We are at the end of our Business Model Canvas and of our education about the boxes that will help you to mitigate or remove risks from your innovative idea or company. I have used this process three times. Two of the companies are still in business and doing well with minimal iterations, and one did not make it off the canvas, which saved me millions of dollars. Now that all the boxes are completed it is time to look at what the new venture will cost you. Such costs can be calculated relatively easily after defining Key Resources, Key Activities, and Key Partnerships. This building block (cost structure) describes the most common costs incurred while operating. Creating and delivering value, maintaining customer relationships, and generating revenues all incur costs for a start-up.
Other than not having enough customers, the cost structure box puts more companies out of business than any other. Startups are known for undershooting this number. This is why I always add in a 20% contingency fund just in case I missed something. 90% of new businesses fail in the first three years because they do not understand their costs or what it will take to create the goods and services they have promised in their value propositions. As I stated above, once the startup gets a clear vision of key resources, key activities, and key partnerships, the overall cost is an easy number to come up with.
The following are terms you need to know:
- Types of Business Structures:
- Cost-Driven – This business model focuses on minimizing all costs and having no frills (e.g. Southwest Airlines, Walmart). Normally, starting a company on cost is what I call a race to the bottom. A business which is cost-driven focuses on creating a lean cost structure through offering cheaply priced value propositions. The only way this can be done is with a high degree of automation, low fixed costs, and outsourcing of costly functions. This is exactly what I did with my company, Credit Justice Services creditjusticeservices.com. Our technology allowed each paralegal to work 1,475 files per month compared to the competition’s 200 files per month. Being able to accomplish this is important to lowering your prices based on internal costs and expenses rather than in response to what the competition is doing. During a 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.
- Value-Driven – Less concerned with cost, this business model focuses on creating value for products and services (e.g. Rolex, Ruth’s Christ Steak House). Not all companies drive their business based on costs. Some focus completely on the value they are providing to their customers, thus taking the value-driven approach. This strategy is characterized by complete focus on the creation and delivery of a high-value, high-brand value proposition, which is customized to the customer segment’s preferences. Luxury hotels like the Hyatt pride themselves on their customer services and amenities. Ruth’s Christ Steak House prides itself on five-star service. They know their repeating customers by name and what there likes and dislikes are.
- Types of Cost Structures:
- Fixed Costs – Costs are unchanged across different applications (e.g. salary, rent, utilities). Business expenses 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. These are the costs that I pay attention to the most. Up-fitting a building or a restaurant will turn into a 20-year fixed cost with a loan. The less money you spend to build your company, the more you will have leftover to survive the lean times, and I promise you, there will be lean times.
- Variable Costs – These costs vary depending on the amount of production of goods or services (e.g. restaurants). They are heavily dependent on the volume of output a company produces. These are costs incurred when you produce a product. Variable costs are represented by utility bills and raw materials used for production of the end product. A great example of this is when my restaurant, Bella’s bellas-restaurant.com has a reduction in sales due to seasonal effects. The cost of goods sold for food, wine, and beer will decrease because we will order less. Another cost important to management is operational cost. These are the costs associated with the day-to-day running of the company. Examples include raw materials, electricity bills, and expenditures on maintenance of buildings and machinery.
- Economies of Scale – Costs go down as the amount of goods are ordered or produced. As a company expands and increases cost, sales do not always increase at the same rate. The higher the volume, the lower the overall cost per unit. This cost advantage is a benefit enjoyed by most big companies with a high output and large purchasing power such as Wal-Mart, chain restaurants, etc. The reason costs decline when volume is higher is because higher volumes spread fixed costs more thinly, making the cost per unit fall dramatically; hence the average cost per unit is reduced. As your company grows, expenses can get out of hand. Keeping your infrastructure constant as long as you can will increase your profit margin. I see too many companies expand into larger places with more overhead. Their costs increase significantly, their sales drop for one quarter or year, and then they are doomed.
- Economies of Scope – Costs go down due to incorporating other vertical businesses within your company. For example, Credit Justice Services provides leads to attorneys after the credit repair process is completed with the consumer. It will reduce your costs when a business invests in multiple markets or a larger scope of operations. Another example is Bella’s restaurant created Mama’s Red sauce, software for ordering on-line and managing inventory. 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.
For more information about starting a company or new product development please feel free to contact me at firstname.lastname@example.org
Blanks, S. (n.d.) Business Model Canvas, Retrieved November 13, 2015, from www.udacity.com