© Entrepreneurial Insights based on the concept of Alex
Osterwalder
In this post we
explore the ninth and final building block in the business
model canvas serieswhich is called the Cost Structure. We briefly look at what we
mean by the cost structure of an organization before delving into the key
question every entrepreneur must answer if he/ she is to do a thorough and unflinching
analysis of their business models. We also look at what kind of
characteristics most cost structures display; cost structure have fixed and
variable costs and they can have benefits of economies of scale or economies of
scope.
Read on to learn about
1) cost structure, 2) types of businesses, 3) characteristics of
cost structures, and a 4) case study of Google.
COST
STRUCTURE
This building block
represents all the costs that a business can or will incur if it opts for a
particular business model. 90% of new businesses fail in the first 3
years because they fail to understand their costs or what it will take to
create the goods and services they have promised in their
value propositions. At least three other building blocks are contributors to the
cost structure block. One must evaluate the cost of creating and delivering the
value proposition, creating revenue streams and focus
on long-term customer relationships. All three of these blocks represent a
financial investment into the business. However, when an entrepreneur has
effectively figured out their key resources, key activities and key
partnerships the aforementioned costs become easier to calculate. If you have a
major cost stream which cannot be matched to a Key Activity, it needs to be
given a closer examination. Either your Key
Activities block is missing a vital activity or your costs are being
inflated by an activity which is unimportant and yet has still been included in
the business model. It is important to note that cost can be a fundamental
concern for some business model. One example is ‘no frills’ airlines like
SouthWest which are completely focused on reducing costs.
Key questions to ask
When doing a thorough
analysis of your business model, it is imperative to ask the followingquestions when filling in the Cost Structure
building block of the business model canvas;
1. What are the
fundamental costs derived from my business model?
3. Which Key Activities
represent a significant expense to the business?
4. How do your Key
activities drive costs?
5. Are the above
mentioned activities matched to the Value Propositions for your business?
6. By exploring different
permutations of your business model, do the costs remain fixed or become
variable?
7. Is your business more
values driven or cost driven?
TYPES
OF BUSINESSES BY COST STRUCTURE
Costs will always
remain a major concern for all businesses. It is in fact the universal concern.
However, some businesses make it an organizational mission to minimize costs as
much as possible and all their strategies and tactics are derived from this one
goal. Hence businesses can be categorized into two extremes based on the volume
of goods produced; both ends of the spectrum are either cost driven or values
driven. Realistically though, companies usually fall somewhere in the middle of
this spectrum.
Cost-driven
As the name suggests,
such a business model is utterly focused on reducing costs. This is essentially
a race to the bottom. This obviously impacts the other building blocks. A
business which is cost-driven focuses on creating a lean cost structure through
offering cheaply priced value propositions, a high degree of automation, and
outsourcing of costly functions. It is important to lower your prices based on
internal costs and expenses rather than in response to what the competition is
doing. Industries prone to price wars experience this tragedy all the time.
During the price war competitors will steadily undercut each other’s prices to
attract the price sensitive customer. However, if your competition is able to
manage its costs and create operational efficiencies, they will be able to
sustain their business on the lower price and continue to attract customers. If
your business fails to do so, you may end up arriving at a price you are stuck
with, which is unrealistic considering your expenses.
Ryanair is another
example of a ‘no frills’ airline which provides a cheap solution to its
customer segment for air travel by reducing costs incurred by in-flight meals
or other amenities traditionally offered by major airlines. Such airlines have
increased seats in their planes and have a limit on luggage size. However, the
swift takeover of the market airlines like Ryanair have accomplished clearly
show an unmet need that these airlines have fulfilled. Conversely, more
expensive airlines have aircrafts which now spend more time on the ground than
they do in the air.
Values-driven
Not all companies
drive their business based on costs. Some focus completely on the value they are
providing to their customers, hence taking the value-driven approach. This
strategy is characterized by complete focus on the creation and delivery of a
high value, value proposition which is highly customized to the customer
segment’s preferences. Luxury hotels opt for a values driven approach. The
Hyatt prides itself on its customer services and amenities. They put a lot of
effort into creating an experience which customers are willing to pay top
dollar for. Employees of the hotel are encouraged to anticipate individual
customer’s needs right down to greeting a repeat customer by name and providing
them with a room with their preferences already in place.
Another volume
specific example is of the transistors used to amplify or switch electronics
signals called metal oxide semiconductor field effect transistors or MOSFETs.
This is one of the most commonly used transistors in analog and digital
circuits. The price per unit is 21 cents. If you buy 10, the price per unit
becomes 19 cents and if you buy a hundred the price per unit falls even further
to 17 cents. Hence this is a variable cost dependent entirely on the volume you
are trying to produce which requires the MOSFETs. There is a price difference
depending on how much you buy, leading to economies of scale.
CHARACTERISTICS
OF COST STRUCTURES
Cost structures have
multiple characteristics. These are highlighted below;
Fixed costs
Fixed costs are business expenses that remain the
same regardless of the volume produced by the business. These costs are usually
time bound such as monthly salaries or rent for office space and can also be
referred to as overhead costs. Manufacturing businesses are typically
characterized by high fixed costs due to the investments required in renting
the facilities and the equipment. However, it is important to note that fixed
costs will not remain the same forever. Instead, they may change with time but
will remain stable over a period of time. Hence these costs are also known as
sunk costs for the relevant period of time.
Decisions for costs
are often related to management. Capital
Expenditure or CAPEX are investments in the long-term, things that are bought
and go on the balance sheet of the company and will
be depreciated over the years.
Variable costs
Variable costs are costs which are heavily dependent on
the volume of output a company produces. These are costs incurred when you
produce a product. If you do not produce, you will have no variable costs.
Similarly you may have delivery costs but if customers aren’t asking for delivery
then this is a possible variable cost which you can avoid. These costs are
therefore sensitive to changes in demand and supply and cannot be easily
predicted. They increase directly proportional to increases in labor and
capital. Variable costs are represented by utility bills and raw materials used
for production of the end product. The organization and execution of a music
festival will typically be characterized by high variable costs.
Another cost close to
the management’s hearts and minds are Operational costs or OPEX. These are the
costs associated with the day to day running of the company or the used up
expenses. Hence a 3D
printer is
an example of an expense that falls in OPEX. Other OPEX related expenditures
are purchase of raw materials, electricity bills and expenditure on maintenance
of buildings and machinery. Companies often have different budgets for CAPEX
and OPEX.
Economies of scale
The higher the volume,
the lower the overall cost per unit. Economies
of scale are
a benefit enjoyed by most big companies with a high output quota. Essentially
this is a cost advantage which big companies can enjoy due to their size, sheer
quantity of output or scale of operation. The reason costs fall with higher
volumes is because higher volumes spread fixed costs more thinly making the
cost per unit fall dramatically; hence the average cost per unit is reduced.
Hence a bigger company will have a lower cost per unit output than a smaller
company or a company with more facilities will have more of an advantage than
one with fewer facilities. Not only do economies of scale help lower fixed
costs, they may also help reduce variable costs by creating synergies and
increasing efficiency.
Bulk buying is a
common indicator of mass production and automatically leads to economies of
scale. Bulk buying often leads to lower prices. When you are buying in volume,
you often have a stronger negotiating position and can create lower prices for
your raw material. This is a tactic used most successfully by Walmart which
uses bulk buying to negotiate much lower prices for the items in its stores. It
is then able to transfer these savings to its customers, providing them with
lower than market prices for regular items.
Economies of scope
Economies
of scope refer
to the reduction of costs when a business invests in multiple markets or a
larger scope of operations. The average cost of production is therefore
expected to decrease if a company opts to increase the number of goods it
produces. A company will have a structure in place already along with all the
departments such as Marketing, Finance or HR operating, so the company can
increase their scope and hence economize the entire structure.
Economies of scope
based on product diversification are only achieved if the different
products have common processes or share the use of some resource. Hence
spending on marketing the products or distribution channels may lessen per unit
if both products require similar marketing efforts or use the same distribution
channel. The uses of product bundling and family branding are also an example
of firms trying to achieve economies of scale. However, where economies of
scale are easy to achieve and measure, economies of scope present a bigger
challenge when trying to measure them
Economies of scope
have multiple advantages for the business. These are listed below;
1. A great deal of
flexibility in the design and mix of the product
2. Increased response
rate and decreased response time to market driven changes
3. Processes are
repeatable with a higher degree of control over their execution
4. Costs are reduced
because wastage is minimized in this particular business model
5. Organizations can more
accurately predict changes and cycles
6. Software and hardware
utilized more efficiently
7. There is less risk
associated with a company which sells multiple products, or targets multiple
markets or does both. Even if one product or market falters, the company will
have alternatives to help tide it over while it readjusts strategy.
Let’s take a look at
the Coca Cola brand. Coca Cola already has a number of drinks launched in the
brand other than Coke itself. Supposing we look into how Coke can diversify
even further by launching an as yet unheard of drink such as Coca Cola Green
Tea. Distribution of the different products under one company will use the
established Distribution Channel leading to a major saving for the company.
CASE
STUDY: GOOGLE
We all recognize Google as a
multinational corporation which specializes in internet based products and
services. It is one of the biggest internet companies in the world and has made
an unprecedented success of its Search
Engine Optimization products. It has dedicated fans worldwide and is the most
preferred search engine on the internet.
For the purpose of
this article, we will take a look at Google’s Cost Structure in particular.
Holistically, Google’s cost elements can be divided into four categories which
are:
·
Data center operations,
·
Traffic Acquisition, and
·
Sales and Marketing.
Google invests deeply
into its research and development with the purpose of bringing around
improvement in existing products and constantly creating new and innovative
solutions. This expenditure has helped Google maintain its position at the top
despite the typical short-lived cycles of popularity of most internet based
successes. This has led to economies of scope for Google because it has
resulted in a great deal of product diversification such as Google’s entry into
the mobile app market as well as its cloud sharing services.
It is speculated that
Google has almost a million servers globally and these servers help process
around a billion search requests daily. Google has invested a great deal into
these data centers and they represent a significant fixed cost for the company.
Even the management of these servers’ represents a major cost for the company.
However, due to the high volume of searches these centers process, they are
able to increase economies of scale for the company by optimizing the servers
search capacities.
Traffic acquisition
costs refer to the money given to the Google Network through its Adsense program or to websites which
redirect users to Google or provide the Google Toolbar to their customers. All
these players help Google in attracting more and more users to its products and
services daily.
Finally, Google
invests in advertising and marketing to the wide customer base it is targeting.
These costs also include the worldwide Sales Force that Google maintains which
aims to sell its campaigns as well as its support team, available to handle
customer complaints or hiccups.
