 Hello and welcome to the session in which you would look at cost structure and how would a cost structure for a company affect its profit stability? Cost structure is the relative proportion between the fixed and variable cost for a particular company. What does that mean? Each company will have cost, various types of cost. Cost can be broken down in theory, fixed and variable. Now the question is, what percentage of your cost is fixed? What percentage of your cost is variable? Is it 40% fixed, 60% variable? Is it 60% fixed, 40% variable? This is what we mean by cost structure. For example, automated companies, companies that use automation, they will have machinery, they will have equipment and they will have to invest in those companies in order to have those automated machineries. They will have a high fixed cost relative to a company that relies on labor. Why? Because labor cost is variable. If you don't need the labor, you can lay them off. It's easy. But if you don't have a business to run the machine and you paid so much for that machine, you cannot turn around and sell it. So which cost structure is better? And the answer is, there is no real answer. The answer depends on many factor. It could sometimes be, you're glad you chose fixed cost and sometimes you're going to say, well, I hope I never invested in fixed cost. It all depends on the future prospect of the company and the vision of the owners, the long-term stability, the appetite risk. How much risk are you willing to take? Now obviously, the more fixed costs you have, generally speaking, the more risk you are taking because it's harder to turn around when you have a large fixed cost. But if you have a high fixed cost, automated company, you will benefit more when sales go up and we'll see an example illustrating these concepts. So let's assume we are in the olive oil business. And to produce olive oil, you need to first pick the oil. So we have farms and we are picking olives. And this company here, this is what we're going to call the Sling company. They rely on labor and notice those are kids. But to make the point is they rely on labor. Big company, what they did, they invested in machinery and the way they picked the olives is through using a machine. Now, lean company sales is 100,000. Variable expenses is 60. Contribution margin is 40. Their contribution margin percentage is 40%. They have a fixed cost of 30. Big company, they also have sales of 100,000. Variable expenses of 30. A contribution margin of 70,000, which is a contribution margin of 70%. Fixed expenses is 60 and their profit is 10. So notice they're both making the same amount of sales and they're both making the same amount of profit. Although they have a different cost structure. Well, that's fine for now. Now, what happened if we change sales? So let's assume sales increase by 10%. What would happen? If sales increase by 10%, we're gonna see that big company will benefit more and we're gonna look at if sales decrease by 10%. We're gonna see that lean company benefit more. Let's first look at sales increasing by 10%. If sales increasing by 10%, sales is 110. Variable expenses goes up by 10%. Contribution margin is 44,000. Fixed expenses is 30, which is fixed. Net operating income equal to 14. For big company, sales increasing by 10% will yield a 17,000 profit. So notice big company benefited more when sales went up by 10%. Why? Because big company already invested in fixed expenses. So if they generate more sales, more of that sales will flow down to the operating income because they already covered their fixed cost. Now, let's reverse. Let's assume sales in a bad year went down in 10%. Well, sales went down for lean company by 10% down to 90,000. Variable expenses 54, their net operating income is 6,000. The net operating income for the big company now, if sales decrease by 10% is 3,000. Wow. Notice now lean company is making double the profit of big company. Why? Because in bad times, lean company is more protected. They can lay off the employees. They don't have to pay them. They have a less variable expense. Therefore they protect their profit much better than big company can because they bought those machines. They cannot just return them. And if they return them, they're gonna, even if they sell them, they're gonna incur additional losses and they don't want to sell them because the next season is coming up and you don't wanna get rid of your assets of your property, plant and equipment, how are you gonna operate? So that's why lean company is better during downturn. Let's also take a look from a break-even perspective and from a margin of safety perspective for lean and big company. If we look at the dollar sales to break-even, which is we'll take fixed expenses divided by contribution margin for the lean company. Now, if you don't know how to compute the break-even, please go to Farhat Lectures and look the break-even lesson because it's there. This is part of this lesson, which is the break-even point is $75,000, which means they break-even at 75. Sterling, they'll break-even at a higher. So they need more sales to break-even. So why? Because they have a higher fixed cost, that's why. Margin of safety, lean company, when we compute their margin of safety, which is current sales minus the break-even, they can lose up to $25,000 in sales before incurring a penny in losses, which is which represent 25,000 divided by 100,000, represent a 25% decrease in their sales, which is margin of safety. Also, we look at margin of safety in the previous lesson, go to farhatlectures.com if you don't know what margin of safety is. Overall, what can we say? Just kind of so we understand which one is better and which one is not, there's not really no answer. Here's what we can say. We can say that lean company in bad time, they can withstand lower sales before incurring a loss. So if you like to avoid losses, rely more on variable expenses because you can cut down on your expenses much faster. Lean is protected in bad years. Big is more vulnerable to a downturn in sales, but big can benefit more in good years. So in good years when they have a lot of sales, when it's a good season and they're selling a lot, they will benefit more because they already covered their fixed costs. And now each additional dollar, remember 70% of it, now it's gonna go down to profit. For lean company for each additional dollar in a contribution margin, only 40% goes to the bottom line. At the end of this recording, I'm gonna remind you, well, I haven't, but please go to farhatlectures.com, work multiple choice questions, invest in yourself, whether you are a student or a CPA candidate, I can help you in both situations. Good luck, study hard and of course, stay safe.