Using Cost Structure Analysis to Maximize Profit

It is advisable for small business owners to pay close attention to what happens to their profitability when they change either the amount of goods produced or the prices charged. A cost structure analysis is a good way to do just that: take an in-depth look at how your firm’s cost structure affects its optimal quantity of goods to produce.

Throughout our discussion, we’ll be referring to the chart below, and there will be some very simple math involved.

But if you stick with us, you’ll be rewarded with a powerful tool to help you gauge the quantity your business should be producing in order to maximize your profit.

Fixed Costs and Variable Costs

Let’s begin by defining the two types of costs that make up the cost structure of all businesses: fixed costs and variable costs. Our first, very simple, equation to remember is that Fixed Costs + Variable Costs = Total Costs (FC + VC = TC).

Fixed costs are those that must be paid regardless of how much your company is producing. In fact, they still must be paid even if you are producing nothing at all. Rent is a fairly obvious example of a fixed cost.

Variable costs, as the name implies, vary according to how much you are producing. A very important variable cost is labor – if you want to make more stuff you will need to hire more workers – thus your labor costs will increase as your output rises.

Now let’s take a look at the table above to see how both fixed and variable costs affect the fictional Tasty Pizza Corporation’s (TPC) decision on how many workers to hire and thus how many pizzas it can bake. 

For the purposes of this example, we’ll assume that TPC’s variable costs increase by $800 each time it hires a new employee and that it is able to sell its pizzas for $10 each.

If TPC doesn’t hire any workers then it won’t be able to make any pizzas, so in order to cover its fixed costs it needs to bring some employees onboard. 

The key questions, of course, are how many pizzas it should produce and how many employees it should hire?

In order to help us answer this question we need to examine a very important economic concept:

Marginal Cost

Marginal cost is defined as the cost to produce one additional unit of output, in our case one additional pizza. Mathematically speaking, Marginal Cost = Change in Total Costs divided by Change in Quantity Produced (MC = Change in TC/Change in Q).

It is also important to understand the concept of marginal revenue, which is simply the amount of additional revenue generated by selling one additional unit (in our example marginal revenue is always $10 as each pizza sold brings in that amount).

In order to see how marginal costs function let’s take a look at what happens as TPC adds employees. With no employees, TPC has $1000 in fixed costs but can’t produce any pizza. Upon hiring its first employee, total costs increase by $800 and the number of pizzas produced jumps by 100, so the marginal cost per pizza is $8. 

Upon adding a second worker TPC can produce another 180 pizzas at a marginal cost of $4.44 each. As more workers are added beyond that, however, TPC’s marginal cost starts to increase. 

This makes sense because the first few employees are able to make good use of the company’s equipment to efficiently increase output, but as more workers join, the additional quantity of pizzas that they are able to produce is limited by other factors. (If you hire one-hundred workers but still have only one pizza oven, all those extra workers aren’t going to be able to produce many more pizzas.)

So how is a business owner to determine the ideal quantity of goods to produce?

Remember the following: profits are maximized when marginal revenue equals marginal cost (MR = MC). In our example that takes place when TPC is producing 880 pizzas with 7 employees. 

If TPC produces any more pizzas, the marginal costs of those pies will be greater than the $10 in marginal revenue that the company can generate from selling them.

What holds true for Tasty Pizza Corp. holds true for all businesses: profits are maximized when MR = MC. This is a very important rule to remember when starting or expanding your business and demonstrates how crucial it is to accurately track all of your fixed and variable costs. 

While your business will likely be more complex than what we have drawn up in our example, a thorough job of accounting and bookkeeping can help you to produce a similar analysis of your firm’s cost structure and help you determine how much to produce and how many people to hire.

Next: How Much Cash Should You Have On Hand?