Cost structure is pretty dorky even compared to the dorky things I usually write about in these posts, but it is something that is good to know about, because (like liquidity) it is key to the success of a business, and yet is often kind of invisible to consumers.
So, what is cost structure? It is all the costs or expenses that a business has.
We all know the saying, “You have to spend money to make money,” and yes, you do. But if you put out more money as costs than you take in as revenues, you are losing money. That is bad, especially over the long term. For a businessperson, it is every bit as important to understand how and where you are spending money as it is to understand how and where you are making money. (This is why most employees of a company will complain about how their bosses are obsessively cheap–costs matter as much as revenues.)
The fact that cost structure is important is the very reason it is often hidden. If you’re a business, you usually can’t effectively conceal the way you make revenues, especially not from competitors who are in the same business as you and know it just as well. As a result, companies will brag about revenues all day long: We’re the biggest K-Pop label by revenues! OMG! Look at us!! And all our great revenues!!! Which are huge!!!!
In contrast, you often can conceal the ways your business has figured out to spend less. If your company is public, you have to report your costs by certain categories, but those categories are pretty broad. How, exactly, you keep your costs so low is something that you can keep quiet about–it can even be a trade secret, and then your competitors may get so desperate that they wind up engaging in illegal corporate espionage to ferret it out!
If you have the same revenues but lower costs than everyone else, then you will always be more profitable and will always be doing better than the competition–mwa-ha-ha-ha!
We have become rich! Through thrift!
So, let’s say you run a traditional K-Pop label–indeed, the very label that handles A Large Group of Attractive People. Plus, you’ve got trainees that you’re hoping to debut one day as A Large Group of Underage Attractive People.
What are your fixed costs?
Office rent, insurance, paying for the dormitory for both groups, feeding both groups, chaperones for both groups, any regular and routine maintenance for the members (training, dermatology, plastic surgery) that is unrelated to any specific revenue-generating activity.
Note that you can alter your fixed costs–they’re not “fixed” in the sense of being unchangeable. For example, you could cut your fixed costs by shit-canning all the A Large Group of Underage Attractive People trainees. But fixed costs don’t rise or fall depending on how many comebacks or other activities you do.
What are your variable costs?
Production of songs, production of CDs, choreography, videos, costumes for appearances, transportation to appearances, shoots and production for photobooks, etc. These are the costs that increase the more active your groups are. Doing a ton of comebacks? You’d better be ready for a ton of variable costs.
In my post on liquidity, I caused your label a liquidity crisis by jacking up your variable costs. However, you can just as easily have a liquidity crisis caused by your fixed costs–the landlord suddenly doubles the rent on those dormitories, and you don’t have the cash on hand to cover it. High fixed costs mean that you need to either have a lot of money (or credit) on hand, or that your label needs to start making a lot of money ASAP.
Are there any benefits to being in an industry with high fixed costs? Yes. High fixed costs are a great barrier to entry–if your industry is really expensive to get into, few people will try, which means less competition for you! (In fact, one big exception to the rule that companies don’t talk about costs is when they spend an enormous shitload of money doing something. That they are very sure to publicize–ideally where any potential competitors can see it!)
You see the connection between high fixed costs and barriers to entry in this interview Decipher had with Snacky Chan. Chan talks about how it used to be that the only way to promote effectively in the Korean music industry was to be on television. The tricky bit was, the only way to be on television was to spend years paying off producers.
Can’t afford the payola? You can’t afford to be in this industry!
You’ll notice that I categorized bribing television producers as a fixed cost. That’s because even if you, the K-Pop label owner, want only A Large Group of Attractive People to appear on television, you’re still going to have to spend years handing out (cash) gifts to television producers for their birthdays, and their children’s birthdays, and their college roommate’s cousin’s children’s birthdays. . . .
If that’s the case, then why wouldn’t you also debut A Large Group of Underage Attractive People as soon as possible? You’ve already spent the money needed to get any group on your label on television; it will be more profitable if you have more than one group out there generating revenue to offset that fixed cost.
But . . . debuting A Large Group of Underage Attractive People will increase your variable costs. From that point of view, it’s better to hold off on debuting your second group, or not debut it at all.
Which is the right call? It depends. As a business owner, you’re going to have to weigh all the variables, make a decision, and hope that your judgement is correct.
In any case, industries with high fixed costs–think airlines or manufacturers of computer chips–tend to be dominated by large players: You need big revenues to cover those big fixed costs. Industries with low fixed costs tend to be waaaaay more friendly to small businesses and individual entrepreneurs (apps or other software development is a good example–all you need is a computer).
Can an entire industry see its cost structure shift dramatically? Yes. Since we’re being K-Poppy here, let’s do two scenarios!
You own a business in an industry with high costs. You figure out a way to bring down your cost structure–and your cost structure alone. Significantly.
That’s a very nice position to be in. You’ve still got the (perceived) barriers to entry keeping potential competitors out, you’ve got a consumer base that is used to paying a high price for something, and your existing competitors still have high costs. You can cut your prices juuuuust a little below theirs, and you’re going to be a very profitable operation indeed while they struggle to remain solvent.
Of course you’re going to keep your mouth shut about how you keep costs down–that is key. If you make a big deal about your great new cost structure, customers are going to expect you to pass along the savings–plus they may start viewing your brand as the cheap discount one. In addition, existing competitors will start trying to figure out how to copy your methods, while potential competitors will realize that those barriers to entry into your industry that they thought were so high are maybe not that high after all.
Basically in business, you always want your costs to be low, but you want other people to think that your costs are high. That’s the sweet spot.
You own a business in an industry with high costs. A new technology comes along that is available to everyone and that allows everyone to to bring down their costs. Significantly.
This is actually a much-less desirable position to be in than Scenario #1, and that’s the situation that digitization has brought to many media companies. Newspapers, for example, had this carefully cultivated network that allowed physical copies to be reliably delivered to people’s doorstep every day. But now everyone just looks on-line for news.
The fixed costs that newspapers had–printing presses, fleets of vans, hundreds of employees–didn’t just vanish overnight: It’s hard to change a business model that quickly (especially when it involves laying off half your staff). Meanwhile, new companies stepped right in, offering advertising-supported on-line news, often at no cost to consumers! You see why newspapers (and record stores, and book stores, and encyclopedia publishers) are having such a hard time these days.
Is there a term for these kinds of outmoded cost structures? Yes, those are called legacy costs.
So, here’s the question: Should the cost structure that comes with owning a traditional K-Pop group–which includes payola for television producers and money spent manufacturing CDs–be considered legacy costs?
I would argue that the answer is no–if you can make that business model work. If you want A Large Group of Attractive People to be a conventional K-Pop group, then it makes a lot of sense to have a cost structure that includes things like sucking up to television producers and manufacturing elaborate CD sets and other expensive merchandise, because that’s how you 1. develop a fan base, and 2. monetize your fan base.
But if that’s not what you want to do, it makes no sense to adopt that cost structure. High fixed costs require high revenues–revenues that are often much higher than what is needed to turn a lovely profit when you have a different cost structure–and generating massive revenues is hardly an easy task.
People sometimes buy into the notion that you have to do Big Company things (selling X many units, having huge marketing campaigns, etc.) if you’re serious about your career and want to be “successful”–a term they define very narrowly indeed. But all that rigamarole could potentially bankrupt you.
If you’re happy putting out digital singles and having your major promotional cost be the T-shirts you sell at concerts, and you can make money doing that, there is absolutely no business reason to cough up for all the rest. Don’t borrow trouble, and don’t try to adopt the wrong cost structure.