The cost structure is one of the building blocks of a business model. It represents how companies spend most of their resources to keep generating demand for their products and services. The cost structure together with revenue streams, help assess the operational scalability of an organization.
Why it’s important to know how companies spend money
There are two elements to understand about any company:
- How it makes money.
- How it spends money.
While most people focus on how companies make money. A few truly grasp how those same companies spend money. However, understanding how companies spend money can give you insights about the economics of their business model.
Thus, once you grasp those two – seemingly simple – elements you’ll understand a good part of the logic behind the company’s current strategy.
Defining and breaking down the cost structure
In the business model canvas by Alexander Osterwalder, a cost structure is defined as:
What are the most cost in your business? Which key resources/ activities are most expensive?
In other words, the cost structure comprises the key resources a company has to spend to keep generating revenues.
While in accounting terms the primary costs associated with generating revenues are called COGS (or cost of goods sold). In business modeling, we want to have a wider view.
In short, all the primary costs that make a business model viable over time are good candidates for that.
Therefore, there is not a single answer. For instance, if we look at a company like Google, the cost structure will be primarily comprised of traffic acquisition costs, data center costs, R&D costs, and sales and marketing costs. Why? Because all those costs help Google business model keep its competitiveness.
However, if we had to focus on the main cost to keep Google making money we would primarily look at its traffic acquisition costs (you’ll see the example below).
This ingredient is critical as – especially in the tech industry – many people focus too much on the revenue growth of the business. But they lose sight of the costs involved to run the company and the “price of growth.” Defined as the money burned to accelerate the rate of growth of a startup.
Too often startups burn all their resources because they’re not able to create a balanced business model, where the cost structure can sustain and generate enough revenues to cover for the major expenses and also leave ample profit margins. Companies like Google have been pretty successful in building up a sustainable business model thanks to their efficient cost structure.
Indeed, from a sustainable cost structure can be built a scalable business model.
In the Blitzscaling business model canvas, to determine operational scalability, Reid Hoffman asks:
Are your operations sustainable at meeting the demand for your product/service? Are you revenues growing faster than your expenses?
Blitzscaling is a particular process of massive growth under uncertainty that prioritizes speed over efficiency and focuses on market domination to create a first-scaler advantage in a scenario of high uncertainty.
Reid Hoffman uses the term operational scalability as the ability of a company at generating sustainable demand for its products and services while being profitable.
Indeed, lacking the ability to build operational scalability represents a key growth limiter, and the second key element (together with lack of product/market fit).
While most startups dream is to grow at staggering rates. Growth isn’t easy to manage either. As if you grow at a fast rate, but you also burn cash at a more rapid rate, chances are your company or startup might be in jeopardy.
That is why a business model that doesn’t make sense from the operational standpoint is doomed to collapse overtime!
Google cost structure case study
I know you might think Google is too big of a target to learn any lessons from it. However, the reason I’m picking Google is that the company (besides its first 2-3 years of operations) was incredibly profitable. Many startups stress and get hyped on the concept of growth. However, it exists a universe of startups that instead managed to build a sustainable business model.
TAC stands for traffic acquisition costs, and that is a crucial component to balance Google’s business model sustainability.
More precisely the TAC rate tells us the percentage of how Google spends money to acquire traffic, which gets monetized on its search results pages. For instance, in 2017 Google recorded a TAC rate on Network Members of 71.9% while the Google Properties TAX Rate was 11.6%.
Over the years, Google managed to keep its cost structure extremely efficient, and that is why Google has managed to scale up!
Part of Google‘s cost structure is useful at keeping together the set of processes that help the company generating revenues on its search results pages, comprising:
- Server infrastructure: back in the late 1990s when Google was still in the very initial stage at Stanford, it brought down its internet connection several times, by causing several outages. That allowed its founders to understand they needed to build up a robust infrastructure on top of their search tool. Today Google has a massive IT infrastructure made of various data centers around the world.
- Another element to allow Google to stay on top of his game is to keep innovating in the search industry. Maintaining, updating and innovating Google‘s algorithms isn’t inexpensive. Indeed, in 2017 Google spent over $16.6 billion in R&D, which represented 15% of its total revenues.
- The third element if the acquisition of continuous streams of traffic that make Google able to create virtuous cycles and scale-up.
Cost structure and unit economics
A cost structure is an important component of any business model, as it helps to assess its sustainability over time. While startups business models, trying to define a new space might not be able to be profitable right away, it’s important to build long-term unit economics.
There are two key elements you need to understand to have insights about how companies “think” in the current moment. The first is how they make money. The second, how they spend money.
When you combine those two elements you can understand:
- How a company really makes money (where is the cash cow, and how and if a company lowers its margins to generate more cash flow for growth).
- Whether that company is operationally scalable.
- Where the company is headed in the next future and whether it will make sense for it to invest in certain areas rather than others!
In this article, we focused on operational scalability and cost structure, and we saw how Google managed to build an extremely efficient cost structure.
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