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Chapter 12

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COMM 103
Gary Bisonnette

Understanding The Organization’s Cost Base - Having a good understanding of such cost base information will enable managers to better assess their financial options in the event of unexpected changes in market dynamics, unanticipated reductions in revenue and strategic positions shift which the organization is planning - To develop a good understanding of organization’s cost base, managers need to focus on: o The make-up of their cost base o The percentage of the cost base which lies within their control in the near term o The market pressures which will impact the cost base going forward o Understanding the volume and dollar requirements necessary to achieve breakeven o Evaluating their cost structure with respect to “good” cost versus “bad” costs The Composition of an Organization’s Cost Base - An organization’s cost base is made up of the total cost associated with delivering the organization’s products or services to the marketplace - Costs(total cost base) are split into 2 types of costs o Direct or variable costs(directly involved in the manufacturing process) o Indirect or fixed costs(operational support costs) - Key questions: o What are the direct or variable costs versus the percentage which are considered to be indirect (fixed or semi-fixed)? o Are there cost areas that make up a significant percentage of our overall cost base? - Variable Costs, also known direct costs, are directly tied to the manufacturing or delivery of a product or service o Main sources of variable costs include:  Cost of components  Cost of labour  Cost of packaging  Shipping costs - Fixed Costs, also known as indirect costs, are costs which the organization commits itself to within an operating year which often are spent in advance or at the front end of a manufacturing /sales cycle o Main sources of fixed costs include:  Insurance  Utilities  Interests expense  Administration costs  Marketing costs  Software technology upgrade costs  R+D costs - After identifying the cost base organizations now need to build an understanding of it - By understanding the cost base, an organization can determine the required pricing strategy which will be utilized in the marketing of a product and its corresponding impact on profit - Variable costs + fixed costs = total costs Degree of Managerial Control - The more the cost base is composed of variable or direct costs, the more control managers have over the actual management of this cost base on a day-to-day basis o Example: manufacturing operations often has large percentage of total cost base being variable cost, can easily respond to downturn in demand by, temporarily laying off workers, reduce future purchases of materials and component, shutting down or reducing volume - The more the cost base is composed of fixed or indirect costs, the more difficult it is for managers to use cost reduction strategies to protect the organization’s profitability in response to decrease in demand for products o Example: retail operations, cost base made up of fixed or indirect costs, costs mostly made from lease expenses, utilities and core staffing levels. Costs of actual product being sold makes up a small percentage of the cost base. Because of inability to respond to downturn in demand, a small reduction in sales volume can have significant import on the profitability of the organization. - Important to note that market dynamics will also influence the composition and overall competitiveness of an organization’s cost base - Global marketplace increasing options  greater price awareness and sensitivity on the part of consumers - The ability to manage one’s cost base more efficiently and effectively can lead to competitive advantage resulting in larger market share and profitability - Specialization, or key suppliers to produce key components may also cause an impact on the management teams ability to control costs - The ability to manage an organization’s cost base is not limited to the relationship between variable costs and fixed costs, but is also dependent on the ability of management to have flexibility and choice in adjusting VC and FC in order to effectively support and execute an organization’s corporate and business level strategies. What is the Best Way to Cut Costs? - Ensure that actions focused on the reduction of the cost base of the organization do not impact the sources of value(value cells) - Keep a mind on the future of the company - Cuts do not erode productivity standards, accountability, or eliminate vital processes, functions or activities, especially within value cell zones. The Concept of Breakeven Point Analysis (BEP) - Breakeven Point (BEP) = the level of sales revenue or volume which is required in order for the organization to cover all of its costs o Total sales revenue – total costs(VC+FC) = $0 profit  Minimum acceptable position for the short term • Operating below BEP means the organization is operating in a loss position( need to draw upon its cash reserves to cover its expenses, which will eventually lead to insolvency and business closure) • Operating at breakeven point means that total costs are covered but the lack of profit = organization is not generating future cash reserves to cover things such as R+D, equipment replacement and other initiatives that help the long term sustainability of the organization o Need current profit to sustain long term profitability To compute an organization’s breakeven point: - Estimate an organization’s cost and determine the nature of these costs(FC or VC) - Take cost analysis and place in into the breakeven point formula to find the breakeven point for the organization - Breakeven point: anticipated revenue = total costs o Volumes of production above this point would yield a profit o Volumes of production be
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