Cost Structure Analysis and Forecasting
Almost every business requires an initial investment before it generates revenues. In addition, some of the expenses in every period are independent of the scope of manufacturing or sales. In order to finance such fixed periodic expenses, the company needs to reach a certain minimum level of sales. For every unit sold at a price higher than the variable cost of its production (that includes, for instance, raw materials and labor), the company gains a contribution margin. The level of sales at which the total contribution margins from the company's operations equal its fixed costs is referred to as the "break-even point."
Analyzing the Break-even Point
An analysis of the break-even point usually assumes that the price and cost of each unit do not change with the increase in the volume of production/business, i.e., that the contribution margin of each dollar is similar. Clearly, this assumption is not necessarily realistic, and any analysis of the break-even point must include the appropriate formulas for the change in the contribution margin of each dollar of revenue.
The following example (in Table 3-2) presents a company that sells products with relatively low variable production cost. In fact, almost every product based on software or other information goods (such as downloadable music or movies) is characterized by such low marginal production cost structure. However, note that the assumption is that the overall marginal cost increases with the increase in the number of units sold, mainly due to increasing marketing costs per unit. This assumption represents the further assumption that the target clientele is exhausted in each stage, so that a larger overall expense per customer is required in the subsequent stages in order to convince them to buy the product.
Under the revenues item, the company receives $20 per unit for each 100,000 units. In other words, it earns revenue of $2 million for each 100,000 units.
The situation is more complicated in the expenses item. The variable production costs do not change with the scope of production, and remain at $4 per unit. The marketing costs, however, increase from $6 per unit (for the first 100,000 units), up to $15 per unit, between the 350,000th and 400,000th units.
The company's fixed expenses are as follows: $500,000 for research and development (R&D), $500,000 for depreciation, $400,000 for fixed marketing expenses, and $400,000 for fixed general and administrative expenses (G&A).
As we can see, the company starts making an operating profit when sales exceed 200,000 units. Beyond 400,000 units, the contribution margin per unit is $0, since the marginal cost per unit is $20 ($4 for production, $15 for marketing and $1 for G&A expenses). In other words, there is no advantage in manufacturing beyond 400,000 units. However, the break-even point at 200,000 units includes the cost of depreciation, which is not a cash cost. Assuming that this cost does not require a recurring investment and that all sales are made for cash, the company turns cash-flow positive at under 150,000 units.
Forecasting Fixed and Variable Costs
It is also important to understand the links between various costs and the company's volume of business. Every sophisticated product requires a certain amount of manpower, but a certain amount of manpower is also required if no sales are made in the early stages, since the company must prepare for the possibility of future sales. As it is clear that every development person requires a minimum amount of equipment, so it should be understood that a material part of the company's cost structure includes, besides fixed components, variable expenses that change with the company's volume of business.
From the point of view of the cost structure analysis, the startup needs to estimate the cost structure it will have as accurately as possible. It is essential to understand the difference between a cost structure that includes components of high fixed costs, and a structure that includes mainly variable costs. In a power station, for instance, the cost of producing the final product—electricity—is low, since most of the costs are fixed: Some are financing costs incurred for the construction of the infrastructure and the building, and some are expenses incurred for maintaining the generators in proper working order. Similarly, the cost structure of hotels indicates that the cost of occupying an additional room is low, since the hotel employs a team that services other rooms. Hotel owners can modify their cost structures by engaging the services of an external company to maintain the hotel, in return for a percentage of the revenues (it is, in fact, customary for hotels to be run by such management companies). In other words, such outside companies reduce the fixed costs component upon themselves in consideration for a share in the revenues.
By outsourcing, many companies are able to reduce their fixed costs. This is done, for instance, by hiring programming services (as in the ASP model) or hosting services instead of constructing and maintaining a server farm, and so on. Companies which sell products can similarly use other companies for shipping, customer service, and so on. Such services allow the company to focus on the core of its business without spending resources on activities that are less vital to the business. The strategic use of outsourcing enables startups and those who invest in them to reduce the risk involved as long as the company is still uncertain of its success (by cutting considerably on expenses at an early stage by hiring the service). Some of these services become too expensive and jeopardize the company's business, however, when the company grows beyond a certain level. The electronic retail company Amazon, for instance, earlier used Ingram as its outside warehouse and supply provider as long as Amazon was still a small to medium-sized company. However, at some point Amazon began developing its warehouses independently. This was done mainly to reduce the risk of dependency on an outside service supplier, which was then negotiating for its sale to Barnes & Noble, Amazon's competitor in the field of bookselling, on which Amazon was focusing at the time. Over the long run, Amazon was even becoming a provider of outsourcing services to other e-merchants.
The Costs of Market Entry and the Network Effect
Companies always aim at a cost structure in which every sale yields a positive contribution margin, in order to be able to finance its fixed costs. However, a company could clearly be prepared to execute transactions with a negative contribution margin for certain periods of time, even long ones, in order to penetrate into the market or start/ignite a network effect. The network effect is essential for a company to become differential in the market and to establish a user base that would make it difficult for competitors to enter the scene and compete against the company.
The basic principle in the network effect is that the value of the service to each user rises with the growth in the number of users of the service. Therefore, from a certain threshold number of users, the service becomes easier to sell, since there is already a base of users that makes the product highly valuable to new users. For instance, without a telephone on either side of every potential phone call, it would have been impossible to derive any income from telephone communications. If DVD players were not widespread, production companies would have no justification for releasing movies on DVD and vice versa—without DVD movies, people would have no reason to buy DVD players.
In the computer business, software engineers justifiably tend to first write programs for popular operating systems. Thus, even if the more popular operating system is technically inferior to an alternative system, users will tend to prefer the more popular system since it comes with wider technical support and a larger and more diverse selection of software.
On the Internet, software like ICQ (that essentially enables immediate communication between groups of users of the service without any charge to the users), Paypal (a service through which payments can be made among users of the service, usually without a per-transaction commission), and others would never have succeeded in breaking into the market were it not for the network effect. However, in many cases companies fall short of turning their user base into a source of revenues (or "monetizing" their user base), and may therefore be sold to companies that are better equipped to derive income from their users. ICQ, for instance, was acquired by AOL (America Online), which assumed that at some point it would be able to generate income from the ICQ users (for example, by advertising, direct sales, or cross sales of other services).
Cost Structure Analysis and Forecasting
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