The Business Model Cost Structure

All components of a business model have related costs and the size and behavior of the costs provide an indication on the flexibility and scalability of the business model. As all managers know, lowering cost with $1 has a greater impact on the bottom line than increasing the revenue with $1 as revenue almost always comes with an associated cost.

Having a low cost structure is a strong competitive advantage which market leaders in industry after industry recognize, when companies with low cost business models enter their markets. In the steel industry the mimimills took on traditional smelters, in automobile manufacturing standardized Japanese cars won out over customized vehicles, "no frills" airlines such as Southwest Airlines or Ryanair took down traditional airlines such as US Airways and Swissair, open source software has taken large market shares within several software areas, and a hot topic right now is the struggle of traditional newspaper companies as a consequence of low cost online substitutes. See separate post here

Online companies with low costs structures are currently disrupting traditional industries and have created some very high operating margin businesses, with Craigslist perhaps the most referenced example, generating an estimated $100mm in annual revenues with an operating margin of 90%.

The Business Model Framework

The business model concept is a good framework to identify where costs arise, and how it relates to the creation and capturing of value for customers and other value recipients. Identifying significant costs and assets needed, relating to each component of the business model, provides an overview that can be used to improve the existing model or completely alter it.

Not only a number

When doing the cost analysis in relation to each business model component it is important to identify underlying cost drivers, relationships between different costs and the behavior in terms of size, growth, volatility, and whether it is linear, degressive or progressive in relation to increasing activities. This will answer an important question on how the business model will correspond to change, and how predictable that is, and can be used to find ways to balance the need for growth while managing costs and risks.

Knowing how much things costs and how it will change over time is the only way of maintaining a rational cost structure. Also knowing how choices in the different business model components affects costs in other components is a great starting point for business model innovation.

General questions once the full picture is known

Few if any managers and executives have visibility of the costs associated with the different parts of the business model. Especially in times of cost reduction it often ends up cutting too deeply in areas that are critical to the business while leaving money on the table in areas that are less critical. Once the different major costs are identified you can start question each of the business model components:

• How can this be performed differently at lower cost, or even be eliminted?
• What companies are focusing on low-cost alternatives in this particular business model component but perhaps in another industry?
• How could collaboration with another actor lower or eliminate costs?

Below are some examples on more specific questions:

Customers and Value propositions

Do we need to serve all existing customers or market segments? Are some of the segments more costly? What if we configure our value proposition differently? What if we reduced performance, eliminated features, changed the mix of value propositions, adjusted the level of service, and eliminated expensive value propositions exposed to price competition? Would it be possible to create synergies between different value propositions? What if we changed the way or time of delivery? What if we employed or changed to other channels of delivery?

Resources and activities

What if we used other raw materials? Shifted location? Changed specifications for purchased components? Lowered wages paid, amenities provided to employees or training? What if we replaced owning of IT systems and software, and replace it with software as services? What if we abandoned unused patents, or sell and license them back? What if we outsourced development, marketing or installation? What if we invested in new processes? Automation? Simplification? Elimination? Centralization? Standardization? Shared Services? Can we create synergies between different activities or use resources in a more efficient ways?

Partners and relationships:

What if we change specifications? Quality? The number of partners? The type of partnerships? What if we partner with upstream, downstream or horizontal actors? Configure the value network in a different way? Etc.

Even though the cost side of a business model to a large extent determines flexibility and scalability, it is seldom discussed in relation to business model innovation. Growth in revenues is of course important but it’s only half of the value creation equation.

Further reading:

10 Tips on Business Model Innovation

Scalable Business Models

External links:

When Talking About Business Models, Remember That Profits Equal Revenues Minus Costs

Scalable Business Models

When a business model has the potential to generate growth in revenues significantly faster than its cost base, the business model is scalable. As growing revenues increases the operating margin, scalable business models have the potential for earning very high profits. The key to scalable business models is to have small Costs Of Goods Sold (COGS), and to get a demand driving revenues up.

Cost Of Goods Sold
COGS is the cost for each product or service, plus additional costs necessary to get the product into inventory and ready for sale, including shipping and handling, and is a variable cost associated with each unit sold. With low COGS, the contribution margin has the potential to increase dramatically relative to the fixed cost base, resulting in high profits. A product business with outsourced manufacturing can supply thousands of units with the same staff as it might supply hundreds of units.

A less scalable business model
When selling services per hour growth in revenues totally rely on personal output of staff, and there is a linear relationship between revenues and cost base. Growth is depending on the acquisition and retention of highly qualified people delivering the services, and those are not always that easy to find, even though there might be a high demand for the services.

Selling Software
A common example of a scalable business model is selling software. The development costs are high but once ready for launch, the costs for each new copy of the software is very low. When packaged and distributed in physical copies, software still has a COGS per unit.

The Internet enables zero COGS
Internet platforms with user-generated content, viral or word-of mouth marketing, and close to zero in costs for each new user has created very scalable and profitable businesses. An interesting example is Craiglist, a company generating estimated $100 M with less than 30 employees, having an operating margin of 90% . Another interesting example of scalable businesses is the rapid growth of companies producing virtual goods for online games and platforms. San-Francisco based Zynga apparently turned in 2008 revenues near $50M.

Designing a scalable business model is one thing...
It is easy to design scalable business models, especially using the Internet. It is not as easy to create demand and generate high growth in revenues. Perhaps the Internet bubble in 2000 was due to the fact that people only understood the first sentence?