This month we are covering ‘Cost Structure’, the last of the nine building blocks of the Business Model Generation developed by Alexander Osterwalder and Yves Pigneur. ‘Cost Structure’ describes all the costs incurred to operate a business. Here are three things to consider:
- What are the most important costs inherent in your business?
- Which key resources are most expensive? Key resources describes the most important assets required to make your business model work. In our business, the key resources are intellectual and human resources.
- Which key activities are most expensive? Key activities describes the most important things your company must do to make its business model work. Key activities refer to production, problem solving and platform/network. In our business, it is a combination of problem solving and production.
There are two general types of business models:
1) those that are cost-driven
2) those that are value-driven
While it is natural to minimize costs in all businesses, most business models fall somewhere between a cost-driven model and a value-driven model. Cost-driven models focus on reducing costs wherever possible. This approach aims at creating and maintaining the leanest possible cost structure, using low price value propositions, maximizing automation, and typically extensive outsourcing. Think of Southwest and Costco. On the other hand, there are the value-driven models which are less concerned with cost implications and instead focus on creating value for customers. Value-driven models focus on premium value propositions and a high-degree of personalized service. Our business would be an example of a value-driven model, as well as luxury hotels and the treatment that you receive when you have a luxury car serviced at the dealer.
Cost structures generally have the four following characteristics:
Fixed Costs – These are costs that remain the same without regard to the volume of goods or services that a business produces. Examples could include rent, salaries, physical manufacturing facilities and machinery. A great example would be a commercial printing company that may spend more than $1 million on a printing press and the cost is fixed. Their goal is to keep the press running 24/7.
Variable Costs – These costs, by definition, vary as the volume of goods or services varies. In the printing example, the ink and paper are the variable costs, as the amount used correlates directly to the output of the machine.
Economies of Scale – Businesses enjoy cost advantages as their output expands. Think about Costco. Costco is able to reduce the cost to consumers because it buys in bulk and sells in bulk. Consider that fact from a packaging perspective. When you go to Costco and buy toilet paper, you get 48 rolls all packaged in one unit. If you go to the grocery store and buy a pack of six, the cost of packaging those six rolls is not proportionate to the cost of packing 48 rolls. Packaging and selling in bulk reduces the cost to both Costco and the consumer.
Economies of Scope – These are cost advantages that a business enjoys due to a larger scope of operations. Let’s take Proctor & Gamble as our example. P&G sells Tide, Gillette, Crest, Pantene, Charmin, and Dawn to name just a few. Consider how the scope of their operations serves their business model. They are selling multiple products and can deliver and shelve them for less than smaller companies. They are in a position of power with their customers because their customers buy so many of their products.
Now that we have covered the basics of the Cost Structure, consider how your business fits into the discussion. Is your business cost-driven, value-driven, or a blended combination? Also, consider your cost structure. How is it impacted by fixed and variable costs, and do you have any economies of scale that you can exploit to be more competitive or profitable? Take an hour to reflect on this as it relates to your business and write out a few paragraphs on what you considered and learned. Writing is thinking!
As always, if you want to take a deeper dive on this or want someone to share your ideas with, let me know.