This is part of a series of reflections inspired by my courses at HBX, an online business school cohort powered by Harvard Business School. With Business Analytics, Economics for Managers, and Financial Accounting, I'm learning the fundamentals of business. Find the whole series here.
Turns out, lots of things cost lots of money.
Millennial griping aside, it's not revenue that matters. It's costs. We face them in our daily lives:
- Fixed costs you would incur no matter what for your business. Imagine a Starbucks without their coffee machines! They have to have them or there isn't a business.
- Variable costs change based on the amount you're producing. You only need so much organic cacao and whipped cream for cappuccinos based on your output.
- Opportunity costs hide behind all of your decisions like buyer's remorse. It's the cost of what you could have done with that asset--like instead of paying rent, renting it out to someone else. If you don't have your coffee, your opportunity cost is being a complete zombie, even though your absolute monetary cost might be lower. You're giving up functioning like a human being, so most people say it's worth it to make the purchase.
Accounting can only tell you so much about the picture. Your strict accounting costs might tell you one story, but without adding the nuance of the opportunity cost and the breakdown of fixed vs. variable, you might make a completely different decision.
Battling the Competition
To really beat the competition, though, you have to think outside of advertising spend. What value can we capture from the market? The difference between the price we set and our willingness to sell determines the value we can capture. What determines our WTS? Our costs.
Relative costs matter more than the absolutes in the real world. In business, we need to set our prices lower than our competitor's costs, but not above ours. It's like the joke about outrunning the bear: you don't need to outrun the bear, just your friend. Understanding the other guy's costs helps you make better decisions on pricing, but also sets a benchmark for how efficient you're operating.
Entering New Markets
Note that when companies set costs, they need to set above their variable costs, not fixed. Fixed have already occurred as a sunk cost (as with the matching principle in accounting, they've already been recorded on the books) so it's variable costs that matter once you're a player.
If you're looking to enter a new space, though, fixed costs really do matter. It's the biggest barrier to entry. To successfully enter a new market, you must cover your costs, but also have lower average costs than your competitor's variable costs. That's why we haven't seen a huge growth of players in the airline market, but thousands of local lawn maintenance companies exist.
Is Bigger Really Better?
Economies of scale have magical properties when used correctly, just like network effects. It's why large dinosaur companies are having trouble keeping up with nimble, newer ones. The leading hotel provider doesn't own hotels (AirBnb) and the leading taxi service doesn't own any cars (Uber).
When a company endures large fixed costs on the local level, like a gym, then it's hard to scale, because those fixed costs occur over and over. Companies like Uber can scale exponentially and globally without incurring those costs again and again, which is why they're so powerful.