Your cost structure as it relates to the Business Model Canvas is closely related to your value proposition.

A company’s cost structures represents the specific costs that the business will incur while operating under a particular business model to create and deliver the business’s value proposition, as well as maintaining its customer relationships all have costs to the business.

These costs have to be allocated across all product or service offerings to minimize costs.

A company’s cost structures can be calculated after it considers the key resources, key activities and key partners it will require.

In a vertically integrated business like one of the major Japanese Keiretsus, which can spread their fixed costs across different business units, these companies manage all the essential resources, activities, and their partner units to choose which industry they want to lead.

For the small business owner, however, the best option when it comes to understanding cost structures is to look at the contact area between the company and its customers, buyers, and suppliers using Porter’s Five Forces model.

At its highest level, cost structures are either cost-driven or value-driven.

Let’s find out how you can leverage the cost structure business model.

What is the Cost Structure?

The cost structure business model is a fundamental aspect of any company’s strategic plan.

It involves a detailed analysis of the types and nature of costs a business incurs. Understanding the cost structure is crucial for making informed decisions about pricing, scaling, and profitability.

Business Model Canvas Building Blocks

  1. Key Resources: These are the assets required to offer and deliver the previously mentioned elements, such as intellectual property, capital, and human resources.
  2. Key Activities: These include the most important actions a company must take to operate successfully.
  3. Key Partners: Collaborations and alliances that help optimize operations and reduce risks are crucial in the business model canvas.
  4. Distribution Channels: The means by which a company delivers its value proposition to its customer segments.
  5. Customer Relationships: This entails the type of relationship a business establishes with its customer segment.
  6. Customer Segments: Different groups of people or organizations an enterprise aims to reach and serve.
  7. Revenue Streams: The way a company makes income from each customer segment.
  8. Value Proposition: The bundle of products and services that create value for a specific customer segment.

Cost-driven Structures

Cost-driven structures are focused on keeping costs or expenses down.

Companies that embrace a cost-driven structure use automation or outsourcing to keep internal costs low, resulting in competitive pricing.

Operational excellence is often at the core of the business model of cost-driven structures and are exemplified by Walmart and McDonald’s. Since margins are small, a business that is cost-driven has to rely on economies of scale and scope to achieve satisfactory returns.

  • Economies of scale represent cost-saving that a business enjoys as it grows. For example, a larger company like Walmart benefits from volume discounts on the items it purchases, resulting in lower costs per unit.
  • Economies of scope represent cost savings that a business enjoys as the scope of its operation grows. For example, a large online retailer like Amazon used its market leadership in online book delivery to expand into other consumables.

Value-driven Structures

Value-driven structures are focused on providing more value or revenue through premium offerings or services.

Companies that embrace a value-driven structure use customer intimacy and high-end components to create premium products.

Customers that buy value-driven products and services are less price-conscious, and value quality, performance, and convenience over price. Nordstrom and Rolex are examples of companies that have value-driven structures.

Operating Leverage

Another element of a company’s cost structure is the ratio of fixed to variable costs they have and are known as Operating Leverage.

High variable-costs relative to fixed-costs have less upside reward, but also less downside risk.

In contrast, low variable-costs relative to higher fixed-costs have high upside rewards, but have substantially higher downside risk if break-even volumes are not reached.

Cost Structure Examples

Here are some examples of cost structure business model in action:

  • Operational Costs: These are the day-to-day expenses necessary for the basic functioning of a business. Examples include rent for office space, utility bills, and payroll for employees. These costs are often fixed and predictable, forming a regular part of the budget.
  • Production Costs: These costs are directly related to the production of goods or services a business offers. They can include raw materials, labor directly involved in manufacturing, and costs related to maintaining or operating machinery. Production costs can vary greatly depending on the scale of production and the nature of the business.
  • Marketing and Sales Costs: These are expenses associated with promoting and selling the product or service. Marketing costs can include advertising, promotional materials, and digital marketing tools. Sales costs might encompass salaries for sales staff, commissions, and travel expenses for client meetings.

Differentiating Cost Structure Types for Your Business

Generally, there are 3 different cost structure types you can use in your business:

Fixed Cost Structure:

  • Definition & Explanation: Fixed costs are expenses that do not change with the level of production or sales activities. Examples include rent, salaries of permanent staff, and insurance.
  • Advantages: They provide predictability for budgeting and financial planning.
  • Disadvantages: Fixed costs can be a burden for new or small businesses with fluctuating revenues.

Variable Cost Structure:

  • Definition & Explanation: Variable costs change in proportion to the business’s production volume or sales. Examples include raw materials used in production, utility costs in manufacturing, or commissions for sales staff.
  • Advantages: Variable costs align more closely with business activity levels, offering flexibility.
  • Disadvantages: They can lead to unpredictable expenses, making budgeting more challenging.

Hybrid Cost Structure:

  • Definition & Explanation: A hybrid cost structure includes both fixed and variable components, allowing businesses to enjoy the benefits of both.
  • Advantages: This approach offers a balance, providing stability while also scaling costs with business activity levels.
  • Disadvantages: Managing a hybrid cost structure can be complex, requiring careful planning and analysis.

Factors to Consider When Choosing a Cost Structure

  • Business Size and Stage of Development: Smaller or newer businesses might benefit from a variable cost structure to keep fixed expenses low. In contrast, larger or more established businesses may prefer the predictability of fixed costs.
  • Industry Type and Competition: In highly competitive industries or those with fluctuating market demands, a variable or hybrid cost structure might be more advantageous to adapt quickly to changing conditions.
  • Product or Service Offered: The nature of the product or service also influences the ideal cost structure. For instance, technology-based companies might have higher initial fixed costs due to research and development but lower variable costs per unit produced.
  • Market Demand and Customer Behavior: Understanding market trends and customer preferences is crucial. A business catering to a market with steady demand might opt for a fixed cost structure, while one in a market with variable demand might choose a variable or hybrid structure.

Final Thoughts

When considering the cost structures business model, you should consider what your most important costs are that need more attention, and which have less impact on the quality of your product or service.

You should also consider which key resources and activities are the most expensive and whether you benefit from moving up or down the value chain.

Do you understand your cost structures?

There is also a FREE Podcast Series we offer on Applying the Business Model Canvas

For more detailed information on how to apply the Business Model Canvas to your business, check out my book:

Applying the Business Model Canvas, A Practical Guide For Small Business

 

Read more: 9 Types of Different Business Structures