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In the highly volatile markets of today‟s economy, detailed profit planning is the foundation for longterm
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 be when a firm creates a strategic alliance with a supplier rather than building a
vertically integrated value chain. In this case, as output increases, costs from sourcing would increase
in a relative manner. That is, they would be variable in nature. If the firm were to have built the
infrastructure, the costs would have been fixed.
Although this discussion can easily describe a manufacturing environment, it is also relevant for a
service business. Throughout this chapter we will use the generic term output, which can describe a
tangible unit of production or the more intangible unit of service. Finally, profit planning and the
analysis of cost structure assume some type of relevant range since it is clear that if a firm were to
double output, its fixed infrastructure costs would most certainly increase and variable costs per unit
would be impacted by scale factors. 2
History is overflowing with examples of the importance of cost structure analysis in strategic
planning. In the early 1980s the U.S. airline industry was deregulated. Given a set number of routes
flown every day, which then required a fleet of planes and salaried employees, this industry, at the
time, had one of the highest operating leverage factors of any industry. Almost all of its costs were
fixed. The more financially sound competitors cut prices, fully aware of the short-term impact on their
profits. But they also realized that those less financially sound carriers would not be able to sustain the
losses due to lack of coverage of the fixed cost burden. Airlines such as Braniff and Eastern soon fell
into bankruptcy. Ten years later Sun Microsystems did much the same thing in the computer industry.
At that time, Hewlett-Packard, IBM, and Digital Equipment Corporation all had vertically integrated
infrastructures, which produced proprietary designed systems sold at premium prices. Andy
Bechtolsheim, one of the three founders of Sun and the technology leader, realized that with the
advances in technology, a competitive system now could be assembled from low-cost, readily
available components at a fraction of the traditional cost. Sun built its business model on an open
platform and priced aggressively. Management argued it was “better positioned to deal with low
margins than IBM or DEC, who‟ve got to financially feed layer upon layer of bureaucracy.” 3 In
approximately 10 years, this initiative restructured the industry from proprietary technology players
with vertically integrated infrastructures and correspondingly high operating leverage to open players
with minimal infrastructure and radically different cost structures. And in today‟s business
environment, all one has to do is follow the debate on outsourcing to understand the continued impact
of cost structure on business models.