If you’re reading this, you probably know already that handling finances for a business can be quite challenging. It’s one thing to come up with a product idea, and it’s a whole different ball game when it comes to operating the business and managing all the bills.
That’s where having an effective cost structure (CS) in place is important to ensure a company’s success. Further in the article, we’ll tell you more about the importance of choosing the right CS and its influence on the entire business operation. We will also provide some useful tips on how to adjust it so that it best fits your needs.
Read on to explore more!
- What Is a Cost Structure?
- Cost Structure in a BMC
- Understanding the Types of a Cost Structure
- Important Considerations When Choosing a Cost Structure
- Final Thoughts
What Is a Cost Structure?
Let’s start by explaining what the term “cost structure” means to avoid ambiguity. Essentially, when this term is mentioned, it refers to a set of various costs and bills that a company needs to pay in the course of its operation. This could be:
- Fixed costs, like rental pay, utility bills, insurance, license, etc;
- Variable costs, like hourly-rate wages, bills for delivery and packaging supplies, commissions, raw material costs, and so on.
In addition, the cost structure should provide ways to cover unexpected costs such as repairs and equipment breakdowns, as well as increased provider prices, taxes, and permit fees. When all these costs are put in writing, businesses can better prepare for challenges and adjust their spending in the most effective way.
Cost Structure in a BMC
To put it straight, you can’t run a successful business without a clear CS. Therefore, creating a BMC with a detailed cost model is a must-step after deciding on the product idea.
Not only will this allow you to cut costs and use resources more efficiently, but it will also help you embrace innovation and increase demand for your offering.
The BMC is arguably the best tool for visualizing business concepts and strategies. What makes it so popular is that it makes it easy to establish connections between different business processes and understand the impact of each of them.
Cost structures are one of its many building blocks. Once you fill them out and analyze how they are connected with other areas, you can gain valuable insights into the overall health and profitability of your business and, if necessary, improve your financial performance for long-term success.
Building Blocks of a Business Model Canvas
Let’s quickly touch upon the building blocks that can be found on the BMC, so you can better understand how the tool works. Overall, the canvas comprises nine elements, which are:
- Customer segments;
- Value propositions;
- Customer relationships;
- Revenue streams;
- Key resources;
- Key activities;
- Key partnerships;
- Cost structure.
They are all organized under the same template, making it easy to analyze the business strategy and identify areas where it could be improved.
The first building block on the right side of the canvas is customer segments. This is where you add information about all the groups of people that your business is planning to reach. You should start by filling out this block since understanding your target audience is the cornerstone of a business.
The next block is the value proposition. Basically, it should include all the reasons why your product is valuable to end users and what makes it different from the rest. For example, this could be price, design, a certain service, speed, etc.
Unless you plan to distribute your goods or service directly to your customers, you should specify here all of the channels that your business can use to communicate with customer segments. Some examples of distribution channels are social media, email, websites, and advertisements, to name a few.
In this block, you need to describe how your business will interact with customers and what means it will use to generate new leads and retain existing contacts. Make sure to be descriptive here. The more details you include, the easier it will be to map out all other steps.
Revenue streams outline your company’s earnings. In general, there are two types of possible streams: transactional and recurring, but they can often be used together, depending on the nature of the business.
Key resources may include a variety of assets, such as physical, financial, intellectual, and human. These are the resources that are available to you and can be used to achieve your business goals.
This block should include all business activities that are necessary to keep business operations running smoothly and effectively, including marketing and sales, customer service, financial management, supply chain management, etc.
Most businesses rely on their partners to deliver goods or services to their customers. Use this block to include details about suppliers and partners that you plan to collaborate with.
Understanding the Types of a Cost Structure
Now let’s focus more on the CS, which goes in the lower left corner of the BMC. What are you writing here? While the idea may seem pretty simple, it can be quite tricky to figure out what to put in there. What makes things worse is the realization that if you get your costs wrong, it may pivot your whole business in the wrong direction.
To not let that happen, play it safe by sticking to one of the existing, tried-and-tested models described below.
Fixed costs are the costs that stay the same, regardless of how much physical products or services organizations sell or deliver. This can include rent pay, salaries, insurance, etc. As these costs are constant, businesses can predict them, allowing them to make informed decisions about pricing, marketing, and investment opportunities.
Another benefit that a fixed CS brings is economies of scale. When the fixed costs are known, it’s easier for companies to spread them out over a larger volume of goods. As a result, they can reduce the cost per unit and boost their overall business profitability.
Other than that, a fixed CS provides more control over expenses and can also be used to set prices, as it gives you a clear idea of the constant spending during each period of time.
Here are some of the cons of this type of structure:
- Not easy to adjust to the changing market;
- Initially, fixed costs are quite hard to forecast;
- Whether your business is thriving or experiencing a slowdown in sales, these costs remain the same;
- Oftentimes, fixed costs eat lots of businesses’ resources, making it hard for them to grow.
Along with fixed costs, there are variable costs that companies should factor in when creating a Cost Model. These typically include hourly wages, delivery fees, and costs for materials and equipment upgrades. Depending on the amount of products or services provided, these costs may vary from one time period of time to the next.
The main advantage of this CS is flexibility. Thanks to this, organizations can swiftly adapt to the changing market demand. In addition, since these costs are often related to a specific area or unit, with a proper planning strategy in place, they aren’t too difficult to predict.
As an added benefit, cost fluctuations can serve as a useful indicator for organizations to identify products that have room for improvement, thereby enabling them to improve their cost efficiency.
Of course, this structure of costs entails certain challenges, too. Some of them are:
- They can’t be controlled;
- The volatility makes it hard for businesses to plan their budgets;
- Price fluctuations expose companies that deal with a large volume of physical products to greater financial instability.
Hybrid Cost Structure
Another type of CS is hybrid, which incorporates characteristics of both models. Many businesses use this type of cost model because it allows for a greater level of stability while also allowing them to quickly embrace change.
When it comes to disadvantages, these usually include:
- The complexity involved in understanding and managing expenses;
- Forecasting can be more challenging, as businesses must factor in the challenges of both structures;
- Due to the complexity involved, it may also be necessary to invest in additional tools or personnel to effectively manage the costs and stay on top of expenses.
Important Considerations When Choosing a Cost Structure
To choose a CS that will be right for your business, you should consider a few factors such as:
- Business size;
- Product or service;
- Market demand.
Let’s briefly discuss each of them.
As we’ve stated, most companies operate on a hybrid CS. Nonetheless, the ratio of fixed versus variable expenses may vary depending on the size of an organization. As a rule, fixed costs predominate in large businesses, while variable costs are more typical for smaller companies.
It’s important to note that as business grows, this proportion may change. Therefore, in order to define the right cost model, it’s critical for managers to envision how they may change over time.
Some CSs are directly tied to the industry of a business. For instance, grocery stores, clothing retailers, and department stores will have more variable costs due to a higher turnover of physical goods. Service businesses, in turn, will tend to have more fixed costs, such as salaries for employees and office rent payments.
Competition is another important point of consideration, as it can impact your business in several ways. If the market is highly competitive, you may need to offer high-quality products or services, which may increase your overhead costs.
Alternatively, you may need to lower your prices to remain competitive, which could result in lower profit margins.
Product or Service
Next up, the product or service itself should be taken into account. If your business is offering goods, you should include costs of materials, supplies, and shipping, which can vary unpredictably.
On the other hand, if your company specializes in providing a certain type of service, shifts in the costs won’t be as frequent and will mostly relate to employees’ wages.
It’s also necessary to estimate the market demand. The last thing you want is to overstock on something that people don’t really want or need. Besides, some goods may be seasonal, making them more difficult to sell at certain times of the year.
In such cases, it may be necessary to provide discounts, which are additional costs that should be planned in advance.
In the end, understanding your business’s cost model is just as important as understanding your target audience, if not more. Not only can the right CS help you stay competitive in your industry, but it can also help you balance stability and agility, and effectively maximize profits.
What’s more, with a solid cost structure in place, you’ll be able to better manage your expenses, allowing you to innovate, reach new markets, and ensure the long-term success of your business.