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Cost Structure and CFO Decision Making

A CFO is driven by the goal of maximizing profitability of an organization’s operations. And because profitability is revenue minus costs, growing revenue and decreasing costs are both top priorities.

Predicting costs

Maximizing profitability isn’t just about growing sales. The critical factor in what might look like irrational relationships is costs. This is why cost management is so important for running a profitable business.

To effectively manage and control your costs, you need to be able to predict what they’ll be. If the actual costs differ from your prediction, you need to understand what’s behind the discrepancy. So you must understand what drives costs. Any examination of the cost structure of an organization begins by making a distinction between fixed costs and variable costs.

  • fixed costs — Fixed costs are costs that aren’t directly related to sales or production. This means they don’t change or fluctuate in response to changes in sales.
  • variable costs — Variable costs are costs that are directly related to sales or production. When sales or production levels change, variable costs change in tandem. For instance, if production increases by 20%, variable costs will increase by 20%. When production decreases, variable costs decrease to the same extent.

Costs, sales, and profits

When a CFO’s working to maximize profitability, consideration is given to the relationship between costs, sales, and profits. Four fundamental principles apply. First, sales don’t affect fixed costs. Second, sales do affect variable costs. Third, breaking even requires a minimum level of sales. Fourth, profit is highly sensitive to sales changes.

The first principle, that sales don’t affect fixed costs, means that fixed costs remain constant even when sales increase. If an organization’s fixed costs are, for example, $800 per week, it doesn’t matter if sales are $0, $1,000, or $2,000 — fixed costs stay constant at $800.

However, sales do affect variable costs, which is the second principle. Variable costs increase when sales increase. When sales are $0, so are variable costs — but they increase when sales do.