cost-structure-business-model

What Is The Cost Structure Of A Business Model And Why It Matters

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 into 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’s 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 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.

Operational scalability

blitzscaling-business-model-canvas

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 over time!

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 a startup’s 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.

Google cost structure case study

google-business-model
Google is a platform, and a tech media company running an attention-based business model. As of 2021, Alphabet’s Google generated over $257 billion in revenue. Over $209 billion (over 81% of the total revenues) came from Google Advertising products (Google Search, YouTube Ads, and Network Members sites). They were followed by over $28 billion in other revenues (comprising Google Play, Pixel phones, and YouTube Premium), and by Google Cloud, which generated over $19 billion in 2021.

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.

Google is an example of a company that came out of the ashes of the dot-com bubble thanks to a hugely profitable business model:

what-is-google-tac

To appreciate Google’s business model strength, it is critical to look at its TAC rate.

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!

google-traffic-acquisition-cost-fourweekmba
The traffic acquisition cost represents the expenses incurred by an internet company, like Google, to gain qualified traffic – on its pages – for monetization. Over the years Google has been able to reduce its traffic acquisition costs and in any case, keep it stable. In 2021 Google spent 21.75% of its total advertising revenues (over $45.56 billion) to guarantee its traffic on several desktop and mobile devices across the web.

Part of Google’s cost structure is useful for keeping together the set of processes that help the company generate 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, 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 its game is to keep innovating in the search industry. Maintaining, updating, and innovating Google‘s algorithms isn’t inexpensive. Indeed, in 2021 Google spent billions on R&D.
  • The third element is the acquisition of continuous streams of traffic that make Google able to create virtuous cycles and scale up.

How do we judge the ability of Google’s advertising machine

I envisioned a metric called traffic monetization multiple, which is the ability of the company to monetize its traffic: 

googles-traffic-monetization-multiple
Companies like Google have to cut distribution deals and split revenues with content partners to bring traffic back to their main properties online. For instance, in 2021, Google spent over $45 billion in traffic acquisition costs, but it generated over $209 billion in advertising revenues. This means that Google could monetize its traffic 4.6 times its traffic acquisition costs. An increased monetization multiple over the years is a good sign. It means that Google was able to keep its advertising machine competitive. On the opposite side, a negative monetization multiple means the advertising machine is losing traction.

As you can notice from the above, this is a purely financial metric, which needs to be balanced out with a qualitative analysis of why the metric increased in the first place. 

Indeed, it’s critical to keep into account these questions: 

  • Has monetization increased thanks to an improved UX?  Or is monetization worsening the UX?
  • Has monetization improved thanks to an increased customer base? Or has it increased due to higher prices per ad?
  • Lastly, how is monetization balanced with legal risks posed by increased tracking? 

All these questions are critical to answer, because, financially Google’s advertising machine seems as strong as ever.

There are hidden risks underlying it, which might, all of a sudden threaten its overall business model

In fact: 

  • On a positive note, Google has managed to further scale, as a consequence of the pandemic. Thus, bringing its products to hundreds of millions of new users. Yet. this further scale (especially on mobile devices) has created new challenges for the company. Which is finding it harder and harder to properly index a web made of billions and billions of pages, and growing. This poses a threat in the long term, as it might reduce the quality of organic search results.
  • To monetize this expanded user base, Google is serving more ads. This might work in the short term to squeeze the advertising machine. But it might make the overall experience bad in the long term. So it’s critical to balance these things out. 
  • To further expand its revenues, the company has also increased the price per ad. While, in the short-term, the strategy works, in the long-term, this might substantially reduce the customer base. 

The points above, are some of the things you want to look at, qualitatively, to really understand what’s going on, with the changing cost structure of the company. 

Netflix cost structure case study

When we look at the overall Netflix business model it’s important to understand a couple of things in order to frame its cost structure: 

  • The Netflix revenue model.
  • And the Netflix capital expenditure. 
netflix-business-model
Netflix is a subscription-based business model making money with three simple plans: basic, standard, and premium, giving access to stream series, movies, and shows. Leveraging on a streaming platform, Netflix generated over $29.6 billion in 2021, with an operating income of over $6 billion and a net income of over $5 billion.

Netflix runs an on-demand streaming platform, on top of a subscription service.

Members pay a fixed subscription monthly or yearly price, in exchange for having access to a library of content that continuously updates. 

If Netflix revenues are higher than the cost that it takes to run the platform, then the platform is profitable. 

Is Netflix profitable? It is indeed. However, to understand its cost structure we need to have a deeper look at Netflix’s capital expenditure.

is-netflix-profitable
Netflix is a profitable company, which net profits were $5.1 billion in 2021. Growing from $2.7 billion in 2020. The company runs a negative cash flow business model, where it anticipates the costs of content development and licensing through the platform. Those costs get amortized over the years, as subscribers stick to the platform.

In short, in order for Netflix to keep generating revenues in the long-term, it needs to have a library of content that is guaranteed in the coming 5-10 years.

How can the company do that? 

It can do that by either licensing or producing content.

Those mechanisms have two different dynamics. 

licensed-vs-produced-content

In fact, for most of its life, Netflix has been spending a massive amount of resources to license content and make it available on its platform.

This is the epitome of a platform business model

Thus, Netflix invested capital to guarantee a continuous flow of content on top of its platform.

This advanced capital would be repaid back, with revenues coming from memberships.

This also means that for most of its history Netflix run at a negative cash flow cost structure.

Meaning that Netflix had to advance the money needed to license the content.

This money would be recouped many times over, in the long run, as the platform kept growing its members’ base. 

On the other hand, starting in 2013, Netflix started to invest more and more into produced content.

What we know today as “Netflix Originals” or a library of content exclusive to paying members. 

This sort of investment, while similarly, to licensing content, makes Netflix advance the costs of content, which would be recouped over the years.

It also gives the company the ability to freely distribute this content and dispose of this content over the years. 

In conclusion, even though the content production investment doesn’t change the Netflix cost structure in the short term, it will change it in the long run.

Thus, we might expect Netflix to move from a cash flow negative cost structure, to a cash flow positive cost structure as it moves from the platform (investing primarily in licensed content) to a media powerhouse (as investments in produced content pass those in licensed content). 

netflix-licensed-vs-produced-content

Thus, what I like to call “the mediafication” of Netflix, will be a key component of its business model advantage, in the long term.

How do we assess the evolution in this process?

This process of “mediafication” started in 2013. And while today, 66% of the content investments on Netflix are still about licensed content, the company is ramping up its investments in owned content, further. 

From a formal standpoint, when new content investments in produced content will pass the license ones, we can officially call Netflix a Media Powerhouse! 

And for now, it’s critical for the company to keep “arbitrating content:”

netflix-content-arbitrage-multiple
In order for Netflix to keep its business model healthy over the years, it needs to keep investing in content, which the company needs to be able to monetize. Therefore, the Content Arbitrage Multiple is a ratio made of Revenues/Content Investments, which tells us the ability of the company to generate revenues for the content investments performed. For instance, in 2021, the Content Arbitrage Multiple was 2.4x. Indeed, on the $29.7 billion of total revenues in 2021, Netflix had invested over $12.2 billion in content. This was a 5% growth compared to a Content Arbitrage Multiple of 2.3x in 2020.

Amazon cost structure case study

When we look at the overall Amazon business model it’s important to understand a couple of things in order to frame its cost structure: 

  • The Amazon revenue model.
  • And Amazon’s capital expenditure. 

When it comes to Amazon, in particular, understanding its cost structure is a bit trickier, as the company runs a business model with many moving parts, business units, and cost structures. 

amazon-business-model
Amazon has a diversified business model. In 2021 Amazon posted over $469 billion in revenues and over $33 billion in net profits. Online stores contributed to over 47% of Amazon revenues, Third-party Seller Services,  Amazon AWS, Subscription Services, Advertising revenues, and Physical Stores.

In fact, it’s important to look at Amazon’s business model, according to two perspectives: 

  • Amazon e-commerce platform (everything that runs on top and adjacent to Amazon e-commerce).
  • And Amazon Enterprise/B2B platform (Amazon AWS). 

When it comes to the Amazon e-commerce platform, its primary mission is to enable variety, low costs, and a great customer experience. 

Thus, Amazon runs it (as a choice) with very tight profit margins. However, this doesn’t give us a complete picture of its e-commerce cost structure.

Indeed, while the Amazon e-commerce platform has tight profit margins, it still runs with a widely positive cash flow structure. 

How? Through its cash conversion cycle: 

cash-conversion-cycle-amazon

In short, Amazon is able to turn its inventories very quickly, get paid quickly by customers, and pay back suppliers with a wider term, thus enabling the company to generate wide cash margins, in the short-term, invested back into the business. 

When instead, we look at Amazon’s Enterprise/B2B platform, Amazon AWS, we need to frame this in a different light:

amazon-aws-business

You can see how over the years Amazon AWS profitability has been running at wide margins. As the infrastructure costs are well paid for, from its revenues. 

This is true also today (2021), where Amazon AWS contributed to 55.5% of the overall Amazon operating margins.

This means, that if you were to spin off Amazon AWS from Amazon’s operations, you would get a much lower operating profit figure. 

Amazon AWS, while also requiring substantial technological investments, for now, it enjoys market dominance (In 2021 Amazon AWS had revenues of over $62 billion, whereas Microsoft Intelligent Cloud, for over $60 billion, and Google Cloud, for over $19 billion) and wide margins, which might last over the next 5 years, as more startups move to AI, as a core paradigm of software companies (Amazon AWS is becoming the leading infrastructure powering up the AI and software industry). 

Spotify’s cost structure analysis case study

spotify-key-performance-indicators-2022

When we look at Spotify’s cost structure, it’s important to emphasize the difference between the two main revenue streams: 

  • Ad-supported: free users can get unlimited music for free, but they have limited options and features. For instance, before they can skip listening to new songs or podcasts they will have to listen to the advertising. Thus advertising amortized the cost of Spotify to run the platform for free users.
  • Premium: free users are channeled through a self-serving funnel that prompts them to subscribe to the paid service. Thus, enabling Spotify to monetize at wide margins the free platform, once free users become paid subscribers. 

When it comes to cost structure, therefore, it’s worth noticing: 

  • The ad-supported business runs at tight margins, and its cost gets amortized with advertising. However, the free platform is used as a self-serving funnel to prompt free users to become paid members. In fact, chances are – if you are a paid member – you were a free user before. In short, being a free user widely increases the chances of becoming a paid member. 
  • The premium business, while it has a lower subscriber count, it has much wider margins. Thus, the premium platform widely pays off for the free platform. 

In other words, in this specific case, the cost structure analysis helps us frame the importance of the free platform. 

As if we were to analyze that from the perspective of revenues along, the free platform would not be justified.

In fact, the free platform has tight margins, and it generates costs the more it widens up.

In fact, the more free users on the platform, the more royalties Spotify has to pay back to creators for the streamed content. 

Instead, the free platform needs to be judged beyond revenue generation along. And the cost structure analysis of the premium members helps us assess that. 

The free users’ platform is critical to enhancing Spotify’s sales model, thus increasing the chances of free users becoming paid members.

And it plays a key role to enhance the brand and visibility of Spotify, as a consumer platform. 

In short, chances are that if to become a premium member, you were a free member first.

licensing-model-spotify
Spotify licensing deals affect its business model. The company runs on both a free service, which is ad-supported, and a subscription premium service. They have different economics.
The ad-supported business had a 10% gross margin in 2021, compared to 29% of the subscription-based business. That’s because the more the content gets streamed on the platform, the more that increases royalty costs for Spotify. That is also why the company invested in developing its content. Thus, in part transitioning from platform to brand.

Therefore, on the one hand, the ad-supported business is key to amplifying the brand of the company.

On the other hand, the ad-supported business is critical to funneling free users into premium members. 

That is why, it’s important to perform bot a revenue model analysis, combined with a cost structure analysis

To understand the reasons for running certain business segments, that go beyond revenues alone. 

spotify-business-model
Spotify is a two-sided marketplace where artists and music fans engage. Spotify has a free ad-supported service and a paid membership. Founded in 2008 with the belief that music should be universally accessible, it generated €9.66 billion in 2021. Of these revenues, 87.5% or €8.46 billion came from premium memberships, while over 12.5% or €1.2 billion came from ad-supported members.

Key takeaway

There are two key elements you need to understand to have insights into how companies  “think” in the current moment. The first is how they make money.

The second is 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.

Cost structure examples

Here are some more cost structure examples from a few well-known companies.

Walmart

According to Statista, Walmart has a total of almost 11,000 stores around the world with a sophisticated and optimized supply chain.

The company benefits from a cost-driven structure characterized by economies of scale and scope, but it nevertheless must meet numerous expenses.

One of the main costs Walmart must absorb is labor. This is no surprise since the company at one point was the third largest employer in the world after the United States and Chinese armed forces.

Employee wages are the main component of the labor costs, but the company’s strong anti-union stance means it is frequently embroiled in various legal disputes over worker rights.

The company also spent $107.1 billion on selling, general, and administrative expenses in 2019 (around 20.5% of total revenue).

Cost of sales for the same period was $385.3 billion, which includes the cost of product transportation, warehousing, and import distribution.

Ferrari

As a premium manufacturer of sports cars, Ferrari utilizes a value-driven cost structure.

While it is difficult to compare exact data, manufacturing relatively bespoke vehicles by hand is more expensive than churning out thousands of the same model on a production line.

Nevertheless, estimates suggest Ferrari only makes about $6,000 in profit for each car that sells for an average price of $200,000.

Ferrari’s main costs are incurred from:

  • Raw materials and parts.
  • Research and development – this was the company’s most significant expense in 2016 because of expenses associated with its Formula 1 racing team.
  • Labor – relatively high compared to less prestigious car brands.
  • Sales tax.
  • Advertising, and
  • Other – which includes depreciation, overheads, markups, logistics, etc.

Wizz Air

Wizz-Air is a Hungarian ultra-low-cost airline carrier that unsurprisingly employs a cost-driven structure to provide the most value to travelers.

Like Walmart, Wizz Air can undercut the vast majority of competition by using economies of scale.

In 2020, for example, it was offering two-hour flights for as little as $21 each way.

Wizz Air can offer these extremely low ticket prices because it chooses to collect a smaller profit from more passengers rather than earning a larger profit on fewer passengers.

This means populating each of the company’s Airbus A320s with as many seats as possible and removing business class altogether.

The aircraft themselves are also turned around as quickly as possible to ensure they spend the maximum amount of time in the air.

The company also minimizes costs with the following initiatives:

  • A fleet comprised of one type of aircraft. With staff only required to be trained on one model, costs are reduced.
  • Continuous leasing. This means Wizz Air has access to only the most reliable and fuel-efficient models.
  • Undesirable flight times. Many of Wizz Air’s flights take off early in the morning or very late at night.
  • Basic airport services. Scheduled services also operate in satellite or budget terminals that do not contain lounges or other creature comforts.

Alternatives to the Business Model Canvas

FourWeekMBA Squared Triangle Business Model

This framework has been thought for any type of business model, be it digital or not. It’s a framework to start mind mapping the key components of your business or how it might look as it grows. Here, as usual, what matters is not the framework itself (let’s prevent to fall trap of the Maslow’s Hammer), what matters is to have a framework that enables you to hold the key components of your business in your mind, and execute fast to prevent running the business on too many untested assumptions, especially about what customers really want. Any framework that helps us test fast, it’s welcomed in our business strategy.

fourweekmba-business-model-framework

An effective business model has to focus on two dimensions: the people dimension and the financial dimension. The people dimension will allow you to build a product or service that is 10X better than existing ones and a solid brand. The financial dimension will help you develop proper distribution channels by identifying the people that are willing to pay for your product or service and make it financially sustainable in the long run.

FourWeekMBA VTDF Framework For Tech Business Models

This framework is well suited for all these cases where technology plays a key role in enhancing the value proposition for the users and customers. In short, when the company you’re building, analyzing, or looking at is a tech or platform business model, the template below is perfect for the job.

business-model-template

A tech business model is made of four main components: value model (value propositions, missionvision), technological model (R&D management), distribution model (sales and marketing organizational structure), and financial model (revenue modeling, cost structure, profitability and cash generation/management). Those elements coming together can serve as the basis to build a solid tech business model.

Business Model Template - FourWeekMBA

Download The VTDF Framework Template Here

FourWeekMBA VBDE Framework For Blockchain Business Models

This framework is well suited to analyze and understand blockchain-based business models. Here, the underlying blockchain protocol, and the token economics behind it play a key role in aligning incentives and also in creating disincentives for the community of developers, individual contributors, entrepreneurs, and investors that enable the whole business model. The blockchain-based model is similar to a platform-based business model, but with an important twist, decentralization should be the key element enabling both decision-making and how incentives are distributed across the network.

vbde-framework

A Blockchain Business Model according to the FourWeekMBA framework is made of four main components: Value Model (Core Philosophy, Core Values, and Value Propositions for the key stakeholders), Blockchain Model (Protocol Rules, Network Shape, and Applications Layer/Ecosystem), Distribution Model (the key channels amplifying the protocol and its communities), and the Economic Model (the dynamics/incentives through which protocol players make money). Those elements coming together can serve as the basis to build and analyze a solid Blockchain Business Model.

VBDE Blockchain Business Model Template

Download The VBDE Framework Template Here

Companion Frameworks to Cost Structure Analysis

Comparable Analysis

comparable-company-analysis
A comparable company analysis is a process that enables the identification of similar organizations to be used as a comparison to understand the business and financial performance of the target company. To find comparables you can look at two key profiles: the business and financial profile. From the comparable company analysis it is possible to understand the competitive landscape of the target organization.

Business Analysis

business-analysis
Business analysis is a research discipline that helps driving change within an organization by identifying the key elements and processes that drive value. Business analysis can also be used in Identifying new business opportunities or how to take advantage of existing business opportunities to grow your business in the marketplace.

Capital Structure

capital-structure
The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).

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