In this issue, you'll learn:

1. How could your company benefit from economies of scale and scope?

2. How can the proper selection of fixed vs. variable costs improve visibility and protect your cash flow?

3. The key to improving your profit margins: Direct and Indirect costs

Reading time: 2 minutes.

Strategyzer's cost structure Attributes

Last week we covered various types of cost structures.

The other dimension of your cost structures outlined by the business model canvas is the types of costs:

1- Fixed costs: The costs that do not increase or decrease with production, i.e., fixed compensation. 

2- Variable costs: Costs that go up and down with production, such as hourly or time-and-materials.

Extension to the cost attributes

We've added two more important categories that should be in every cost structure because they affect how much a company is worth and how much money it can get:

1- Direct costs: The costs that are specific to a certain product or service. 

2- Indirect costs: are costs that can't be tied to a specific product or service.

As a business owner, you will have to make these kinds of decisions on both a big and a small scale.

Go with Fixed or Variable?

Across my service business, direct cost resources, sales and marketing teams are on a variable cost model. 

That helps me figure out how profitable services are and measure important sales and marketing KPIs like CAC to LTV ratio.

I could do that by estimating and dividing, but being accurate helps and gives people a lot more freedom with other things.

Such as: flexible working hours, working from home, a 4-day work week, etc.

Direct vs. Indirect

Direct costs are a key part of figuring out your gross revenue and should be kept to a minimum to meet your profit goals.

Since gross profit is equal to revenue minus direct costs.

If you want a 70% gross margin, for example.

Let's say your income is $1 million.

You shouldn't spend more than $300,000 on direct costs.

Your operating margin will now be determined by your indirect costs.

If that's 40%, then your indirect costs shouldn't be more than $300,000.

Since operating profit = revenue - direct costs - indirect costs.

As a rule of thumb, your indirect costs shouldn't be more than 35% of your revenue.

Many investors and banks only lend money based on direct costs, and if there is any indirect financing, they put a cap on it.

Walmart says some suppliers working with retailer to cut prices | Reuters — www.reuters.com

Senior Walmart Inc executives said on Friday some suppliers have been responding to the largest U.S. retailer's efforts to lower prices despite their own struggles with high inflation, material and labor costs.

Economies of scale

As your output goes up, your cost per unit goes down. This is good for both you and your suppliers.

Walmart is using this advantage in a controversial way.

Walmart CEO Doug McMillon said that the company is making it easier for suppliers to keep costs down by doing things like ordering more in advance or asking for changes in pack sizes or case sizes.

McMillon said at the meeting, "In my 30 years of experience, most of which have been in merchandising, there has always been something you can do, there has always been a way to cut costs to relieve pressure."

Besides price increases, Walmart is dealing with an inventory surge caused in part by a shift in purchasing patterns toward food and other basics. Inventories rose 32% in the first quarter, a fifth of which came from merchandise arriving earlier than it anticipated.

Furner said getting the inventory "right" was going to be key to its success after it contributed to a quarterly decline in first quarter profits. It will, however, take a couple of more quarters "to get back to where we want to be," Furner said.

As a service business, I've gotten better deals from hotels, coworking spaces, and other partners by predicting how much business I'll get and using this to my advantage.

Economies of scope

An economy of scope is when you use the same business infrastructure to help with a wider range of activities.

In 2015, I started a business academy. In 2017, I started a consulting business, and in 2020, I started a coaching business.

Each has its own way of making money. I could have set up a legal entity with an accountant, human resources, sales and marketing, and offices for each.

Since they were close to each other and worked well together, I could use the infrastructure they shared to my advantage.

When I worked at a $40 billion company, they would often buy other companies. And they all took advantage of the fact that the economy of scope saves money. They created an organization called "OFS," which provides shared services to all of these acquired and core companies, which they call "segments."

The HR, Supply Chain, Legal, Contracts, Finance, Sales, and Marketing departments were all part of this OFS organization.

Even though each company/segment had its own unique parts that were kept in the HQ organization of that company.

Wrap up

1- Measure what matters.

2- Tune and calibrate your cost attributes to get the best results and margins.

3- Make the most of economies of scale and scope.

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How can I improve the Business Builder?

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- Luqman