Irwin/McGraw-Hill Copyright © 2004 The McGraw-Hill Companies. All Rights reserved Chapter Analyzing the Cost of a Business Model 9

Irwin/McGraw-Hill Copyright © 2004 The McGraw-Hill Companies. All Rights reserved 9-2 Cost Drivers (1 of 4) Defined: The basic factors that determine costs. The factors associated with the firm’s resources, activities, positions, and industry that have a causal effect on the business model’s costs.

Irwin/McGraw-Hill Copyright © 2004 The McGraw-Hill Companies. All Rights reserved 9-3 Cost Drivers (2 of 4) Industry Drivers – Competitive Environment – Cooperative Environment – Macro Environment Resource Drivers – Quality – Quantity – Rate

Irwin/McGraw-Hill Copyright © 2004 The McGraw-Hill Companies. All Rights reserved 9-4 Cost Drivers (3 of 4) Activity Drivers – Which – How – When Position Drivers – Customer Value – Strength of Position – Price

Irwin/McGraw-Hill Copyright © 2004 The McGraw-Hill Companies. All Rights reserved 9-5 Figure 9.1 Cost Drivers of a Business Model (4 of 4)

Irwin/McGraw-Hill Copyright © 2004 The McGraw-Hill Companies. All Rights reserved 9-6 Measuring Costs By measuring costs, a firm can pinpoint where costs are lowest or highest and then it can determine why they are low or high by backtracking to the cost drivers.

Irwin/McGraw-Hill Copyright © 2004 The McGraw-Hill Companies. All Rights reserved 9-7 Financial Statements (1 of 4) Terms defined: 1.Cost of Goods Sold – total cost (direct and indirect) directly attributable to products whose manufacturing was completed during the period 2.Gross Margin (gross profit) – difference between revenues and costs of good sold 3.Selling and General Administrative Expenses – costs associated with the marketing and selling of the goods and with the general administration of the company 4.Operating Income – difference between gross margin and selling and general administrative expenses 5.Interest Expense – interest paid on the debts of the firm

Irwin/McGraw-Hill Copyright © 2004 The McGraw-Hill Companies. All Rights reserved 9-8 Table 9.1 Income Statement of Microchip Technologies, Inc. (2 of 4) Amount ($)Lines 1Revenues430,000 2Cost of goods sold: 3Beginning finished goods inventory, Jan. 1, ,000 4Cost of goods produced200,000 5Cost of goods available for sale300, Ending finished goods inventory, Dec. 31, ,000 7Total cost of goods sold270, Gross margin (gross profit)150, Selling and general administrative expenses100,000 10Operating income60, Interest expenses28,000 12Income before Taxes32, Taxes1,000 14Net income31,

Irwin/McGraw-Hill Copyright © 2004 The McGraw-Hill Companies. All Rights reserved 9-9 Financial Statements (3 of 4) Activity-Based Cost Measurements – Frequency of Activities – Duration of Activities – Complexity of Activities

Irwin/McGraw-Hill Copyright © 2004 The McGraw-Hill Companies. All Rights reserved 9-10 Figure 9.2 Conversion of Resource Costs into Activity Costs and into Product Costs (4 of 4)

Irwin/McGraw-Hill Copyright © 2004 The McGraw-Hill Companies. All Rights reserved 9-11 Tracking the Sources of Cost Differences (1 of 6) Identifying the sources of cost disadvantage or advantage: 1. Identify the activities of the business model’s business system—value chain, value network, or value shop. 2. Determine what drives the cost of each activity, and see if there is anything that can be done to improve the cost of the activity.

Irwin/McGraw-Hill Copyright © 2004 The McGraw-Hill Companies. All Rights reserved 9-12 Tracking the Sources of Cost Differences (2 of 6) Research and Development (from Table 9.2) – Industry Drivers: R&D spending depends on whether a firm is in the Wintel or Apple PC consortium. R&D spending in the Wintel camp is lower than that in the Apple camp and also depends on suppliers and complementors that have bargaining power. – Position, Activity, and Resource Drivers: It costs more to be a differentiator like Apple. Firms that choose to join the Wintel camp spend less on R&D. Emphasizing resources at the right points helps.

Irwin/McGraw-Hill Copyright © 2004 The McGraw-Hill Companies. All Rights reserved 9-13 Tracking the Sources of Cost Differences (3 of 6) Product Design (from Table 9.2) – Industry Drivers Sophistication and cost of designs depend on the camp a firm belongs to (Wintel or Apple) and on powerful suppliers of microprocessors and software. – Position, Activity, and Resource Drivers Some business customers may require special features that can drive up costs. Cooperation with Wintel partners to release products on time keeps the cost of early product introduction low.

Irwin/McGraw-Hill Copyright © 2004 The McGraw-Hill Companies. All Rights reserved 9-14 Tracking the Sources of Cost Differences (4 of 6) Manufacturing and Operations (from Table 9.2) – Industry Drivers The rapid rate of change of the industry’s technology, rapid drop in prices, and powerful suppliers of microprocessors and software mean inventory carrying costs can be a very high cost of manufacturing. – Position, Activity, and Resource Drivers Location. Management of component inventory. Build to order more critical to keeping costs low.

Irwin/McGraw-Hill Copyright © 2004 The McGraw-Hill Companies. All Rights reserved 9-15 Tracking the Sources of Cost Differences (5 of 6) Marketing and Sales (from Table 9.2) – Industry Drivers Installed base decreases cost of advertising. – Position, Activity, and Resource Drivers The commodity nature of the product suggests that PC firms may end up having to advertise more. Coopetitors in Wintel camp also advertise.

Irwin/McGraw-Hill Copyright © 2004 The McGraw-Hill Companies. All Rights reserved 9-16 Tracking the Sources of Cost Differences (6 of 6) Distribution (from Table 9.2) – Industry Drivers The rapid change in technology and rapid drop in prices make it costly going through dealers. Customers are sophisticated enough to bypass dealers and go straight to manufacturers. The Internet helps reduce the cost of distribution – Position, Activity, and Resource Drivers Bypass Distribution

Irwin/McGraw-Hill Copyright © 2004 The McGraw-Hill Companies. All Rights reserved 9-17 Role of Fixed Costs and Demand (1 of 3) Profits = revenues - variable costs - fixed costs = PQ - V C Q - F C = ( P - V C )Q – F C = contribution margin – FC = (contribution margin per unit)Q - F C

Irwin/McGraw-Hill Copyright © 2004 The McGraw-Hill Companies. All Rights reserved 9-18 Role of Fixed Costs and Demand (2 of 3) Break-Even Analysis – the quantity at which revenues equal total costs The point where the firm has zero profits: From this Since P – V c = the contribution margin per unit

Irwin/McGraw-Hill Copyright © 2004 The McGraw-Hill Companies. All Rights reserved 9-19 Role of Fixed Costs and Demand (3 of 3) Sunk Costs and Competitive Position: The costs of an asset that have already been incurred and cannot be recovered. – Barriers to Entry – Rivalry – Investing in Technological Change

Irwin/McGraw-Hill Copyright © 2004 The McGraw-Hill Companies. All Rights reserved 9-20 Questions Analyzing the Cost of a Business Model