Small Business Adviser

What is cost structure? This refers to a business ‘s proportion of fixed expenses in relation to variable expenses.

Variable expenses are those expenses that rise and fall in tandem with sales or production levels. For example product delivery costs or purchase of raw material.

Fixed expenses refers to those expenses that are to a large extent not affected with the variations in sales or production levels. Examples include rent and pay for senior management.

Operating Leverage-a company that has a high proportion of fixed expenses (in relation to variable expenses) is said to have a high operating leverage. Such a company will realise more profits in a situation where volume of production and sales are high than when they are low. This is because it is very difficult to reduce costs related to fixed assets. During the current recession, it is no coincidence that the big car manufacturers needed a bailout from the U.S. government. These companies have high operating leverage arising from the high costs of maintaining the capital intensive assembly plants. Whether or not the production volumes are high or low, these companies will still incur high costs.

In contrast, a company that has low operating leverage has more control of its costs because it has low proportion of fixed costs. Management is in a position to cut the variable expenses when volumes are reduced.

As part of his financial analysis, your banker will also examine the business’s operating leverage and related trends.