The Cost Structure is the last – but not least – component of a Business Model. It gathers the most important costs involved in the whole operation from the outset. This is the final block, precisely because we need to have all the previous components already defined so we can estimate the costs of each one. This is because creating a Value Proposition, maintaining a Customer Relationship, and developing Revenue Streams generates costs, just as the Key Resources, Activities and Partners demand their own expenses. Some Business Models, however, are much more cost driven than others. So let’s get to know the role and importance of the Cost Structure for your Business Model.
Cost Driven Businesses vs Value Driven Businesses
Cost-driven business models focus on minimizing any costs wherever possible. They seek, therefore, to create and maintain a cheaper structure, by means of Value Propositions of smaller prices, using processes of automation and outsourcing whenever possible. The goal is to have less expense to generate a more affordable final product. However, it’s worth remembering that a business should only reduce its own costs based on its internal expenses and never in response to what its competition is doing. Anyone who opts for price warfare may face ruin in the marketplace. This is because if the company is not able to manage costs by creating operational efficiency, the low price may become unsustainable. On the other hand, value-driven business models are less concerned with transaction costs and focus on the creation of Value Propositions. These value propositions usually have a high level of customization, developed according to the preferences of the clients. This is the case with luxury hotels, for example, that strive to create an experience for which customers are willing to pay dearly.
Cost structures can have the following characteristics:
- Fixed costs: in these structures, the expenses of the business are always the same, regardless of the size of the production. Costs are time-limited, as is the case with salaries and rentals. And value propositions focus on low price, maximum automation and extensive outsourcing.
- Variable costs: in these structures, the costs depend very much on the volume of production. If you do not produce, for example, there are no variable costs. These costs are therefore sensitive to demand and difficult to predict, as they increase proportionally to the increase in labor and in capital. They involve spending on services and raw materials, for example.
- Economies of scale: here, the larger the volume of production, the lower the total cost per unit. Most large companies with a high production quota are characterized by this cost structure. This is because the total costs are divided by the quantity of articles produced. So the average cost per unit gets smaller. That is why, generally, a larger company has a lower unit cost than a small business. And this saving is usually transferred to the final consumer, who is able to pay a lower price on the market.
- Economies of scope: in this structure, costs are reduced when the company invests in varied markets or in a greater scope of operations. This is because different products share resources and processes. For example, the company already has an ongoing infrastructure, with Marketing, Finance and HR departments, for example, and can enjoy the same organization and only expand the scope, saving in the end. Scope economies offer several advantages, such as: design and product mix flexibility, faster response rate and shorter time to market changes, reduced waste, more accurate change and cycle prediction, more efficient use of software and hardware. In short, there is less risk in a business that sells more than one product and / or segments several markets, since even if the market falters, the company will have more alternatives to sustain itself as it rebalances its strategy.
What to ask when creating a cost structure
When doing a complete analysis of your Business Model, the time will come when you need to establish your own Cost Structure, which matches satisfactorily with each of the previous blocks. To help you with this journey, you can ask yourself the following questions about your venture:
- What are the baseline costs that derive from my business model?
- Which Key Resources can be a heavy expense for the business?
- What Key Activities may require high costs for the business?
- How do your Key Activities generate costs?
- Do these same Key Activities correspond to the Value Propositions chosen?
- When you reconfigure your business model, costs continue fixed or they become variable?
- Is your business more cost-oriented or value oriented?
It is important to note that 90% of new businesses fail in the first three years of life because they have not been able to understand the costs required to develop their Value Propositions. However, when an entrepreneur is able to pinpoint their key resources, key activities and key partners, costs become easier to calculate. And finally, keep in mind that your cost structure should be re-evaluated from time to time, just as the other blocks. This will be the only way to ensure the long-term sustainability of your business.