business model cost structure building block

Cost Structure – How To Minimize Costs and Maximize Value

In this last section, I’ll walk you through the cost structure building block of the business model canvas. I’ll explain the different types of costs and show you the key questions every entrepreneur must be able to confidently respond to when analysing the business model.

You will learn about the different types of cost structure: fixed and variable costs and they can have benefits through economies of scale or economies of scope.

What Is The Cost Structure In The Business Model Canvas?

The Business Model Canvas cost structure describes the costs that business occurs through its operations. These include employees, infrastructure, costs associated with all activities as well as sourcing through key partnerships.

Business Model Cost Structure

business model cost structure building block
The Cost Structure of the Business Model Canvas

The cost structure building block presents all the costs that you incur as a business. 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.

In another study, CB Insights looked at the post-mortems of 101 startups to compile a list of the Top 20 Reasons Startups Fail. The number two position ‘ran out of cash’.

When reviewing the cost structure block you need to recognise where your main costs will be:

  • Key Activities
  • Key Partnerships
  • Customer Relationships
  • Channels

Key Questions To Ask

When doing an analysis of your business model, it is vital 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?

What Are The Different Types Of Cost Structure?

Cost-Driven

This kind of approach concentrates on reducing costs as much as possible. This can be done through outsourcing and automating wherever possible.

Examples include:

Value Driven

This is a more value centred approach which focuses on maximising worth for the customer. This approach focuses on a highly personalised and tailored service that really focuses on minimising Customer Pains and increasing their Gains.

Examples include:

Characteristics of Cost Structures

How costs work depends on their characteristics. It’s important to appreciate the difference between fixed costs, variable costs and ultimately being able to calculate your break-even point.

Fixed Costs

These costs are usually a fixed percentage of your overall costs. While they do change, often incrementally they remain fairly staple.

Examples include:

  • Amortization. This is the gradual charging to expense of the cost of an intangible asset (such as a purchased patent) over the useful life of the asset.
  • Depreciation. This is the gradual charging to expense of the cost of a tangible asset (such as production equipment) over the useful life of the asset.
  • Insurance. This is a periodic charge under an insurance contract.
  • Interest expense. This is the cost of funds loaned to a business by a lender. This is only a fixed cost if a fixed interest rate was incorporated into the loan agreement.
  • Property taxes. This is a tax charged to a business by the local government, which is based on the cost of its assets.
  • Rent. This is a periodic charge for the use of real estate owned by a landlord.
  • Salaries. This is a fixed compensation amount paid to employees, irrespective of their hours worked.
  • Utilities. This is the cost of electricity, gas, phones, and so forth. This cost has a variable element, but is largely fixed.

Variable Costs

These types of costs change depending on the number of goods and services produced by a business. These include things like raw materials, shipping costs web hosting servers.

Here are a number of examples of variable costs, all in a production setting:

  • Direct materials. The most purely variable cost of all, these are the raw materials that go into a product.
  • Commissions/Affiliate payments. A commission is an additional compensation a company gives to its employees. Employees may receive commissions for exceeding their expectations and meeting the company’s requirements. Most companies give sales commissions at a rate predetermined in a contract agreement.
  • Shipping Costs. Shipping costs refer to the expenses incurred when a company moves its products and raw materials from one point to another. This can be through water channels, roads, air or railways. Shipping costs are variable in the sense that they tend to change with the production and sales volume.

Economies of Scale

Economies of Scope are savings generated when the cost of producing a range of products together is cheaper than manufacturing them individually. For example, several products may share the same marketing activities or Distribution Channels.

One of the advantages of big organizations is that they benefit from the fall in costs with higher volumes which spread fixed costs more thinly making the cost per unit fall dramatically; hence the average cost per unit is reduced. As a result, a bigger company will have a lower cost per unit output than a smaller company. An example is when a big company buys and gets a much lower cost than a small business.

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 decreases if a company opts to increase the number of goods it produces.

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.

Economies of scope have multiple advantages for the business:

  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.

Contingency Costs

A common mistake is to underestimate the day to day expenses or odd things that crop up that you haven’t thought about. These might be legal costs e.g. filing patents…it could be anything. The fact is that most entrepreneurs under-estimate daily expenses as well.

The solution is to allow for an overall contingency percentage in your budgeting. A typical figure of ten per cent will suffice until you do the detailed budget planning.

How To Do Some Research On Cost Structure

Within a market that has a dominant business model companies often have similar partners, activities and costs associated with sales and marketing. By looking at their publicly available reports you can get a good sense of what costs they incur as well as the costs associated with sales and marketing.

Another benefit of this is to use this information to then consider how you can change the business model, change the cost structure and therefore produce a more sustainable competitive advantage.

Doing your research will eliminate the risks and help to produce a successful business model design.

Learn More

How to use the Business Model Canvas plus free pdf downloads.

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