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
following questions when filling in the Cost Structure building block of the business model
canvas;

1. What are the fundamental costs derived from my business model?

2. Which Key Resources represent a significant expense to the business?

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.