Cost Structure Business Model | 6 mins read

Determining the Cost Structure of a Business Model

determining the cost structure of a business model
Jin Hyun

By Jin Hyun

A company's cost structure is one of the key parts of a business model as it represents how resources are utilized to generate revenue.

Often, companies focus on how much money they bring in. However, being able to understand how they are spending money can help them find ways to minimize costs and identify expenses that do not add value to core business activities.

Types of Businesses by Cost Structure

When it comes to cost structure, some companies choose to make it their goal to minimize expenses as much as possible. This can impact how they choose to develop their business model and strategies.

Others may want to focus solely on the value they provide to customers. While both ends of the spectrum are either cost or value-driven, most businesses fall somewhere in between. Management can identify key resources or a key activity in their operations to determine if their model is cost or value-driven.
Cost Driven
A business that is cost-driven is completely focused on reducing their costs whenever possible, as the name suggests. This is often achieved by low-value propositions, high rates of outsourcing costly services, and maximum automation to keep internal costs low. By keeping these expenses down, companies are able to offer competitive pricing.

Since margins tend to be small when a company is cost-driven, it usually needs to rely on economies of scale and scope to bring in revenue. Companies that are cost-driven need to demonstrate a streamlined operation since it relies heavily on high volume and increased product variety.

Payless shoe stores are a classic example of a cost-driven company that offers competitive prices for its customer segment by offering a wide variety of shoes and reducing material costs.
Value Driven
While some companies are cost-driven, others prefer to focus solely on the value they can offer to customers. As the name suggests, businesses with a value-driven cost strategy deliver high value focused on making their product and services attractive to consumers.

Companies like Bloomingdales and Nordstrom are value-driven, choosing to focus their efforts on creating a shopping experience customers are willing to pay a pretty penny for. Employees of these high-end brands are trained to greet consumers as soon as they walk through the doors, offering help and expertise to enhance the customer relationship and assist in finding the products buyers are looking for.

The Attributes of Cost Structures

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A company's cost structure is not characterized by one expense or business strategy alone. Rather, cost structure can include the following attributes-

Fixed Costs
Fixed costs are business costs that stay the same regardless of the volume of goods or services produced. This type of expense is generally associated with time periods; for example, monthly rent payments, yearly insurance payments, or bi-monthly salary payments. It is important for businesses to be aware of how a high fixed cost can affect their profit margins. For example, a retail business paying a high monthly rent fee will require a higher revenue level in order to avoid losses.

Variable Costs
These are business expenses that change in proportion to the volume of output produced. Since these costs are heavily dependent on production volume, they increase as production rises and decrease as production falls. The most familiar types of variable costs are related to raw materials needed to produce an item, as well as the packaging materials necessary to ship it.

Variable costs are difficult to predict as they are impacted by supply and demand. When demand for a product increases, the variable cost of labor and raw materials increases as well. For example, food festivals are usually characterized by high variable costs. If there is an increase in sales, the amount of raw materials and labor needed to run the festival also increases to meet the demand.

Economies of Scale
This refers to lowering the cost per unit by increasing production through higher volume. Take, for instance, a fast food company such as McDonald's. These franchises are able to bargain with suppliers for lower rates by purchasing in bulk. This in turn enables the company to mass-produce its menu items, lowering production costs, and increasing profit margins.

Economies of Scope
This is the concept that the cost to produce an item declines as the variety of that product increases. A company could use their key resources to make more similar products to be sold to the same target market, ultimately driving costs down while creating more revenue streams.

For example, a clothing company, which manufactures men's suits, increases their economies of scope by using the same facilities, equipment, and suppliers to create a new line of women's suits. As the operation grows into other consumables, the cost for production on suits declines.

How to Track Cost Structure Metrics

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Regularly reviewing the company's performance is crucial to improving its cost structure. Tracking success metrics is not a one-and-done task, it needs to be monitored and analyzed continuously over time to help a company spot its weak points.

By adjusting expenses in different areas of the company and tracking how it affects metrics, businesses can determine whether these adjustments increase or decrease revenue.

So, what are these metrics to help track company performance? Below are some of the most important metrics managers should keep an eye on if they want to improve the cost structure of their business model.

  • Customer Acquisition Cost (CAC) - This is how much it costs a company to acquire one customer to buy a product and/or service. To find the CAC figure, simply divide the total marketing cost by the total number of new customers gained during this specific marketing initiative.
  • Revenue Retention - This refers to the revenue generated from customers in the previous month or year. Revenue retention is one of the metrics used to measure churn, the ratio of returning customers. If a company provides a product that fits their market, offers competitive pricing and great customer service, revenue retention should be high.
  • Customer Lifetime Value - LTV is the total revenue a company can expect to earn from the average customer. In other words, LTV is a prediction of the net profit attributed to a company's entire relationship with a customer.
  • Annual Contract Value - ACV refers to the annual value of subscription-based revenue gained from each contracted customer. For example, say a customer subscribes to a SaaS (Software as a Service) company for 4 years at $4,000. The ACV for this customer is $1000.
  • Recurring Revenue - This is the total amount of subscription-based revenue expected to be gained in the future. Unlike one-time sales, these revenues are more predictable and stable, ensuring a high degree of certainty for a company. Recurring revenue has several ways of being measured, including monthly recurring revenue (MRR) and annual recurring revenue (ARR).

Cost Structure and Long-Term Growth

In order to achieve long-term growth, companies can track the above metrics to observe spending habits while identifying problem areas within their cost structures. This practice, when used in conjunction with financial forecasting and budget planning, can determine the long-term growth potential of a business.

Additionally, the scalability of cost structure gives lenders and investors a better understanding of the financial health of a business and whether the establishment should be considered for business funding. By reviewing the metrics associated with cost structure, potential investors can predict whether a company is gaining traction or staying stagnant.

Luckily, forecasting software can provide business owners with essential information in an easy-to-digest format. Choosing the right forecasting software can help crunch numbers faster and remove the possibility of human error by providing automatic financial forecasting.