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Cost Structures and Operating Leverage
- 1. Who is the greatest athlete in the world today? (thought question) Session: What are Cost Structures? Dan Crean Product Camp Feb 2019
- 5. The DuPont Equation Net profit margin Operating efficiency Asset turnover Asset use efficiency
- 6. Applicability Is it accurate? Is it useful?
- 7. Cost Structure - fixed costs vs variable costs If sell 500 units Company A Sales = 200 x 500 = 100000 Fixed cost = 5000 Variable cost = 100*500 = 50000 Operating profit = 45,000 Company B Sales = 200 x 500 = 100000 Fixed cost = 25000 Variable cost = 60*500 = 30000 Operating profit = 45,000 Sales Price = 200 Cost structures: Company A Fired cost = 5000 Variable cost = 100/unit Company B Fired cost = 25000 Variable cost = 60/unit
- 8. Effect of change in sales Increase to 700 units Company A Sales = 200 x 700 = 140000 Fixed cost = 5000 Variable cost = 100*700 = 70000 Operating profit = 65,000 Company B Sales = 200 x 700 = 140000 Fixed cost = 25000 Variable cost = 60*700 = 42000 Operating profit = 73,000 Decrease to 300 units Company A Sales = 200 x 300 = 60000 Fixed cost = 5000 Variable cost = 100*300 = 30000 Operating profit = 25,000 Company B Sales = 200 x 300 = 60000 Fixed cost = 25000 Variable cost = 60*300 = 18000 Operating profit = 17,000
- 10. Operating Leverage How much operating profits change in response to sales. Operating leverage factor = Contribution margin / operating income = %Change in op income / %Change in sales Companies in industries tend to have similar operating leverage
- 13. Cost structure determines the magnitude of the upside potential and downside risk.
- 14. These decisions change the cost strcture and thus the operating leverage of a firm. ➪ A fundamental change in risk. Changes in Operating Leverage Capital investment and outsourcing decisions are not simple NPV calculations.
- 15. Implications for Product Managers Capacity utilization coupled with cost structure is a critical driver of profit. Can you choose your cost structure? Depends on Nature of production/industry Your position in organization Portfolio of products Ways to easily change
- 16. What business schools teach Accounting ➜ Revenue - Cost = Profit Marketing ➜ To increase revenue, customize ➜ make many products and services Operations ➜ To decrease costs, standardize ➜ make few products and services Strategy/Integration ➜ Decide where to live in this tension
- 17. How do businesses compete? Porter’s generic strategies: low-cost, differentiation, focus within a market segment Operationally Efficiency Scale Quality Network and Ecosystem
- 18. Trends and Fads in modern business Information processing and communication easier - decades long trend, will continue Globalization - decades long trend, might continue “Disruption” - easier said than done, and more a phenomenon than a business model. Analytics/Big Data Asset sharing and usage-based pricing. - Not new, but gaining favor. Can help reduce operating leverage Agile processes - benefits to revenue, cost, and can lower operating leverage if done right