reserves.
• Cost Control: Cost control is the practice of measuring a project’s cost performance according to cost and schedule baselines that provide points of comparison throughout the project life cycle. The specific requirements for effective cost control are set out in the project management plan. The individual in charge of cost management investigates the reasons for cost variations - if they deem cost variations unacceptable, corrective action is likely. Cost control also includes other related responsibilities, such as ensuring that updated project budgets reflect changes to a project’s scope.

Key Components of the Cost Management Plan

The cost management plan guides these four processes. Created during the project planning phase, the cost management plan is a document that defines how you manage, control, and communicate a project’s costs in order to complete the project on budget.   Among other things, a cost management plan identifies the individual or group responsible for cost management, details how you will assess a project’s cost performance, and sets rules for how to communicate cost performance to project shareholders. It also establishes the methodologies by which you will control project cost variations.   While you can customize a cost management plan to fit your organization’s needs, they generally follow a standard format. Sections often include the cost variance plan, the cost management approach, information on cost estimation, the cost baseline, cost control, and reporting processes, the change control process, the project budget, and approvals. You may also want to include the spending authority levels for key project personnel, specifying which roles can approve costs up to specific thresholds.   Let’s look at the sections in greater depth:

• Cost Variance Plan: Cost variance is when the actual amount differs from the budgeted amount. In your cost management plan, you’ll need a section that details the actions you should take, including who is held responsible in the case of a cost variance. The size of the variance usually necessitates different action: a cost variance of less than five percent might result in an explanation of that variance, while a 95-percent-or-greater variance could force the project to be abandoned. To learn how to calculate cost variance, read Hacking the PMP: Studying Cost Variance . For a more detailed template on tracking schedule and budget variances, see this template:
• Cost Management Approach: This section outlines the approach a manager uses for cost management. The level of rigor can vary, but this describes how to establish a cost baseline and how to compare actual costs. You usually track and report costs through control accounts, where you roll up costs of subtasks. This often occurs at the third level of the work breakdown structure, a tool that breaks a project into small components or chunks of work to determine the resources needed to complete a job or project. However, the point at which you track and report depends on the scope of the project.
• Cost Estimation: Here you will define the methods used for estimating project costs, the levels of variation, and the expected precision, accuracy, and risk.
• Cost Baseline: This has a specialized meaning in project management and represents the authorized, time-phased spending plan against which you measure cost performance. It’s the sum of the estimated project cost and contingency reserves. 
• Cost Control and Reporting Process: This section establishes how you measure costs and their key metrics during the project. We’ll provide greater detail on this later.
• Change Control Process: This describes the process for making changes to the cost baseline and how to approve those proposed changes.
• Project Budget: The budget builds on the cost baseline by totalling the cost of executing the project (including contingencies for possible risks). It also adds in management reserves, which is an amount to cover unanticipated risks or unidentified events that may arise. An organization will usually set a policy for this, and the amount is often five to 15 percent of the total budget.

Cost Management Activities: Essential Functions at Each Phase

Cost management includes a number of activities conducted at different phases during the project life cycle. It’s important to include the cost management function while developing project plans so that you build solid financial controls into the project structure. Here are some key terms and stages relevant to cost management:   Planning: Using the work breakdown structure to determine the resources needed to complete a job or project.   Estimating: The act of calculating or predicting the expected total cost of completing a project.   Budgeting: The authorization of a budget based on a cost estimate to complete the project. You typically authorize budgets in tandem with schedules, so you can assess cost performance at specific points.   Financing and Funding: The process of requesting, authorizing, and receiving money for a project.   Cost Management: The general practice of overseeing project expenditures and making cost-related decisions throughout the project life cycle.   Controlling: Addressing cost variations to avoid cost overruns.   Job Control: Controlling project expenditure by comparing costs predicted by the cost estimate and costs actually being incurred.   Scheduling: You can determine a project’s cost performance by using a schedule that compares the expected expenditure to the actual costs the project is incurring at any point in time.   Accounting: The practice of recording expenditures and reconciling transactions.

How Accurate Project Cost Estimating Aids Cost Management Efforts

The first step towards robust cost management is having a clear idea of your project’s likely costs. However, it’s futile to track and control costs if you base your spending on unrealistic estimates.   Project estimating considers several variables, including the method you use to create the estimate, the stage at which you build your estimate, and the types of cost you include.     The first variable is the method you employ. You can produce cost estimates using a variety of estimating techniques, depending on the extent to which you define a project and the type of information you have access to. Here are some common estimation techniques:

Analogous Estimating: This uses historical data from similar past projects to create estimates for new projects. This method works if you have experience with projects of the same type.

Parametric Estimating: This method estimates time and cost by multiplying per unit or per task amounts by the total number expected in the project. The rates are often standard or publicly published rates and can be expressed in hours of work, amount of data entered, or the number of units of a product manufactured. This technique has a reputation for good reliability, but it’s less relevant when output isn’t uniform, such as when writing computer code. Some projects have widely varying or unprecedented tasks, so they do not lend themselves to this method.

Bottom-Up Estimating: This is a determinative estimating technique that estimates costs for work breakdown structure components and adds them together to create a cost estimate for an entire project. The project team members help create the estimate. Since the people who are going to be doing the work are engaged in estimating, professionals consider this method highly accurate, as well as a team commitment builder.

Three-Point Estimating: This is a PERT -related statistical method that uses the optimistic (lowest), pessimistic (highest), and most likely cost estimates to create expected values and standard deviations for project expenditures.

Software-Based Estimating: You can use software-based estimating techniques, such as Monte Carlo simulation, to model the effects of risk events on project costs.   Another factor influencing the cost estimating is the stage at which you build your cost estimate. As a project progresses, you discover more variables and actual costs, so project estimates become more refined. You can classify cost estimates based on how well you define the project scope at the time of estimation and on the type of estimation technique you use - the latter generally determines the accuracy of an estimate. In order of accuracy, the main classes of cost estimates are:   Order of Magnitude Estimates: These are very rough cost estimates based on expert judgment and on adjusting the costs of the current project to reflect the costs of similar, past projects. Created before fully defining projects, they are only used in high-level project screening.   Preliminary Estimates: A preliminary estimate uses somewhat-detailed scope information to form estimates based on unit costs. These estimates are accurate enough to use as the basis for budgeting.   Definitive Estimates: Created when you’ve fully defined a project’s scope, a definitive estimate uses deterministic estimating techniques, such as bottom-up estimating. Experts agree that definitive estimates are the most accurate and reliable.   The final variable affecting project estimation is the type of cost included. Of course, your project budget must include all the relevant costs for labor and materials, but whether you include a portion of your organization’s indirect costs depends on the policies of your organization and the type of project. Here are the terms experts use to distinguish between various types of costs:   Direct Costs: Direct costs are those which you can directly associate with a specific cost object. They are billable to specific projects.

Indirect Costs: You cannot associate indirect costs with a specific cost object, and you typically incur indirect costs by a number of projects at the same time. They are not billable to specific projects.

Fixed Costs: Fixed costs are costs you incur during manufacturing that are not associated with the volume of produced output.

Variable Costs: Variable costs are costs you incur during manufacturing that are directly associated with the volume of produced output.

Sunk Cost: A sunk cost is an expense you cannot recoup once it is incurred.

Opportunity Cost: When selecting a course of action, its opportunity cost is the loss of potential benefits from all alternative courses of action.

Costing Techniques Determine How to Account for Project Costs

A costing technique is the way in which you compute the total cost of producing a product or performing a task. Depending on the activity or activities being costed, you may use a variety of techniques. Here are some commons ones:   Job Costing: Managers use job costing, also called job-order costing, to determine the cost of a product that is unique or dissimilar to other products. In industries such as construction, it’s extremely rare for two jobs to be identical. Job-order costing uses a unique job-cost record that compiles total labor and resource costs, as well as applicable overheads, for each task or activity completed as part of a task to determine total expenditures for the job. The job-cost record includes both direct and indirect costs.   Process Costing: You use process costing to determine costs for products or tasks that are identical. Unlike job costing, it does not compute the total cost of a product by summing up the costs of all tasks and activities that go into creating the product. Instead, process costing looks at the processes included in the mass production that creates products. By dividing the total cost of a process by the number of units output, it is possible to determine the cost per unit of each process. After this, you may total the costs per unit of every process involved in the eventual manufacturing of the product. In this way, you compute the cost per unit of each product on a process-by-process basis.   Activity-Based Costing: Activity-based costing (ABC) is an approach to assigning overhead costs to products. Since overhead cost allocation based simply on the number of machine hours needed may be misleading, this costing technique looks at the activities focused on creating a product — testing, machine setup, etc. — and then assigns portions of their costs to all products created using these activities. Products that were not created via these activities do not have shares of these activities’ costs added on.   Direct Costing: Direct costing, also called contribution costing or variable costing, is a technique that only assigns variable manufacturing costs to the cost of a product. You do not add fixed manufacturing costs to the cost of creating a product but instead associate those costs with the time period during which you incur them.   Life-Cycle Costing: Life-cycle costing is a comparative analysis technique that involves summing the total costs incurred during the life cycles of project options in order to choose the best option. Since starting capital costs may not be an accurate representation of how much a project will eventually cost, life-cycle costing includes all costs associated with ownership — including maintenance and disposal costs — to enable better decision making. 

Measuring Project Performance With Cost Management KPIs

Once your budget is approved and your project is under way, you’ll want to benchmark your progress relative to your cost management plan. First, there are some key metrics and performance indicators to understand:     Project Cost Performance: A project’s cost performance is an assessment of how actual expenditure on a project compares with planned expenditure as detailed in the project budget. The project manager communicates a project’s cost performance to the project stakeholders, and it may serve as the basis for preventative or corrective actions to avoid cost overruns.   Earned Value: Earned value is a method of measuring project cost performance. It is based on the use of planned value (where you allot specific portions of a project’s budget to the project tasks), and earned value (where you measure progress in terms of the planned value that is earned upon completion of tasks). You may contrast the earned value with the actual cost -  the expenditure you actually incur up to a certain point in the project schedule - to see how actual project costs compare to expected project costs.   Cost Performance Index (CPI): This is a measurement of how earned value compares to actual cost. This ratio measures a project’s cost efficiency at a given point in time by expressing earned value in proportion to actual cost. To calculate CPI, divide earned value by actual cost. A result of 1 means the project is exactly on budget; a number above 1 means it is under budget.

To learn more about KPIs in project management, read All About KPI Dashboards .

How to Control Costs

Effective cost control means performing a number of related activities that all begin by monitoring costs — since you can’t know if costs are greater than planned unless you are tracking actual expenses. Then, project managers need to decide how to respond to cost variances. Here are some key steps and concepts that inform the cost control process:   Monitoring Cost Performance: A project manager routinely monitors a project’s cost performance by creating performance reports that summarize current performance and forecast whether you will complete the project on budget. You provide project stakeholders with information about a project’s cost performance.   Reviewing Changes: You must amend the cost baseline to reflect all cost-related changes, and you should inform the project shareholders about all changes.   Actual Costs versus Budgeted Costs: Upon milestone and entire project completion, you examine the variances between actual costs and budgeted costs. Responses to the cost management plan will depend on the magnitude of the variance and the stage of the plan - this could range from a discussion to changes in the project scope that reduce costs.   Reserve Analysis: Use reserve analyses to allocate contingency reserves to projects based on the likelihoods and magnitudes of risk.   Cash-Flow Analysis: Used in financial reporting, cash-flow analyses detail cash inflows and outflows over a given period of time, and provide starting and ending balances.   Learning-Curve Theory: The learning-curve theory applies to the relationship between the time spent producing a unit and the number of units produced. According to the theory, the time spent on each unit should decrease as workers gain experience and therefore produce units faster.   

Cost Management vs. Strategic Cost Management

While cost management reduces expenses regardless of their cause or purpose, strategic cost management is a sub-discipline that strives to manage cost while also making the organization stronger.    Robin Cooper, Professor of Management at Claremont’s Peter F. Drucker Graduate Management Center and Regine Slagmulder, Professor of Management Accounting at Tilberg University in the Netherlands, define strategic cost management as the “application of cost management techniques so that they simultaneously improve the strategic position of a firm and reduce costs.”   Strategic cost management centers on the idea that cost reduction initiatives can affect an organization’s strategic position. Strategic cost management emphasizes considering the strategic and financial impact of cost management techniques.   Cooper and Slagmulder classify cost management initiatives as one of three types based on how the initiative affects the organization:   Strengthen: An example of an initiative that strengthens competitive positioning is a taxi service that replaces its phone booking system and team of booking agents with an app that allows people to book taxis using their mobile devices. An initiative like this both reduces costs and gives a company a strategic advantage, as it makes it easier to book taxis on short notice.   No effect: An initiative that has no effect on competitiveness might concern a publishing house that outsources proofreading tasks to international freelancers who accept lower wages. While this increases the company’s profitability, it does not affect its strategic positioning.   Weaken: Finally, an initiative that actively harms competitive positioning might involve the taxi company decreasing the frequency of regular vehicle maintenance, a move which, while saving costs initially, will result in cars breaking down more often.   Strategic cost management also comprises a number of important strategies:   Relevant Cost Strategies: Use relevant cost strategies to compare and decide between alternative courses of action. Relevant costs are costs you can reduce by adopting a particular course of action. They are different from sunk costs (which you cannot recoup once spent) and fixed overhead costs (which are the same for all potential courses of action). When you make decisions, a relevant costs strategy focuses only on costs that vary among options.   Evaluating Opportunity Costs: Evaluating opportunity costs is a more holistic approach to decision making that considers not only all the monetary aspects of alternative courses of action, but also all the intangible aspects. For example, a company providing vehicle repair services might have to decide between two qualities of engine oil, taking into account both that one is more expensive than the other and that the more expensive engine oil also preserves engine health in the long term.   Balanced Scorecard Strategy: A balanced scorecard strategy allows businesses to assess the impact of cost management initiatives across four key areas: financial results, customer impact, internal business processes, and employee growth and development. It provides a framework for thorough consideration of the impacts of cost management initiatives. 

Getting Into the Details: Cost Accounting in Project Cost Management

Cost accounting involves the recording and classification of costs associated with a project. It is an internal practice that supports managerial decision making and is a primary discipline concerning cost management.

Cost accounting is different than general financial accounting. Financial accounting concerns  reporting an organization’s past financial performance and does not delve into extensive detail. Since you carry out cost accounting for a specific area of activity within a company — such as a particular project or geographical region — it focuses on more granular aspects and may include projections of future costs.   Cost accounting involves preparing reports for an organization’s management (these reports are not distributed externally). By contrast, financial accounting deals with standardized reports that may be distributed to a variety of stakeholders and regulators.   As such, you typically perform cost accounting on an as-needed basis, such as during a strategic project, and it does not follow a mandated format. Financial accounting, on the other hand, is a mandated and regulated formal process, and you must create financial reports according to international financial reporting standards.   There are a few commonly used cost accounting approaches:   Standard Cost Accounting: This is based on the concept of efficiencies , or ratios that compare the time and resource costs of actually completing an activity with the costs of completing the activity under standard conditions. Variance analysis is a core element of standard cost accounting. However, since the idea of efficiencies is based on a paradigm in which labor costs contribute substantially to manufacturing — which is no longer the case — standard cost accounting is somewhat outdated.   Activity-Based Costing: This is an approach to assigning overhead costs that examines activities that provide a service, execute a task, or create a product, and then assigns portions of their costs to output.   Resource Consumption Accounting (RCA): This approach emerged around 2000, and assigns costs based on the consumption of resources. It uses a German cost management system known as GPK and activity-based costing, a cost allocation method.     Throughput Accounting: This is an accounting approach that aims to maximize profitability by increasing the rate of production of goal units and minimizing operating expenses and investment costs.   Life-Cycle Costing: This is a method of analyzing project alternatives that focuses on total costs of ownership and selecting the most cost-effective option based on more than simple capital costs.   Environmental Accounting: Reporting the environmental costs incurred by a company or project’s activities.   Target Costing: This uses a predetermined market price and preferred profit margin to determine how much money can be used to create a product or service. The target cost is the maximum amount you can spend on production without affecting the profit margin.    Cost Coding: To make cost accounting easier, most organizations have adopted a method of identifying costs with a code, usually a number. The root of the code usually represents the type of expense, cost center, or business unit involved. This makes it easier to group and find related expenses in financial reports. Individual projects may be assigned their own code.   A common structure in an enterprise or very large organization is a top-level, four-digit code that relates to the accounting entity (for example, a subsidiary company). The next numbers pertain to department, followed by a number for the cost, which can be a cost center, profit center, work-breakdown-structure element, fund, or internal order. This facilitates the cost management process by aligning the cost codes with the work breakdown structure, which makes it easier to calculate financial performance.   In addition, costs in cost accounting may be classified by:  

• Traceability: Direct and indirect costs
• Behavior: Fixed or variable costs
• Controllability: Controllable or uncontrollable costs
• Time Incurred: Historical or predetermined costs
• Normality: Normal or abnormal costs
• Functions: The organizational function by which you incur a cost

  Cost accounts make it easy to identify cost overruns in specific sectors that might otherwise be lost in a budget overview. However, managing a large number of cost accounts — up to several hundred accounts and sub-accounts on larger projects — comes with its own challenges. It demands a higher degree of organization in accounting, for one, and classifying costs becomes more time consuming.   In addition, the system of categorization you use for a project’s cost accounts may not match up with the system of categorization you use for an organization’s cost accounts. This complicates the creation of a project budget from a final cost estimate, and is likely to happen when you create cost accounts using a system of categorization different than the performing organization uses.

Aside from recording historical expenditure, project managers must also forecast expected activity costs to ensure that they remain under control. Managers can do this through the use of tables that classify costs for individual cost accounts and cost modeling techniques that indicate whether work associated with a particular activity is due to be completed on budget.

Software’s Role in Project Cost Management

Cost management software simplifies and expedites project cost management activities. This can ease the burden on project cost managers and make it easier to extract insights, such as the cost performance index. Some of the common functionalities include:   Project-Tree Building: A visual representation of a work breakdown structure. This can be useful when employing deterministic estimating techniques.

Cost Estimation: Cost management software can provide powerful estimation capabilities such as using project trees to record activity costs, or running regression analyses to determine cost-estimate relationships in historical data.   Project Cost Management Templates: For projects that are similar, cost management ]templates can expedite cost management activities.   Budgeting: Cost management software can make it easier for project managers to conduct budget planning activities and allocate funding. 

Keep Projects On-Budget Using a Cost Management Template

One tool that can help with project cost management is Smartsheet, a collaborative work management and automation platform. As a cloud-based platform, you can share and collaborate on your cost management activities with internal and external stakeholders, and access the information from anywhere, on any device. 

Plus, with a pre-built, customizable template in Smartsheet, you can get started faster than ever. Track project and budget performance all in one sheet. Use symbols to quickly identify tasks that may be at risk of going over budget, and bring visibility to status of estimated versus actual labor, materials, and other costs. Set up alerts and reminders to notify you as costs change, and attach documents like invoices and purchase orders directly to tasks, to keep details in context.

Try one or all of the following templates to help ensure your next project stays on budget: 

Project Budget Template

‌ Download Project Budget Template

Excel | Smartsheet

Cost Management Plan Template

Download Project Cost Management Template

Activity Cost Estimate Template

Download Activity Cost Estimate Template

‌ Smartsheet Project with Schedule & Budget Variance Template

Cost Management for IT Projects

IT project costs are notorious for going over budget, mainly because of development approaches that allow scope creep during the product development life cycle. There is also a tendency for IT cost estimates to be less fixed than those of hard projects in fields such as construction and engineering, where maturity in planning and estimating is higher. In Information Technology Project Management , Kathy Schwalbe suggests that the people creating cost estimates for IT projects lack experience compared to specialist cost surveyors who create cost estimates for construction projects.   Furthermore, given how multifaceted these projects tend to be and how quickly IT evolves, IT projects often suffer from the “first-time, first-use penalty,” which means that it is hard to form accurate estimates when a project or project elements have not been attempted before. This makes documenting lessons learned crucial for IT projects.   The U.S. research and advisory firm Gartner creates a research report for the project and portfolio management market that categorizes vendors into four categories based on their ability to understand market needs and to drive the acceptance of new technologies. These are graphed on axes labeled “completeness of vision” and “ability to execute,” respectively. The “magic quadrant” is the upper right of this graph in which leaders in both areas cluster.  

Cost Management in Construction Projects

Construction project cost managers, or quantity surveyors, oversee cost estimation and cost control while maintaining a project’s profitability. They are responsible for ensuring that a project remains within budget while meeting its scope, quality, and performance requirements.   Though the majority of construction projects are not subject to the “first-time, first-use penalty,” they are still highly complex. And as hard projects, their design, scope, and budgetary requirements must be planned before work begins. Experience and formal training are essential for quantity surveyors.   The evaluation and recommendation of bids is one of the quantity surveyor’s primary responsibilities, though they may be engaged in a project from inception to conclusion. In fact, quantity surveyors get their name from the bill of quantities , a cost estimate prepared by the surveyor and by which contractors’ tenders are assessed.

To aid cost management for large, complex projects, quantity surveyors or project managers may use cost codes discussed earlier to set up multiple cost accounts. These accounts are essentially portions of budget marked for specific expenses such as labor, construction materials, architectural design, etc.

Home Construction Budget Template

Download Construction Budget Template

Excel |  Smartsheet

Construction Estimator Template

Download Construction Estimator Template

Excel  ‌| Word | PDF |  Smartsheet    

Exploring Cost Management as a Career

Professional cost managers, sometimes called quantity surveyors, work on large projects (such as construction). But project managers also need an understanding of cost management strategies and techniques to perform their duties.   Cost management requires creative problem-solving skills and a thorough understanding of the factors that affect project costs. As such, cost managers are in high demand and have opportunities to progress to lead project managers.   One popular cost management profession is cost accounting, which is determining the costs focused on creating a product or providing a service. Cost accountants deal with budget preparation and profitability analysis, and their main responsibilities include collecting and communicating cost-related data to aid management decision-making and create financial transparency.   Cost accountants typically study accounting or finance at the undergraduate level, and many pursue master’s degrees in business administration or finance with a specialization in accounting. They typically need a license to advance their careers, which can be obtained after meeting some combination of work and educational requirements.

How Smartsheet Can Help with Cost Management Across Your Projects

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SAP Controlling: Assigning and Checking Cost Component Structures

In SAP Controlling, a company code determines which cost component structure the standard cost estimate uses, which ensures that the same cost component structure is used for all plants and costing variants in a company code.

If you use different cost component structures in different plants, the standard cost estimate in one plant cannot access the results of standard cost estimates in another plant. You cannot transfer costing data for materials transferred from one plant to another.

For other cost estimates, the cost component structure is determined through the combination of company code , plant, and costing variant.

To access assignment of organizational units, double-click Assignment: Organiz. Units shown in the first figure below. Once selected, you should see the second figure display.

In this screen, you can assign cost component structures to organizational units such as Company Code , Plant , and Costing Variant . Some entries in this example employ masking. In the Plant column, both rows have the entry ++++ , which is a shorthand method of assigning cost component structures to all plants. You can employ the same technique of masking in many other screens throughout the system.

Specific entries always take priority over masked entries. Here’s an example:

In the Costing Variant column shown above, the row with the specific IPC5 entry takes priority over rows with masked entries in the same column. When you create a cost estimate for any company code with costing variant IPC5, the system will use main cost component structure 07 and auxiliary cost component structure 02. All other cost estimates for these plants will use main cost component structure 01 and auxiliary cost component structure 02.

Now that we’ve discussed assigning organizational structures in general, let’s look first at assigning the cost component structure and then checking this assignment.

Assigning Organizational Units with Cost Component Structures in SAP

The main cost component split is the principal cost component split used by a standard cost estimate to update a standard price. The main cost component split can be for COGM or for a primary cost component split. You assign the main cost component structure in the above figure. You’ll need to widen the columns so you can see the entire text in the column headings as shown below.

You assign the main cost component structure in the first column and the auxiliary cost component structure in the last column. You don’t have to assign an auxiliary cost component structure, but you do need to assign a main cost component structure to each row you define in this screen.

You can use the auxiliary cost component structure in parallel to the main cost component structure to allow comparisons and analysis. You can use the auxiliary cost component structure to analyze costs in cost estimates and CO-PA. When viewing a cost estimate with an activated auxiliary cost component structure, you can switch between the main and auxiliary cost component structures.

You assign an auxiliary cost component structure to an organizational unit in the last column in the figure above. Follow these additional steps needed to activate the auxiliary cost component structure:

1. Create an auxiliary cost component structure.

2. Create a transfer structure mapping the auxiliary cost components to the main cost components as shown below:

3. Assign the auxiliary cost component structure to the plan version per fiscal year in the Price calculation tab shown below.

4. Assign the auxiliary cost component structure to organizational units. See below.

5. Automatically calculate the plan activity price.

You don’t have to enter an auxiliary cost component structure. In most cases, the COGM cost component structure alone provides sufficient cost component reporting. The auxiliary cost component structure is available if you need additional reporting on primary costs, especially in some European implementations.

Next, we’ll look at a quick way to check assignment to organizational units.

Checking the Assignment to Organizational Units

You can check the assignment of cost component structures to organizational units by inspecting the costing variant. Take costing variant PPC1 as an example. Display costing variant PPC1 with Transaction OKKN or double-click the costing variant in the Costing Data tab of a cost estimate.

Select the Assignments tab and click the Cost Component Structure button to display the screen shown below.

The main cost component structure assigned to company codes 0001 and 0005 is 01, and the auxiliary cost component structure assigned is 02.

You can also assign a cost component structure to a plant. To add “Plant” as a column in the previous figure, click the down-pointing arrow to the right of the grid icon and select Change Layout to display this screen:

Double-click Plant to move it across to Displayed Columns and press (Enter) to display the screen shown below.

TIP : Click the Save icon before pressing (Enter) to save this layout.

You can now see the Plant column in the cost component structure assignments for the costing variant.

Notice the SBO Explorer (circle) icon available with Enhancement Package (EHP) 5. This icon allows you direct access to SAP BusinessObjects Explorer.

This blog post summarized the process for assigning organizational units to cost component structures in SAP Controlling. After assigning these units, you learned how to check them. You also read a discussion of both the main cost component structure and the auxiliary cost component structure.

Editor’s note: This post has been adapted from a section of the book Product Cost Controlling with SAP by John Jordan.

Recommendation

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