Defining cost structure is the final step towards completing the business model. Although it is the last component, one must never underestimate its importance. As statistics show, one reason why startups fail is that they did not account for the cost of value creation.
Cost Structure is the ninth and last Business Model Canvas block. It comes after defining Key Partnerships.
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What Is a Business Model Cost Structure?
Cost structure describes how a company spends its resources to create value. In particular, it details the expenses incurred by all business model components. Generally, they can be variable and fixed costs.
Based on the latest statistics, 9 out of 10 startups fail within the first three years. The primary reason is that they did not account for the costs of value creation. As a result, they depleted their funds before putting up a product or generating revenue.
A well-planned cost structure keeps companies in a healthy financial position. But more than that, it also helps them scale their operations if needed. For that to be possible, a company must have a robust cost structure and revenue streams. These two business model blocks are the basis for determining operational scalability.
Types of Businesses by Cost Structure
Costs are a universal concern of all companies. How a company treats costs generally falls under two broad but contrasting categories. In one, the goal is to keep their expenses down. On the other end of the spectrum, the focus is on value instead of costs.
Cost-driven Businesses
In defining the different business model blocks, costs are the primary factors. The goal of cost-driven companies is very simple – keep the cost structure as lean as possible.
Some of the measures taken could include:
Reduce costs of value propositions
Choose automation whenever possible
Outsource costly functions
For existing companies, some may have to lower their costs. One reason is to optimize their business model. In this case, the most usual cost-cutting measures are internal costs and expenses.
Another reason for lowering costs is as a response to competitors. But such a move – going into a price war – is risky. In the worst-case scenario, competing companies would undercut each other.
In price wars, companies that manage their finances better may outlast the competition. For those that could not create operational efficiency, trouble looms. Because of lower profit margins, the revenue may not be enough to sustain the business.
Value-driven Businesses
Instead of cost, value-driven companies aim to provide the best value to customers. As such, their main areas of focus are:
Creating high-value products and services
Customizing value proposition to preferred customer segments
Providing exceptional customer experience
In the hotels and resorts industry, there are cost-driven and value-driven hotels. In particular, those luxurious hotels focus on providing a positive, memorable customer experience. Not surprisingly, they also charge a premium.
Value-driven companies do not cut costs and compromise their value propositions. But that does not mean they cannot optimize their cost structure. For instance, they can form partnerships with suppliers that can offer discounted prices. Moreover, these key partners can further reduce costs as order quantity increases.
Characteristics of Cost Structures
Startups should categorize the types of expenses they will incur. Not only that, but they also have to distinguish between fixed and variable costs.
Fixed Costs
As implied, these expenses are usually fixed. Any change in a fixed cost is usually marginal. Some examples are:
Property tax if owned or rental
Employee salaries
Utilities (usually variable but should remain reasonably staple)
Amortization of intangible assets over the useful life of the asset
Depreciation of tangible assets over the useful life of the asset
Insurances (optional and required by the government)
Interest expenses if a startup borrows from a financial institution.
Variable Costs
Like fixed costs, these are variable costs incurred in creating value and operation. But these variable expenses vary, depending on some factors. Some examples are:
Materials or services used to develop the value proposition
Cost of delivery of goods
Commissions and other compensations to employees based on performance
Miscellaneous expenses, such as office consumables and more
Economies of Scale
Companies can derive benefits from economies of scale. Because of higher volume, the cost of products becomes lower. One reason is because of the spread of the fixed expenses.
Consider property tax as an example. Suppose a company starts producing higher volume. In this case, the tax remains the same, resulting in lower costs for the products. Another advantage is buying a higher volume of materials at lower prices.
Economies of Scope
Offering several value propositions can lower the cost structure by lumping together some blocks. For example, companies can market more than one product simultaneously. In this case, it would be cheaper than marketing the products individually.
Contingency Costs
It is not uncommon for businesses to come across sudden, unexpected expenses. While some of the factors are internal, others may be uncontrollable. The COVID-19 pandemic, for instance, has affected countless businesses worldwide.
Hence, in developing a cost structure, startups should consider contingency funds. Under normal circumstances, 10% is enough to account for unforeseen costs.
What Is Cost Structure and Cost Allocation?
Cost allocation identifies the costs incurred, then accumulates them and assigns them to different cost objects.
The purpose of cost allocation is to spread the costs across different cost objects. Doing so makes it possible to calculate the profitability of various product lines.
Cost objects can be any, but not limited to the following:
Product lines
Service lines
Projects
Departments
Customers
Business units
Cost Pool
A cost pool refers to the grouping of individual costs. A company can then use the cost pool to make allocations, usually by department or service center. One example is the cost of maintenance, which companies can accumulate into a cost pool. They can then assign it to different departments using maintenance services.
Example of Cost Allocation
Manufacturers usually divide overheads into units of production using cost pools. For example, they use direct labor hours as their cost allocation basis.
The company would first accumulate the overhead expenses over some time, such as a year. Next, they divide the total overhead cost by the total labor hours. The resulting figure is the overhead cost per labor hour – the allocation rate.
Manufacturers can now determine the overhead cost for a specific product line. They can do that by multiplying the allocation rate by the labor hours used to manufacture a product.
The importance of Cost Structure and Cost Allocation
Companies can maximize their profits by using every means to reduce costs. Financial analysts or accountants should always review financial statements. One of their intent is to find any unnecessary or excessive expenditures.
Yes, expenses are necessary to operate and keep a business running. But unless management keeps a close eye on its finances, some of the costs might go out of control. There might be expenses here and there that do not add value to the core business activities.
For startups, creating a cost structure on a business model is necessary. But that is only on paper. Even more important is finding a competent accountant/financial analyst.
Analysts must understand the entire cost structure of businesses. This way, they can help provide the following benefits:
Identify viable cost reduction methods. Such measures should not impact the quality of products and customer service.
Keep updated on the cost trends. One reason is to ensure a stable cash flow. Another is to prevent sudden cost spikes from happening.
Any mistake in cost allocation can result in overpricing or underpricing. It may also lead to allocating unnecessary resources to non-profitable products. An analyst can prevent these from happening by choosing proper allocation bases. And then by ensuring correct cost attribution to cost objects.
Analysts can use cost allocation to analyze the per-unit costs of product lines, departments, or business units. Specifically for products, they can determine the per-unit profit of individual products. Hence, they should offer insights on enhancing the profitability of some products.
Final Words About Cost Structure
As you set out to determine the cost structure of your venture, ask yourself these questions:
Is your business model more cost-driven or value-driven?
What are the most important costs inherent in your business model?
Which of the required key resources are most expensive?
Which key activities cost the most money and resources?
How do your core activities drive costs?
Do the key activities match your value propositions?
Do the cost remain fixed or become variable when you permute your business model?
Remember that most new companies fail before reaching their third year. And the most common reason is financial problems, more than customer issues. So, be sure to think through your economic structure. At any rate, this is the last block of a business model canvas. Before wrapping everything up, go back and review each of the earlier blocks while factoring in the other components.