Cost structure: should I always use fixed cost vs. variable cost?

Question

Hi guys, would like to seek your opinion on what is the best way to break down cost structure.

I've seen most people using “fixed cost vs. variable cost”. The shortfall of this approach is that in reality many cost items are semi-variable (a portion is fixed while another portion is variable). On the other hand, other possible ways could be “cost vs. expense”, “cost breakdown by Income statement: rev - cogs- SG&A/R&D, etc”. Which one is the most reasonable way to break down cost structure?

Another question that I have is that should a manufacturing company's staff salary be a fixed cost or variable cost? (I was asked about this question in a MBB written test)

Thanks!

Answer 1

You have to use a breakdown that makes sense for the specific problem. The problem with “fixed vs. variable cost” is that unless you dealing with a scale problem, it is usually meaningless/confusing. You are right, what is variable vs. fixed is not always straightforward.

The reason for this is that variable costs can refer to both costs that correlate with the quantity sold, as well as with costs on which you can make decisions in a short time frame. In other words, if you have a restaurant and on a single night you sell 10% more meals you will have 10% higher food costs, but you pay staff 10% more (you will hire them only if night after night you are operating over your capacity). But I'm being geeky here so I'll move on to the next question.

Manufacturing company's staff salary is a fixed cost. The reason for this is that it doesn't really change according to the quantity sold. If you sell 10% more in a single year, you won't need 10% more people working in the HR, Finance, Marketing and Legal departments. But most certainly you will need 10% more labor in the factory shop floor.

Answer 2

Hi there,

I would argue that you should almost never use FC and VC

This is overly generic, and as an interview I always shake my head when this is used.

Everyone knows FC/VC and this doesn't actually break down costs in a way that helps you solve your problem!

Rather, think about whether it makes sense to break things down by product, geography, customer, back-office vs. front-office, etc.

Think about the case, then use that to determine your cost structure. Make sense?

Answer 3

No need to always use FC/VC method. Follow the case and take hint from it.

Sometimes, you will have to sketch out the value chain.

Have a look at these very helpful Q&A on similar question:

Regarding your question on salary, if employees are on full-time contracts and paid fixed annual salary, then its Fixed Cost. If they are on hourly contract, then its Variable.

Answer 4

Hi there,

The right approach depends very much on the type of cases. Aside from the examples you mentioned, I'd also take into account direct vs indirect costs. Try to keep all of these in mind as you're approaching the case and figure out which would make most sense in your context. Getting good at cases means exactly this - developing the necessary flexibility to approach any case leveraging your prior experience.

Answer 5

Hi!

Very interesting question!

You should break down costs in the most appropriate fashion for the specific case. For instance, you might segment based on a process flow, direct vs indirect costs, etc.

Hope this helps.

Best,

Anto

Answer 6

As laid out by other experts, you don't have to force this breakdown. Instead, think of other MECE categories for operating costs that match the specific problem. As a consultant, your job is generally to challenge whatever needs to be challenged - including such doctrines.

The moment candidates enter the cost bucket in their profit structure and give me the old “so there's fixed and variable costs” they've missed an opportunity to shine by simply skipping an intellectual step. Worst case, it simply doesn't make sense and I have to mark them down.

Not sure about cost vs expense though. There's a technical difference between the two but they're generally used very interchangeably, which may lead to confusion.