Cost Models

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 SUPER GUIDE:
Cost Models

BY DANIEL PEREIRA

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 © THE BUSINESS MODEL ANALYST

The Business Model Analyst is a website dedicated to

analyzing business model types, patterns, and innovations
using the business model canvas as its primary tool. The
site offers a wide variety of free and premium content,
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Daniel Pereira
The Business Model
Analyst Ottawa, ON,
Canada
businessmodelanalyst.com

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 Copyright © 2022 Daniel Pereira
All rights reserved.
ISBN: 978-1-998892-24-2

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 TABLE OF CONTENTS
Introduction 8
What Is The Cost? 9
Terms Associated With Costing 11
Fixed Cost 11
Variable Cost 12
Total Cost 12
Direct Cost 13
Indirect Cost 14
Marginal Cost 15
Opportunity Cost 16
Sunk Cost 17
Examples Of Sunk Costs 18
Cost Allocation 19
Cost Pool 19
Cost Structure 20
Cost Object 20
Economies Of Scale 20
Economies Of Scope 21
Costing 22
Types Of Costing 25
Absorption Costing 25
Historical Costing 26
Marginal Costing 27
Standard Costing 28
Lean Costing 29
Activity-Based Costing 29
Direct Costing 30

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 Uniform Costing 30
Important Methods Of Costing 31
Unit Costing 31
Job Costing 32
Contract Costing 32
Batch Costing 33
Process Costing 33
Service Or Operating Costing 34
Multiple Costing 35
Inventory Costing 35
First In, First Out (Fifo) 36
Last In, First Out (Lifo) 37
Average Cost Method 37
Specific Identification Method 38
What Is A Cost Structure? 39
Cost Driven Businesses Vs Value Driven Businesses 41
Cost-Driven 41
Value-Driven 42
What Is Cost Structure In The Business Model Canvas? 44
Filling In Your Business Model Canvas Template 45
Elements Of The Cost Structure 48
Product Cost Structure 48
Customer Cost Structure 48
Service Cost Structure 49
Types Of Cost Models Used By Buyers Of Manufactured
Products 50
Open Book Cost Modeling 50
Knowledge-Based Modeling 52
Hyper-Optimized Cost Modeling 52
Attribute-Based Cost Modeling 53

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 Example Of Cost Structure 54
Netflix 54
Nike 55
Tesla 56
Airbnb 58
Google 59
How Is Cost Modeling Done? 61
Segmenting The Expenses 61
Identifying Cost Drivers 61
Focus On Total Cost Of Ownership 62
Allocate Costs To Each Supplier 62
Create A Standard Costing System 63
What To Ask When Creating A Cost Structure? 64
Conclusion 65
References 66
About The Author 77

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 INTRODUCTION
The world of business can be quite exciting. Novel
innovations are being discovered constantly, game-changing
mergers and partnerships are an important part of the
business landscape, and every moment new niches offer
entrepreneurs an opportunity to tap into a previously
untouched market.

However, behind the glitz and glamour of the business

landscape, there’s an admittedly unglamorous but vitally
important aspect of business and accounting that most
entrepreneurs find quite boring... counting the cost.

To be honest, nobody likes paying bills, but, just like

everyone else, businesses need to keep the lights on and the
assembly line running. The business world is driven by more
than just profits and quarterly growth. Expenses must be
made in order to acquire and maintain the resources required
to drive an operation.

Anyone with the most basic grasp of the concept of buying

and selling can tell you that a business is only sustainable
when the income it makes is higher than the expenses
incurred. However, the theory of cost is much more complex
and dynamic than this simple understanding.

It involves several different concepts and types. In this article

we’ll delve into the theory of cost, the different types of cost,
what they mean to the average entrepreneur, and how you
can use this knowledge to drive growth and sustainability
within your business model.

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 WHAT IS THE COST?

To be quite frank, when delving deeper into the world of

business and accounting, the concept of cost can become
quite complicated. However, the purpose of this guide is to
simplify this as much as possible while still ensuring that the
necessary information to drive optimal growth is passed
along.

Therefore, in the business world cost can be generally

defined as “any expenditure, typically expressed in terms of
monetary value, that has been spent by a company in order
to produce a product or service”.

From this basic definition, there are a few important key

points to highlight. First of all, this is the definition of cost from
the viewpoint of the producer/service provider. Cost can also
be considered from the perspective of the consumer,
something we commonly refer to as price.

Another important point to highlight is that this definition

considers cost in terms of monetary value. There are other
ways of counting costs, such as man-hours lost, opportunity
costs, economic costs, certain kinds of debt, and so on. Most
of these items can be grouped under the umbrella term
implicit cost, which refers to costs that cannot be easily
reported as cash outlays when balancing accounts.

From the definition, the purpose of cost is also evident. The

expenses incurred by the business should be geared towards
activities associated with the production of a good or service,
or any other activity aimed toward the continued

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 sustainability of the business venture. This could include the
purchase of raw materials, operating costs, payroll
expenditure, legal fees, advertising expenses, and so on.

Even though calculating costs and balancing the books are

some of the most unexciting parts of the business, it is
obvious why it is one of the most important aspects of
building a successful business model. This is because, for a
business model to be sustainable (and profitable) in the long
term, the costs incurred in running the business should be
less than the profits realized from the venture.

This is an oversimplification, as different industries have their

unique ways of ascertaining and defining costs. We’ll expand
upon this more as we delve further.

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 TERMS ASSOCIATED WITH
COSTING

Before we continue, it’s important that you become familiar

with certain key terminologies and minor concepts associated
with the theory of cost as it relates to the business world. This
is because these terms will be repeated frequently
throughout this article. They include:

Fixed Cost
Fixed costs refer to expenses that do not vary with respect to
output. That means that these costs are relatively stable and
will occur even if the business is providing no good or
service. That means that, even in periods of business
inactivity, these costs still occur since they are the base costs
necessary for running the business. For example, rent,
property taxes, utility bills, salaries, loan repayments,
insurance, and so on.

It’s also important to note that, even though fixed costs may
be stable in the short term, in the long run, they may change.
For example, a business that decides to increase the number
of locations in response to increasing demand or a desire for
expansion. Therefore, it’s best to understand fixed costs in
terms of their lack of reliance on output instead of time.

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 Variable Cost
Variable costs are expenses that vary in proportion to the
output of the business. That means, as the output of the
business increases in terms of goods and services, so also do
its variable costs. Some good examples of variable costs
include the cost of raw materials, packaging, delivery and
shipping expenses, credit card transaction fees, and so on.
These costs can vary significantly over both the short and
long term.

Another way of understanding variable costs is in terms of the

variable cost of production, which is the cost involved in the
production of a single unit of a product or service. Variable
costs can also sometimes be defined as the sum of all the
variable costs of production associated with running a
business.

In summary:

Total Variable Cost = Total Quantity of Output X Variable

Cost Per Unit of Output

Total Cost
As the name implies, the total cost is the sum of all the
expenses incurred in running a business enterprise.
Generally speaking, it is a combination of both fixed costs
and variable costs. It is also called the total economic cost of
production.

However, there are several other definitions of the total cost.

Some sources also define total cost as a combination of fixed
costs, variable costs, and overhead costs. Overhead costs are
costs associated with the running of the business, but are not
directly associated with the production of goods and
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 services. For example, rent and insurance payments. They
are also referred to as indirect costs.

Another definition of the total cost is the summation of all

expenses incurred in the production of goods and services,
as well as the opportunity cost of these choices. Opportunity
cost refers to potential benefits forfeited by a particular
business venture by choosing a particular option over
another. It is the “cost” of their choice and is considered a
theoretical cost or missed opportunity.

Total cost is very important to business owners who wish to

make informed pricing, supply chain, logistics, and revenue
decisions concerning the sustainability of their business
model. Total cost is also very useful for tracking the
profitability of a business over time, as it gives a holistic
picture of the state of the business's expenses.

In summary:

Total Cost = Total Fixed Cost + Total Variable Cost

It can also be stated as:

Total Cost = (Average Fixed Cost per unit + Average

Variable Cost per unit) x number of units produced

Direct Cost
This is a term used to describe expenses that are directly
associated with the production of goods and services, as well
as the maintenance of the business. It can also be defined as
incurred costs that can be directly attributed to a cost object,
which is typically a good or service. Another name for direct
costs is specific costs.

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 An important attribute of direct costs is the fact that they are
usually also variable costs, i.e. they are directly proportional
to the output volume, whether in terms of goods or services.
However, some direct costs can also be classified as fixed
costs as well. For example, regular maintenance costs are
charged for machinery directly involved in the production of a
good.

Some important examples of direct costs include direct labor

wages, raw materials, manufacturing supplies, shipping fees,
energy consumption, and so on. Due to their easily
attributable nature, direct costs are somewhat easier to
account for and calculate.

Indirect Cost
An indirect cost is an expense that cannot be easily
associated with a specific cost object — such as a product,
service, or project — within a business structure. These types
of expenses are typically also called administrative expenses
or overhead costs, since they are usually associated with
maintaining or running the business.

Indirect costs may also refer to costs that are not directly
related to the production of a good or service, but are also
essential for the smooth running of the business. It also
includes other expenses which are attributable to multiple
activities and cannot be assigned to a single cost object.

Some examples of indirect costs include accounting and legal

expenses, administrative expenses, rent, security expenses,
telephone bills, office supplies, and utility bills. It’s important
to note that indirect costs could be either fixed or variable
costs.

Correctly identifying and tracking indirect costs are quite

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 important because they sometimes make up a significant
portion of the total cost of a business, and yet they are
notoriously hard to account for. Therefore, proper accounting
of indirect costs is important for both short and long-term
sustainability and profitability.

Marginal Cost
Marginal cost refers to any expense incurred by a company if
it produces one extra unit of output. It is also known as
incremental cost or differential cost. Therefore, it can be
defined as the increase in total cost due to the cost
associated with the production of additional products or
services. From this definition, it is evident that marginal cost is
strongly associated with variable costs and direct costs.

Marginal cost is important because it is usually one of the first

indicators that a business model is heading towards
unprofitability. A business model may initially seem profitable
on paper, but once its marginal cost exceeds its marginal
profit, it is heading towards unsustainability.

Some examples of incremental costs include raw materials,

shipping fees, direct labor, and utilities used in the production
of that good or service.

Therefore, marginal or incremental costs are solely

dependent on the increase or decrease in production
volume. This can be represented mathematically as the
differential of the equation:

Marginal Cost = change in Cost / change in Output

Why it is important to understand marginal cost because a

significant amount of production efficiency and business
success hinges on having a low marginal cost and high

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 marginal revenue. By analyzing the relative incremental costs
and revenues of different products, a business can decide on
the most profitable goods and services to invest its resources
in.

Understanding marginal cost is very important for

implementing Economies of Scale. This refers to a situation
where increased production of goods or services leads to
lower per unit marginal cost. In other words, the average cost
per unit steadily declines as production increases. This
usually has to do with variable costs, as fixed costs tend to
remain stable irrespective of the volume of output.

Opportunity Cost
The concept of opportunity cost is one that is easy to
understand in theory, but difficult to measure in practical
situations. Opportunity cost can be defined as benefits lost
when a business chooses one alternative over another.
Opportunity cost is quite easy to overlook when taking into
account all the expenses a business has incurred, and many
businesses skip this vital aspect of accounting.

However, despite the fact that opportunity cost seems like a

theoretical cost, it has several very important real-life
implications. The principle behind the concept of opportunity
cost is that resources are limited and for a business venture
to be sustainable it must adequately channel its resources in
such a manner that will ensure optimal return on investment.
Therefore, they must not only consider the cost of taking a
particular path, but the cost of not taking alternative paths as
well.

To properly evaluate opportunity cost, all the respective

benefits, costs, and risks associated with each alternative
should be carefully enunciated. It is also important to

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 remember that in terms of accounting, opportunity cost is
strictly an internal cost used for resource allocation and
management. This means that opportunity cost analysis is not
included when accounting for profit and is excluded from
external financial reporting, which includes other types of
costs such as direct and indirect costs.

Sunk Cost
Sunk cost is an interesting concept that applies to many
areas of life, not just the world of business. However, in the
business world, sunk cost is described as any expense that
has already been incurred by a business entity and cannot be
recovered. Due to the fact that these costs cannot be
recovered, they should not be considered in future
decision-making.

One of the reasons that it’s so important that businesses (and

individuals) understand the concept of sunk cost is because
of a phenomenon known as the sunk cost fallacy.
Businesses are run by people and are therefore also prone to
falling for this false perception. It is described as:

“The phenomenon whereby a person is reluctant to abandon

a strategy or course of action because they have invested
heavily in it, even when it is clear that abandonment would be
more beneficial.”

Now, it’s important to note that despite the negative

connotations of the sunk cost fallacy, sunk cost itself may not
be a bad thing. For example, expenses made by a business in
things such as advertising, rent, equipment installation,
salaries, utility bills, and so on, are often considered sunk
costs. These expenses however were necessary for the
continued operation of the business.
Understanding the principle of sunk cost also allows

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 businesses to know when it is time to abandon unviable
projects, goods, or services, irrespective of the resources
which may already have been invested into these cost
objects.

Another vital thing to note is that sunk costs are always fixed
costs. This is because the absolute value of a sunk cost does
not change with respect to the volume of output. However,
conversely, not all fixed costs are sunk costs. A piece of
equipment purchased by a business (a fixed cost) can be
resold to recoup some of the initial investment (therefore it is
not a sunk cost).

Other names for sunk cost include retrospective cost, past

cost, embedded cost, prior year cost, sunk capital, or
stranded cost.

Examples of Sunk Costs

To better understand this concept, let’s take a look at some
real-life examples of the sunk cost fallacy.

● A business spends $10 million on building a factory.

Just before its completion, the managers realize that
there is no longer any demand for the type of goods
that would have been produced in that particular
factory. The market had evolved and consumers now
demanded a different type of product. The
manufacturer has a choice: finish the factory or retrofit
it into a new in-demand factory for a further $5 million.
In this situation, the $10 million already spent on the
old plane is a sunk cost. It should therefore not be
considered in decision-making, and the only relevant
cost is the $5 million.

● The same company has already spent over $20,000

training its employees to use a new assembly line
technology. As the factory is no longer viable due to a

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 lack of demand for that particular product, the
$20,000 is now a sunk cost. The senior management
team wants to discontinue the training program. The
$20,000 spent on training the workers so far is a sunk
cost and should not be considered in the decision of
discontinuing the training program.

Cost Allocation
Costing can be understood as the process of estimating or
evaluating the cost of producing an item or carrying out a
particular activity. It involves the way a business presents this
data in a suitably arranged manner for the purposes of price
control and to guide the management in proper
decision-making.

This could also be done to determine the cost of production

of various goods and services, as well as identify the fixed
and variable costs associated with their operation. Cost
allocation helps a business reduce the total cost of
production and identify wastage within the production
process.

Cost allocation is a vital part of generating financial reports

and comparing the actual cost of production with the
estimated cost — a process known as variance analysis. This
helps a business detect unaccounted or unexpected
expenses which may be draining their revenue, leading to a
drop in profits.

Cost Pool
A cost pool is an accounting term that is used to refer to a
grouping of individual costs which are later broken down
further during cost allocation. For example, a cost pool
labeled “customer service” will likely have various costs
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 within it, such as telephone bills, litigation fees, refunds, and
so on. Cost pools can help in the grouping of information into
an actionable form for easier decision-making.

Cost Structure
A cost structure is a part of a business development model
which highlights the specific expenses incurred by a business
while operating under an outlined business model for the
purpose of delivering the business's value proposition —
typically a good or service.

It refers to the types and relative proportions of fixed and

variable costs that a business incurs. In a nutshell, it is a
well-outlined plan which demonstrates how a business
spends resources — typically evaluated in monetary terms —
to achieve its goals.

Cost Object
A cost object is an accounting term that is used to refer to
items or activities to which costs can be assigned. Cost
objects are typically specific business items or processes
such as equipment, labor bills, raw materials, and so on.

Economies of Scale
This refers to a reduction in per unit cost that larger
businesses enjoy as they increase their production volume.
This decrease in cost per unit of production encourages an
increase in scale. This may be due to the costs saved by
buying raw materials in bulk, increased specialization, the
ability to attract workers with advanced technical skills, or
greater access to capital.

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 Economies of Scope
These are advantages a company enjoys due to varying its
scope of operations. This is because these different products
get to share the same resources and processes. This allows
for greater flexibility, faster response rate and shorter time to
market changes, lower risk, reduced wastage, and more
efficient use of software and hardware.

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 COSTING

We’ve explored the meaning of cost as it relates to business

and economics, as well as the different types of costs and
other related terminologies. Now it’s time to take a look at
another important concept that is closely relegated to the
theory of cost... costing (also referred to as cost allocation).

Costing can be simply understood as the process of

estimating or evaluating the cost of producing an item or
carrying out a particular activity. In more technical terms it can
also be described as the process of a business determining,
classifying, estimating, and evaluating the appropriate
allocation of expenses to determine the costs of products or
services. It also involves the presentation of this data in a
suitably arranged manner for the purposes of price control
and to guide the management in proper decision-making.

There are a few important reasons why a business may carry

out costing. They include:

● To determine the unit cost of production of various

goods and services, as well as identify the fixed and
variable costs associated with the operation of that
particular business model.

● To use this information to guide the determination of

the selling price of their product, as well as guiding
price policies. This is because for a business model to
be sustainable and profitable, the marginal revenue
must consistently exceed the marginal costs, as well
as the overhead costs.

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 ● It helps a business reduce the total cost of production
by allowing them to identify areas that can be
improved upon and increasing operational efficiency
within the supply chain or production process. It is also
a great way of detecting wastage within the
production process and stemming this before it
becomes detrimental to the sustainability of the
business.

● It is also useful for determining both workers' wages

and productivity, since an increase in marginal cost
without an increase in marginal revenue is an early
sign of reduced worker productivity. On the other
hand, reduced marginal costs with increasing or
steady marginal revenue show increased efficiency
and productivity, which can also be reflected by an
increase in worker salary.

● It helps a business identify the most profitable design

when considering the production process. This is
because costing allows a business entity to accurately
measure the respective marginal costs associated with
each particular type of production process and choose
the most profitable form, or make changes to the
design of an already existing process in order to
improve profitability.

● It is a vital part of creating financial reports and

interacting with various entities such as insurance
firms, investors, banks, and even potential buyers. It’s
nearly impossible to carry out activities associated with
these entities without first providing a comprehensive
account of the cost profile of the business.

● To compare the actual cost of production with the

estimated cost. This helps a business detect
unaccounted or unexpected expenses which may be

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 draining their revenue, leading to a drop in profits.

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 TYPES OF COSTING

Before we look into the types of cost, it’s important to

understand the factors which may influence the type of
costing system adopted by a business entity.

● One of the most important factors is the industry

involved in the costing process;

● The number of goods or services being produced;

● The types of goods and services being produced;

● The manner in which the workers are employed and

paid.

Let’s take a look at some of the different types of costs.

Absorption Costing
Absorption costing is a costing system in which the full cost
of manufacturing an item or providing a service is evaluated.
Due to the fact that it takes into account all costs involved in a
business operation, it can also be referred to as full costing.

During the process of absorption costing, all the fixed and

variable costs associated with the production of a good or
service are assigned to particular cost units and the overhead
associated with the operation of the business is absorbed
based on the business's activity level and distributed to
various departments (a process called apportionment). This
also includes both the direct and indirect costs associated
with the operation of the business.

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 It’s important to note that the overhead apportioned by a unit
item is fixed overhead. It’s also important to note that
overhead cost is allocated to an item, whether that product
was sold within that period of time or not. Things such as
labor costs, rent, raw materials, and so on are usually
included in the absorption costing.

A characteristic feature of this type of cost allocation is that

more cost is included in the ending inventory of the business,
which is then subsequently carried over as an asset on the
balance sheet of the next business period. Therefore, due to
the fact that a larger number of expenses are included in the
ending inventory of the business, expenses on the income
statement are typically lower when using absorption costing,
something which must be carefully taken into account.

Historical Costing
Historical costing is another costing concept that is quite
important to note. Historical costing can be defined as an
accounting method or form of cost allocation which takes into
account the value of an asset based on the original cost of
the item at the time of procurement or acquisition. This type
of costing is usually applied for fixed costs.

This is usually done for assets that have the potential to

appreciate or depreciate significantly over time. This could
include items like landed property, production equipment,
and certain liabilities.

There are several reasons why a business may choose to

undertake historical costing. The reason is that it provides a
more convenient and comparable cost analysis of the various
assets of the business, as the valuation of an item in terms of
appreciation and depreciation can be subjective. On the
other hand, the historical cost of the item is fixed and not

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 subject to change.

Another reason is that historical costing is relatively easy

since it deals with fixed costs and most of these costs can be
determined simply by retrieving and compiling their original
certificates or receipts of purchase. It’s also more convenient
for businesses that produce frequent cost reports.

However, one significant drawback of this method is that it

may not reflect the true value of the asset if it has undergone
significant appreciation or depreciation over time. Therefore,
historical costing may not be suitable for a range of uses such
as business acquisition, loan collateral, insurance payments,
and so on.

Marginal Costing
Marginal costing is a system of cost allocation which is
typically used when measuring the cost of variable expenses.
It involves the evaluation of the effect of variable expenses
on the total cost of production with respect to changes in the
total volume of production. This allows a business to
determine the effect of volume and the individual variable
costs on the overall profitability of the business and make
decisions based on this information.

Marginal costing is quite important because it gives a more

accurate depiction of the state of profitability of a business in
the short term. This is because total fixed costs remain
relatively stable over short periods, meaning that significant
short-term changes in profit margins are usually due to
changes in variable costs. This means that a break-even
analysis is essential for this type of cost allocation in order to
determine the level at which the business is profitable or
unprofitable.

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 Marginal costs are the main basis upon which price
fluctuations and price determination occur, since most fixed
costs are relatively stable over time. It also helps prevent the
over or under-allocation of overhead or resources.

Standard Costing
Standard costing is another important part of cost allocation,
which is mostly adopted by large-scale manufacturers.
Standard costing helps a business determine the difference
between the expected cost of production and the actual cost
of production, a process that is also referred to as variance
analysis.

The first step to variance analysis is to determine the

expected cost of the production of food and services under
typical operating conditions — the standard cost — before
comparing it with the actual cost of production.

If it is discovered that the actual cost of production is higher

than the expected cost of production, then the business is
said to have a negative variance. This situation is unfavorable
because it means that the business entity is spending more
than expected for the production of goods or services,
inferring that some form of hidden cost or wastage is
occurring.

On the other hand, if a business finds that the actual cost is

lower than the expected cost, this is called positive variance.
This shows that the business may be enjoying the benefits of
economies of scale or economies of scope.

Within this context, two primary variables significantly affect

the variance analysis result. The first is the cost of the input —
also called the price or rate variance — and the quantity or
efficiency of the input (also referred to as the volume

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 variance). The rate variance simply means the difference
between the expected price of a cost object and the actual
price, while volume variance refers to the difference between
the expected volume of a cost object consumed and the
actual volume utilized.

Lean Costing
Lean costing is a form of cost allocation which assigns
value-based prices to an item in contrast to historical costs or
standard costs, which are not built on the current value of the
cost object being evaluated. This gives a more accurate
analysis of the cost structure of the business and in the
day-to-day or short-term analyses of the price, it is one of the
most important cost allocation systems adopted.

One of the advantages of adopting a lean costing method is

that it helps detect areas of waste where operational
activities can be improved upon in order to maximize profits
and drive down the total cost of production. This is because
the driving principle behind this is an attempt to extract
maximum productivity from as few resources as possible.

Activity-based Costing
Activity-based costing is a form of cost allocation whereby
overhead costs are assigned to specific activities associated
with the production of goods or services within a business.
These activities are collectively referred to as cost drivers
because they typically form the bulk of the total costs of
production a business entity has to shoulder.

This form of cost allocation is generally more accurate than

total costing, since it assigns these costs to specific units of
production. It allows a business to more accurately measure
its costs as well as profitability.
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 Direct Costing
In the direct costing method of cost allocation, a business
entity pays key attention to direct costs associated with the
production of a specific good or service. Following the
calculation of this, all indirect costs are written off in the profit
and loss account. While this type of cost may be somewhat
simplistic, it is favorable in certain situations and easier to do
since direct costs are more easily identifiable and quantifiable
than indirect costs.

It’s also important to note that most times direct costing does
not take into account fixed costs as these do not change with
output and remain relatively stable over time. Therefore, only
direct variable costs are measured, which makes the method
better suited for short-term decision-making.

Uniform Costing
Uniform costing does not refer to a particular costing type,
but rather the practice of a business entity using the same
costing system to evaluate several different entities under the
business. This allows them to perform a comparative analysis
of the performance of these entities.

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 IMPORTANT METHODS OF
COSTING

Now, let’s take a look at some important costing methods

which are usually adopted by various business entities.

Unit Costing
Unit costing is a system that is typically employed by
companies that produce large quantities of identical or nearly
identical products or services. It can be defined as the total
cost incurred by a business entity in the production and
distribution of a single unit of a particular good or service.

It takes into account all the variable and fixed costs

associated with the operation of the business entity. It simply
involves identifying the total cost of production and dividing
this value by the number of items produced. Another name
for this type of costing method is single output costing.

The cost is usually made up of labor costs, the cost of

acquisition of raw materials, shipping and packaging,
payment processing fees, and so on. It is also a quick way of
checking the operational efficiency of a business. A great
way of lowering unit cost which is usually adopted by
large-scale manufacturers is through the use of economies of
scale.

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 Job Costing
While unit costing deals with items that are typically identical
and can be easily grouped, job costing deals with goods or
services which are tailored to the specific requirements of the
task at hand. In simple terms, the cost is charged per “job” or
project carried out. Job costing is mainly seen in areas such
as construction, software design, manufacturing of a small
batch of unique products, and so on.

Using this method can help you identify the class of projects
or jobs which are more profitable and those which are less
profitable. It also gives you a basic idea of how to effectively
and accurately cost similar jobs in the future, which can be
quite difficult in an industry that deals majorly with tailor-made
services.

To calculate the job cost, the cost of labor, raw materials, and
operational overhead for a particular job is pulled together
and analyzed. Therefore:

Total Job Cost = Direct Materials + Direct Labor + Applied

Overhead

Contract Costing
Contract costing (which is also referred to as terminal costing)
is a costing method that is typically applied for large-scale
projects which may carry out over extended periods. It is
somewhat similar to job costing, but it deals mainly with
massive projects. This is because such projects may vary
widely and are typically priced based on the specific
specifications of the project at hand.

Another important thing to note about contract costing is that

in many situations, the costing is not done solely within the
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 business. It is usually carried out between the contractor —
i.e., the business entity which is in charge of executing the job
— and the contracted — i.e., the person for whom the job is
carried out.

It is also important that since these contracts can occur over

extended periods of time which may range from weeks to
months, and even years, the costing (as well as payment) is
usually carried out at regular intervals or when specific
milestones have been met by the contractor. It is also
customary for each party to maintain a separate account of
the cost sheet for comparison and transparency.

Batch Costing
As the name suggests, batch costing is typically carried out
for items that occur in batches of near-identical or identical
units. Unlike unit costing, which deals with businesses in
which all the products are the same, batch costing is best for
businesses that produce different batches of identical items.

Therefore, the cost per unit item is calculated by obtaining

the total cost of a batch and then dividing this value by the
number of identical items within the batch. Also, similar to unit
cost, the cost of the batch is determined primarily by variable
factors such as labor, shipping and packaging, the purchase
of raw materials, electricity bills, and so on. A great example
of companies that may adopt this method of costing is
pharmaceutical and cosmetic manufacturers.

Process Costing
Process costing is a method of cost allocation that is used by
businesses in which the final product goes through different
distinct stages of processing, with the end-product of each
stage forming the starting raw material for the next stage.
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 Each stage is both capital and labor-intensive, therefore in
determining the total cost or per unit cost of the product, it is
more accurate to sum up the individual costs of each phase
of production. This type of costing is also known as
continuous costing.

This form of costing is particularly advantageous in industries

where the end-product of each stage of production can be
sold separately. This is because it allows the business entity
to create accurate total costs for each stage of production. It
is also popular among companies that mass produce identical
or nearly identical items.

It is important to note that both direct and independent costs

are closely monitored during each stage of production.
Process costing is common among industries such as paper
mills, the textile industry, chemical industries, food
production, oil processing, and so on.

Service or Operating Costing

Service costing is a costing method that is usually applied
within the service industry and is used to measure the
expenses involved in providing a particular service. This
could be used in the transportation industry, medical care,
equipment maintenance, the hotel industry, nursing services,
and so on. It is also called operating costing.

This is useful because these services involve a complex mix

of both direct and indirect costs, as well as fixed and variable
costs, which may make it difficult to evaluate the cost using
other costing methods. This is especially true in industries
that are solely focused on the production of intangible
products such as services, making the calculation of the
standard cost per unit somewhat difficult.

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 Therefore, a key way of classifying these costs is based on
the extent to which the service was provided. This unit of
measurement may differ widely in a variety of industries.
Some examples include costing based on kilometer per
person, per kilowatt-hour, per plate, per room per day, and so
on.

Multiple Costing
Multiple costing is a form of cost allocation used when a
finished product is made up of a variety of components that
have unique production processes and are individually
evaluated using different cost allocation methods. Therefore,
multiple costing is a way of determining the individual total
costs or cost per unit of these items and then using this to
determine the total cost or cost per unit of the finished
product.

The multiple costing methods involve the use of several

different costing methods, which must all be properly
integrated to ensure maximum accuracy in the report. That is
why this type of costing can also be referred to as composite
costing.

This form of costing is popular in industries involved in the

manufacture of certain products such as electronics,
automobiles, mobile phones, heavy-duty machinery, and so
on.

Inventory Costing
Inventory costing is a method used by businesses to
determine the costs of various finished goods within their
inventory. Typically, it is used to evaluate the assets held by a
business. There are several different types of inventory
costing that can be used, and one may be better suited for a
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 particular industry than another. Let’s take a broad look at the
most common techniques used in inventory costing.

First In, First Out (FIFO)

In this form of inventory costing, the oldest costs are assigned
to the first items sold, irrespective of whether those particular
items were originally purchased at this price. The formula for
this is:

Value of Inventory Under FIFO = (Units of Newest Inventory

x Value) + (Units of any other Newer and Remaining
Inventory x Value)

For example, assuming you own a company that sells t-shirts.

Your inventory may look like this, you bought:‍

● 200 shirts in January at $2;

● 200 shirts in February at $3;

● And 100 shirts in March at $4.

That’s a total of 500 shirts bought. Assume also that only 300
shirts were sold during the year. If you were charged with
developing the company’s balance sheet at the end of the
year, you can work it out using the FIFO method.

Under FIFO, you must assume that you sold the oldest
inventory first. The beginning inventory — the 200 t-shirts
which you purchased in January — are sold, plus the first 100
in February, for a total of 300 t-shirts sold. If only 300 items
were sold, the 200 t-shirts are still in inventory.
‍
In order to value your inventory using FIFO for the company’s
balance sheet, you multiply the 100 items that are left from
your February purchase by the $3 that you initially paid to
purchase them. You can then add that to the 100 items left
that you bought in March, multiplied by the $4 you spent to

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 buy them.

Practically, it looks like this:

Value of Inventory Under FIFO = (100 X $4) + (100 X $3) =

$700

Last In, First Out (LIFO)

As the rather unimaginative name suggests, this method is
the opposite of the FIFO method of inventory costing. Under
LIFO, you assume that any inventory sold was purchased
under the cost of the most recent stock purchase,
irrespective of when it was acquired by the business.
Therefore, the formula for LIFO is given as:

Value of Inventory Under LIFO = Oldest and Remaining

Units of Inventory x Value

Let’s use the same example illustrated above to work this out.

Remember that even though 500 t-shirts were purchased,

only 300 units were eventually sold. We automatically
assume that these were the last 300 shirts purchased. Out of
that number, 200 were purchased in February at $3 per unit.
100 were purchased in March at $4 per unit. Here is the
equation:
‍
LIFO = (200 X $3) + (100 X $4) = $1000

From this, it is obvious that using different inventory costing

methods can also lead to different results, so it’s important to
choose the one that is best suited for your business.

Average Cost Method

The average cost method — also referred to as the weighted
average cost method — is mostly used by companies that do
not have any major changes to their inventory over a

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 prolonged period of time and is calculated as a moving
average of all inventory purchase costs. It can also be stated
as the average costs of buying inventory, therefore assigning
individual costs to different items.

A feature of this type of inventory costing is that the weighted

average cost must be recalculated every time a piece of
inventory is either purchased or sold, which explains why the
cost is expressed as a moving average. However, this is
usually handled by some form of accounting software.

Specific Identification Method

The specific identification method matches the inventory cost
of an item sold to its actual cost perfectly. This is best used
for businesses or industries which have a low inventory
turnover, where the sale and purchase of each item can be
closely tracked. It gives the most accurate information on the
cost or value of the stock in the inventory, but can be quite
cumbersome or nearly impossible for industries associated
with high product turnover.

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 WHAT IS A COST
STRUCTURE?

We’ve defined costs as expenses incurred by a business

during the course of developing, creating, and providing a
good or service. This is important because when critically
analyzing a business, two key factors must be considered:

● How does the business plan on making money;

● How does the business plan on spending money.

While most people are interested in the first factor, they seem
to overlook the importance of having a deep understanding
of how an organizational structure allocated and utilizes its
resources to achieve several distinct but interconnected
goals, all aimed toward creating a finished end-product. This
easily overlooked process is an important part of business
development and can be broadly referred to as the cost
structure of the business.

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 A cost structure is a part of a business development model
which highlights the specific expenses incurred by a business
while operating under an outlined business model for the
purpose of delivering the business's value proposition —
typically a good or service.

It refers to the types and relative proportions of fixed and

variable costs that a business incurs. In a nutshell, it is a
well-outlined plan which demonstrates how a business
spends resources — typically evaluated in monetary terms —
to achieve its goals.

Having a well-defined cost structure is important for several

reasons, which will be explained more deeply later on in the
article. However, at its core, the cost structure helps you
reliably determine whether your current business model is
sustainable or not. It aids in policymaking, resource
allocation, decision-making, and auditing.

From a multinational Fortune 500 company to a

mom-and-pop shop in a local suburb, virtually every business
is associated with costs in one form or the other. These costs
may be fixed, variable, direct, indirect, and so on. However,
the type, scope, and scale of these costs are usually
dependent on the size and type of business entity involved.

From the explanation above it is obvious that a cost structure

is closely tied to other components of the business model
such as Key Resources, Key Partnerships, Key Activities, and
even Value Proposition. The first three items are usually the
major cost drivers within a business organization, and should
therefore have to be carefully analyzed before an accurate
cost structure can be crafted.

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 COST DRIVEN BUSINESSES
VS VALUE DRIVEN
BUSINESSES

Through the study of cost, cost allocation, and cost structures

we have identified more than just different types of expenses.
We’ve been able to classify business entities based on how
they interact with the concept of cost within their business
model. The two broad classifications are cost-driven
businesses and value-driven businesses.

Before we delve into these classes, it’s important to note that

neither class is inherently better or more profitable than the
other. Each faces its unique challenges and, of course,
possesses unique benefits as well. They are simply distinct
ways of approaching the problem of cost and resource
management within the world of business.

Cost-Driven
When discussing a cost-driven business model, it is important
to understand that the primary interaction of this type of
business with the issue of resource allocation is an attempt to
minimize expenses as much as possible to maximize profits.
Therefore, such businesses are driven by the aim of reducing
costs as much as they can through various techniques.

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 There are several ways through which a cost-driven business
can achieve greater cost reduction. This could include
specialization, outsourcing, automation, and using low-price
value propositions.

It’s important, however, that such businesses do not turn this

aim into a price war, which may only lead to long-term
business unsustainability and eventually business failure.
Prices should only be reduced as a response to greater
efficiency and reduced internal expenses.

It’s also important to note that cost-driven businesses are also

more company-centered as against being
consumer-centered. Some examples of cost-driven industries
include things such as manufacturing industries associated
with the large-scale production of low-budget items, the fast
food industry, non-designer textile and fashion, and so on.

Value-Driven
A value-driven cost structure on the other hand places more
emphasis on its ability to create and provide value to its
consumer base, instead of focusing primarily on the cost.
These types of businesses tend to be high-end, customizable
businesses which are designed to be consumer-centered and
rather flexible. Some good examples of this would be
industries such as the sports car industry, high-end fashion,
fine dining, resorts, and other luxury industries.

Now, this is not to say that value-driven businesses provide

more value for their customers than cost-driven businesses.
In fact, in many cases, the value proposition of cost-driven
businesses is their low prices. An industry is considered
“value-driven” which simply means that experience is the first
factor most of their customers think of before considering the
price of the good or service.

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 However, it’s key to remember that value-driven businesses
are still businesses at the end of the day and even though
their cost structure is not centered around cost reduction,
they must still find ways to ensure that their revenue exceeds
their expenditure. In that case, the only way for them to
achieve this without compromising on consumer experience
would be to charge premium prices for their services.

Another characteristic of this form of business is that they

have a high degree of customer retention and a deep
consumer relationship with their customer base. This may be
absent or not as important with cost-driven businesses, but
there are some important exceptions to the rule on both
sides.

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 WHAT IS COST
STRUCTURE IN THE
BUSINESS MODEL
CANVAS?

Cost structures are an important part of the Business Model

Canvas, typically the last part. Let’s take a look at the basic
structure of a Business Model Canvas.

The Business Model Canvas is a useful tool that can be used

to build a basic layout of how a business operates. It is a
unique visualization tool created by Professor Yves Pigneur
and Dr. Alexander Osterwalder, at the University of Lausanne
in Switzerland in 2005.

The standard chart is made up of nine core building blocks.

Generally, these areas can be divided into four categories:
Client-based areas (customer segments, customer
relationships, and distribution channels), offer-based areas
(value propositions), resource-based areas (key resources,
key partners, and key activities), and finance-based areas
(revenue streams and cost structure).

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 Filling in your Business Model
Canvas Template
Let’s take a closer look at each segment and what they mean
within the field of business development.

● Value Propositions
The value propositions are a summary of the
products/services offered by your company. It’s also an
outline of why a potential customer should choose
your products/services over that of a competitor.

● Customer Segments
This refers to the particular demographic that your
product/service is targeted towards, e.g.
lower-income/higher-income households,
families/singles, and so on.

● Distribution Channels
How do you intend to communicate with your
patients? This can be through email, text messages, an
official website, social media platforms, and
advertising.

● Customer Relationships
Customer relationships involve how a business and its
client interact within the context of the product/service
delivery. This may be through personal assistance,
dedicated personal assistance, self-service,
communities, and so on. Customer relationships also
include how the business plans on acquiring new
clients, retaining old ones, and encouraging clients to
expand their existing services.

● Revenue Streams
This refers to how a business plans to generate

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 income from the products/services they offer to its
consumers. Typically, business models work using
either a one-off payment model, subscription-based
model, pay-per-use model, per-user model, or function
as a pay-as-you-go service.

Also involved is the pricing mechanism that will be

used by the business. This may be volume-dependent
(how much of the service is used), customer
segment-dependent (who is using the service),
product feature-dependent (what is the quality of the
service offered), or a fixed list pricing.

● Key Activities
This refers to essential activities which must be carried
out to ensure the business functions properly, which
may include research and development, production,
service delivery, marketing, customer service, and so
on.

● Key Resources
Key resources are the inputs that are required for this
particular business model to work. This involves things
such as material resources, technological inputs,
human resources, intellectual property, financial
resources, and so on.

● Key Partners
Key partners are other businesses or entities which are
essential to the functioning of your business. They may
offer key services, maximize profits through
economies of scale, reduce risk, help in resource
acquisition, and provide other key services.

● Cost Structure
This involves all costs that are linked to the operation
of the business and the delivery of services. This may
include employees’ salaries, facilities maintenance,

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 acquisition of equipment and software applications,
and so on. Your cost structure is generally divided into
fixed costs, ongoing costs, and one-off costs. Some
other classes include product development costs,
customer acquisition costs, and so on.

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 ELEMENTS OF THE COST
STRUCTURE

Now, it’s not just enough to be aware of the different types of

costs and cost structures. Applying these principles to a
real-life business situation may take practice and practical
knowledge. However, there are a few tricks you can use to
minimize the difficulty of the task.

One of them is dividing the cost structure into several major

components and slotting each cost into where it fits. This may
not work perfectly for all types of costs or all businesses, but
it’s a great place to start, especially when you’re confused.
Let’s take a look at the different elements of a cost structure.

Product Cost Structure

This part is used to describe costs that are attributable to the
direct production of the product or service. It generally
includes both fixed costs and variable costs. Some of the
fixed costs could include worker salaries and factory
overhead. Variable costs include things like raw materials,
shipping, and transaction fees.

Customer Cost Structure

This has to do with expenses that are incurred due to
customer interactions with the business. This could include
warranty claims, customer service fees, credit notes, return of
goods, and so on.
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 Service Cost Structure
This has to do with services that may not be directly related
to the creation and delivery of the product or service, but are
still essential for the smooth running of the business. They
include administrative fees, taxes, legal fees, licensing, and so
on.

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 TYPES OF COST MODELS
USED BY BUYERS OF
MANUFACTURED
PRODUCTS

Costing is quite important within the manufacturing industry

because most manufacturers operate a cost-driven model,
which means that marginal cost and marginal revenue must
be thoroughly evaluated and tightly regulated to ensure the
business remains profitable.

However, costing is not just important to the providers of a

product. Buyers have a strong incentive to be aware of the
cost of production of a good or service to ensure that they
are being offered a fair valuation or that the costs of the items
are not being artificially inflated.

On that note, several key costing models can be used by

buyers to analyze the cost of the goods being provided to
them by suppliers. It is important to point out that these
models may not apply to all forms of business, and some
models work better for particular industries than others.

Open Book Cost Modeling

Open book cost modeling is a form of cost modeling in which
information concerning the costs associated with the delivery

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 of a good or service is openly provided to the consumer by
the supplier. This includes fixed costs like salaries, overhead,
equipment, and variable costs such as raw materials,
shipping, and transaction fees.

In its simplest form, this type of cost modeling adopts what is

known as a cost-plus contract, whereby the customer agrees
to pay the supplier the total costs incurred in the provision of
the product plus a predetermined margin.

One of the key advantages of this system is that it

encourages full transparency both on the part of the supplier
and the buyer. Since the buyer is allowed to see the
individual costs incurred at each stage of the production
process and understand the pricing margins of the supplier,
they are less likely to fall prey to predatory price inflation.

Also, this transparency encourages trust and greater

cooperation between both parties. It helps to build long-term
partnerships, to build a basis for data-driven pricing
decisions, and also helps both parties identify potential risks
and opportunities.

When operating this form of cost, it is important to be in touch

with the legal, financial, and supply chain partners of the
supplier to enable the efficient flow of information between
both parties.

However, certain difficulties may be encountered during this

process. One prominent issue is the level of monitoring
required may be out of the scope and expertise of the buyer,
requiring them to hire an external auditor — leading to higher
costs — or leading to a poorly executed open book contract.

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 Knowledge-based Modeling
Knowledge-based cost modeling is similar to open book cost
modeling, however, the supplier is not the only source of cost
information that is available to the buyer. The buyer may seek
information from similar businesses, third-party auditors, and
even public records. Due to this, the buyer is exposed to a
wider range of information than the open book cost modeling
method.

An advantage to this method is that it allows for preemptive

costing. In an open book costing, the buyer can only add up
the costs as the project transpires. Another advantage is that
due to the fact that the buyer has multiple sources of
information, they are not dependent on the supplier for
information concerning the cost of the project. Also, due to
the availability of additional project- and region-specific
information, these cost projections can be personalized to the
specific region or details of the product.

However, this form of cost modeling is also liable to fall prey

to a large number of the shortcomings of the open book
costing model. This includes the high amount of research and
monitoring involved, however, it is usually less time and
cost-intensive than the open book cost model. Also, a
knowledge-based cost modeling model may end up being
significantly less accurate than an open book cost model due
to the fact that the information utilized is not only actual
costing information from the supplier.

Hyper-optimized Cost Modeling

A hyper-optimized cost modeling system is a way of
determining costs that deal with building a cost structure
based on the best obtainable global rates instead of supplier
information. Therefore, this type of costing system offers a
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 theoretical model of what the cost of a project would be in
ideal situations. Obviously, this is rarely achievable and there
is a significant degree of variance between the calculated
hyper-optimized cost model and the actual cost.

The goal of this type of cost modeling is to establish saving

gaps between the hyper-optimized model and the actual
cost. The goal is then for the supplier to find ways to bridge
this gap through the use of various cost reduction
techniques.

Attribute-based Cost Modeling

Attribute-based cost modeling is a cost allocation that does
not essentially make use of information from the supplier or
third-party auditors. Instead, the cost could be estimated
using regression models obtained from similar products,
projects, or services. This form of cost modeling is generally
less accurate, but much easier, and does not rely on
information from the supplier.

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 EXAMPLE OF COST
STRUCTURE

Netflix
Netflix is an American streaming service and production
company that is currently based in Los Gatos, California. It
was founded by Reed Hastings and Marc Randolph in 1997 in
Scotts Valley, California as a DVD per-rental service before
upgrading its services to a subscription model.

However, due to the negative cash flow business model of

the company, it did not post a profit until six years later in
2003. This shows how a resource-heavy cost structure can
significantly impact cash flow and company growth. Following
this initial phase, the company experienced rapid growth in
both profits and distribution. By 2005 the company was
shipping out about 1 million DVDs a day and had over 35,000
different movies in its catalog.

The company branched out into the streaming industry in

2007 and eventually into production through its original
production company, Netflix Originals. The company posted
revenue of $29.7 billion in 2021 and a net income of $5.116
billion that same year.

The Netflix corporation has benefited significantly from this

growth and has capitalized on both the economies of scale
and economies of scope this position has offered them to
drive growth. Now let’s take a look at the key areas where

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 Netflix spends money to run its operations.

● As expected of a top streaming company, a significant

chunk of Netflix’s costs go towards the acquisition,
production, delivery, and licensing of streaming
content. In fact, the company has reported that it
projected that it would spend up to $17 billion in 2021
solely on content;

● Other significant costs include platform maintenance,

software development, research, and patents, as well
as Amazon Web Services (AWS) for the purpose of
database management, data analytics,
recommendation engines, and video transcoding;

● They also incur significant costs in supporting the data

centers required to host these streaming contents;

● Advertising, Human Resources, customer support,

legal fees, and other related services.

Nike
Nike is a popular multinational corporation that specializes
primarily in the design, development, manufacturing, and
worldwide marketing and sales of footwear, sports and
streetwear apparel, sporting equipment, accessories, and
other related services. The company is headquartered in
Oregon and was founded in 1964 as Blue Ribbon Sports, Inc
by Bill Bowerman and Phil Knight. It later officially changed its
name to Nike, Inc. in 1971.

The brand has since gained a cult-like following and has

ingrained its image into the very fabric of modern culture.
Famous products and spin-off brands such as the Air Jordan,
Converse, Nike Pro, and Nike+ have made the company
extremely profitable, with the firm posting annual revenue of

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 $17.36 billion in 2021.

However, despite their continued success within the industry,

a surprisingly large number of Nike products operate on a
cost-driven system which sees them operate rather thin
marginal revenues per unit product compared to their
competitors. As much as 50% of the price of retail Nike
products is retail markup, meaning that the wholesale cost is
significantly lower than the retail price.

Let’s take a look at how the Nike corporation funds its

business enterprises.

● The biggest expense shouldered by the business is

the cost of sales, which includes inventory sales and
warehousing. It is estimated that this consumes as
much as $21 billion per year;

● Another significant area the company spends money

on is marketing, as the most valuable asset the Nike
corporation possesses is its brand. The total cost of
advertising, sponsorships, promotions, media, brand
events and retail brand presentation is estimated to be
about $3 billion per year;

● The brand incurs significant expenses on sea freight,

insurance, customs duties and taxes, Free on Board
costs, salaries, and so on;

● Other administrative and overhead costs are valued at

about $500 million per year.

Tesla
Tesla, Inc. is a multinational American automobile company
best known for its line of electric vehicles and its advances in
the area of clean energy and self-driving cars. The company

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 was founded in 2003 by Martin Eberhard and Marc
Tarpenning, before being taken over in 2004 by its the
current owner and CEO, the tech celebrity and billionaire Elon
Musk.

Tesla was valued at $62.1 billion in 2021 and has a revenue of

$53.8 billion in that same year. The company initially started
mainly as a manufacturer of electric vehicles, but has since
spread out to invest in a wide range of clean energy sources,
especially photovoltaic cells (solar panels). The company is
currently the largest global supplier of battery energy storage
systems, with 3.99 gigawatt-hours (GWh) installed in 2021
alone.

The business model of the firm was initially a purely

value-driven brand that made high-price, low-volume electric
sports vehicles for a restricted clientele. However, through
advancements in technology and further adoption of electric
vehicles by the general public, the company aims to make
electric vehicles more affordable.

As a manufacturing-focused company, a majority of its costs

go towards production. Let’s take a look at the cost structure
of the Tesla business model.

● Labor and manufacturing overhead together

contributed to 81% of costs. A majority of Tesla's
expenses are geared toward fixed manufacturing
costs. Variable manufacturing costs also feature
prominently and according to data from the company
the costs are divided as follows; equipment (20%),
body (12%), chassis (7%), drive system (15%), battery
(35%), and other (11%);

● General and administrative costs also feature

significantly, as well as taxes, legal fees, interest
expenses, and so on;

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 ● As expected, Tesla invests a significant amount of
revenue into research and development related to
product engineering, prototyping, research, contract
and professional services, and costs from amortized
equipment.

Airbnb
Airbnb is an American online booking company based in
California which provides rental or short-stay lodgings for
tourists, primarily in the form of homestay arrangements. The
business does not own any of the residences it lists, but
simply receives a commission for facilitating the arrangement.

The company first began in 2008 under Brian Chesky,

Nathan Blecharczyk, and Joe Gebbia with the original name
AirBedandBreakfast.com, which was subsequently shortened
to Airbnb. It first began as an idea by Chesky and Gebbia to
lease out an air mattress in their living room to form a bed
and breakfast, offering a place to tourists who had a hard
time finding accommodation in the saturated hospitality
market of San Francisco.

After receiving a much-needed cash injection from some

early investors, the company rapidly expanded and by 2012
had achieved 700,000 bookings. They established their first
international office in 2011 in the City of London and have
since moved on to locations all over the world.

Airbnb posted revenue of $5.99 billion in 2021 and a

negative net income of $0.35 billion, showing that the firm is
currently operating on a negative cash flow model.
Considering the current business model of Airbnb, the
company practices cost reduction by simplifying its cost
structure by not owning any of the locations that it lists.
However, it seems that great marginal revenue or even

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 further reduced marginal costs are required for this company
to achieve consistent quarterly profitability.

Let’s take a closer look at how a company like Airbnb spends

money to keep operations going.

● One of the most significant costs in the business's

operations currently is the cost of revenue. This refers
to all the direct costs incurred by a business in the
process of directly creating, marketing, and
distributing a product. For Airbnb, this may refer to
payment processing fees and insurance payments;

● The business also invests heavily in sales and

marketing to drive customer acquisition and retention
through activities such as customer discounts, brand
promotions, referral programs, and even refunds;

● The company invests in the area of research and

development as well to ensure that its platform is
always competitive, functional, streamlined, and
keeping up with current trends;

● They also have general and administrative costs as

well.

Google
Google is certainly a company that needs no introduction and
is considered one of the most valuable brands in the world.
The reputation of the company is synonymous with the rise of
the information technology industry, both within the United
States and around the world. Google LLC began in 1998
through the work of Larry Page and Sergey Brin. The
company originally started with a search engine but has since
branched out to encompass a wide range of fields within the
tech industry such as online advertising and e-commerce,

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 cloud computing, AI, computer software, quantum computing,
and consumer electronics.

However, despite their diversification into a wide range of

fields, over 80% of the company’s revenue is still derived
directly from ad revenue. The company made over $209
billion in 2021 from its Internet advertising services on various
platforms such as Google Search, YouTube Ads, and Network
sites. This is because Google Ads operates as an
attention-based business model. This means that the
company does not directly market a “product”, but rather sells
user attention to interested brands who are willing to pay for
this exposure to a wider consumer base.

Google also makes a significant amount of revenue from

Google Play, Pixel phones, YouTube Premium, and Google
Cloud. Let’s take a look at the cost structure of Google.

● A significant amount of Google’s expenses are geared

towards the cost of revenue. This includes all activities
directly-associated with the sales of their services;

● They also invest heavily in research and development

as well;

● Marketing, sales, data centers, legal fees, as well as

administrative costs are also a source of expenses.

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 HOW IS COST MODELING
DONE?

Let’s take a look at the stages involved in the process of

constructing a standard cost model.

Segmenting the Expenses

The first step when building a cost model is noting all your
expenses down and categorizing them in terms of any
standard accounting format. They can also be grouped as
fixed costs, variable costs, direct costs, and indirect costs.

These expenses can also be grouped in less conventional

ways, such as costs that are dependent on square footage
such as rent and cleaning expenses, or costs that are
dependent on the number of hours worked such as overtime
wages and electricity bills.

Identifying Cost Drivers

A cost driver can be defined as an activity that triggers a
change in cost. For example, the cost driver for labor costs
could be assumed to be factors such as the number of hours
worked, the amount paid in overtime, worker bonuses, and so
on. Cost drivers are typically variable costs because their
value changes with changes in output.

It is important to remember that variable cost drivers are

usually more important than fixed costs when it comes to
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 profitability. This is because fixed costs are relatively stable
over short periods of time, but variable costs can vary more
widely over the short term and are better determinants of
short-term profitability.

Focus on Total Cost of

Ownership
Once you have identified the different costs associated with
running the business and each of its drivers, you can use this
information to build an estimate of the total cost of ownership.
The total cost of ownership is an accounting term used to
refer to the cost to buy something plus the cost to operate it
over its useful life.

Also, it is important to group these costs into logical groups

which can be used for future policymaking and
decision-making. For instance, if the company is planning on
expanding to new locations in an attempt to drive up sales,
which costs will be affected? This includes both fixed costs
and variable costs. How will this affect profitability? In the
end, is it a wise decision? All these questions cannot be
answered without adequate actionable information.

Allocate Costs to Each

Supplier
It is also a wide decision to segregate your costs among the
different suppliers. This is especially important for large
manufacturers which typically make use of numerous
vendors, each of which offers different benefits in terms of
cost, reliability, and other features. This helps in future

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 decision-making, especially when it comes to changing
vendors.

Larger manufacturers who may find the process of

categorizing these vendors tedious and inefficient can group
them into large categories while still maintaining common
cost-oriented criteria for the purpose of decision-making.

Create a Standard Costing

System
Using the information gathered from the previous stages, it is
now possible to craft a standard, reproducible, and flexible
cost structure that the business can utilize as a framework for
mapping out any current and future costs. Even if minor
changes are made in the company’s operational structure,
these modifications can easily be applied to this costing
model without too much difficulty.

A standard costing model is also great for detecting

variances. This means differences between the expected
costs and the actual costs noticed by a business entity. This
may be positive or negative and should be looked into. If the
reason for this variance cannot be detected, then this may be
a sign of an issue with the costing model and further revision
may be necessary.

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 WHAT TO ASK WHEN
CREATING A COST
STRUCTURE?

When building a cost structure, there are some key questions

that you should ask. They are:

● What are the baseline costs that you expect to

encounter due to your business model?

● Is your business more cost-oriented or value-oriented?

● Which Key Resources and Key Activities can be a

heavy expense for the business, as well as how do
they generate these costs?

● Do these Key Activities and Key Resources correspond

to the Value Propositions of your business?

● How are your variable and fixed costs affected when

you reconfigure your business model?

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 CONCLUSION
Costs are just as important as revenue when it comes to
running a successful business. Having a well-designed cost
allocation system is vital for the success of any business,
irrespective of the industry, size, and type of cost structure. It
helps in decision-making, planning, growth monitoring, and
the determination of an accurate pricing model.

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 ABOUT THE AUTHOR

Daniel Pereira is a Brazilian-Canadian entrepreneur that has

been designing and analyzing business models for over 15
years. You can read more about his journey as a Business
Model Analyst here.

E-mail Daniel if you have any questions

at: [email protected]
You can connect with Daniel at Linkedin:
https://www.linkedin.com/in/dpereirabr/

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This PDF File was purchased by Cesar Gabriel - [email protected]
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