The Portable MBA in Finance and Accounting, 4th Edition

12

Cost Structure Analysis, Profit Planning, and Value Creation

William C. Lawler

 

 

 

In the highly volatile markets of today’s economy, detailed profit planning is the foundation for long-term value creation. It is the basis for efficient resource allocation within a firm and the root of all strategic plans. This, however, is only a necessary condition, and by itself is not sufficient for the goal of value creation. One also must be able to identify the economic logic embedded in the strategic plan of competitors. Running a business is like playing a game of chess; in order to win one must be able to anticipate the moves of the competitor. And in order to achieve this insight, the first step is to discern the cost structure of that competitor.

Economic literature defines cost structure as the relative portion of a firm’s costs that are fixed as opposed to variable. The definitions of fixed and variable are very precise. A fixed cost does not vary in total with changes in output, whereas a variable cost in total will change in a manner proportionate with changes in volume.¹ A term that is often used in describing this structure is degree of operating leverage. A firm with relatively high fixed costs is said to have high operating leverage. This implies that a firm has a choice in creating operating leverage; one could build a large infrastructure and lock oneself into high fixed cost for a period of time, or one could create a more variable cost structure. An example of this would ...