The founders of a clothing startup needed to decide between two options, expanding sales into a new geography or launching new products within their existing market. Having just closed a Series A round, vigilant use of funds was essential for growing beyond the Survival stage. Their plan was to focus efforts on just one of the strategic options to counteract what they foresaw as a ceiling in sales, given their existing customer base. Their core customers were about 4 million males, ages 18 to 40, with disposable income, and a predilection for good quality clothing. Due to the seasonal and scarce buying habits of this limited group, the team didn’t expect many repeat purchases of their existing product line within a year.
The task was quite clear, but finding a viable solution for which option they should pick was a bit subtler. One could do a market sizing project, in this case akin to putting a finger in the air, attach an estimated selling price and unit cost to the expected volume, and come up with a margin of profitability for either geographic or product expansion. A net present value of expected future cash flows from both projects could then be worked out to decide the best option. Yet, the uncertainty in profit margin estimates, reliance on a supposed discount rate, coupled with the pressure to hit made-up targets based on hypothetical forecasts about markets seemed… daunting. Thus, the drive to develop a different yet disciplined approach became necessary.
Our conceived method ran counter to the “grow at all costs” philosophy that has pervasively fueled startup mentality for a half-decade. Instead of throwing resources and money at a problem to force a solution, we decided to bring it back to first principles — understand the costs to drive strategy. What we found as a cost-based approach to choosing one of the options, could also apply to many other types of strategic choices that founders and managers must make towards their business. To help guide our thinking, we agreed that “costs” did not only relate to expenses, but also to the opportunity costs of choosing one of the options — limited resources meant limited opportunities to correctly tackle the next step in growth, whether that was expanding geographies or products.
We started out by collating all respective expenses, tagging each line item with a percent allocation to a product. This method of activity-based costing allowed us to attribute the amounts for direct and indirect expenses to various products. It also allowed us to spread fixed expenses across different product types. Because everything in the business should support the sales of products in some capacity, whether directly or indirectly, activity-based costing enabled us to have a view on how all expenses supported each unit of each product. To get an accurate read on how much of an expense should be allocated to a product, we started by looking at any quantitative data we had (e.g., measure of hours worked, of amount used, etc.). After exhausting all quantitative data, we then interviewed the team to record their views. Recording qualitative measures allowed us to fact check the quantitative data, and fill in the blanks in cases where the expense wasn’t measurable in units.
The next step was to understand the impact that various cost drivers had on unit cost. What would happen, for example, if customers purchased more units per order, driving down shipping and packing material spend per unit, or if warehouse employees became more productive, thereby spreading fixed expenses across more units and reducing unit costs? We modeled this to understand the magnitude of how much unit costs could change if cost drivers fluctuated, using historical costs to develop probability ranges for our thresholds of magnitude.
This exercise helped us understand the sensitivity behind some of the drivers of profitability, and more importantly, presented us with insight into the true nature of the business. Let’s say Product A’s sales were particularly strong, but we found through doing this cost analysis that the risk of becoming unprofitable hinged on the delta of several percentage points in a cost driver, the founders may think more carefully about placing big bets on Product A.
Viewing the business through a cost-based perspective made clear the decision between expanding into new geographies or product lines. We found that expanding geographically would drive up unit costs due to increases in indirect logistics expense, and more interestingly, the option of expanding product lines would drive down unit costs, because we could bundle more products per order, thereby reducing per-unit shipping expense and the cost of picking and packing per order. Although costs should not be the only decision factor when considering the strategy for your business, it should weigh darn heavily given the importance of being profitable. Managing cost can directly improve cash flow, and since cash today is worth more than cash tomorrow, it makes sense to approach the strategy for tomorrow with a view on cost today.
The example here shows the importance of having a clear view of the costs at any stage of the business, and how founders and managers can use that knowledge to help drive strategic decisions such as pricing, marketing, product development, and finding the right product mix. In the wise words of a favorite professor, “If you don’t understand the costs, you don’t understand the business.”
About the Author
Jon Lexa is a consultant with the Boston Consulting Group. He has also worked for startups in e-commerce, data analytics, and fashion. He holds an MBA from INSEAD and an undergraduate degree from UCLA in Cognitive Science and Human Complex Systems.
(The views expressed here are solely of the author’s and do not necessarily reflect the views of his employer)
