How Digital Business Models are Truly Special – Cost Structure

Over the last couple of years, the idea of consciously designing a business model has gained a lot of traction, fueled by the groundbreaking book Business Model Generation from 2010.

However, I believe it is very important to fully understand the impact that the business model has on the cost structure in the financial model – and vice versa.

Before looking at cost structures, let’s quickly wind back to the dot-com boom around the turn of the millenium: At that time, Microsoft was the undisputed leader of the global software market, generating fantastic profits based on its digital business model. As it became clar that the next wave of digital business models was about the Internet, the assumption was that every startup that did “something with the Internet” had a fair chance of becoming the next Microsoft.

Whether the startup was selling physical books over the Internet (Amazon in its early days), or aspiring to become the world’s leading marketplace for online auctions (eBay) didn’t seem to make much of a difference in how people and the financial markets looked at these budding companies.

But there’s a huge difference – although both do  “something with the Internet”, their business models and the resulting cost structures are fundamentally different.

Selling Physical Goods or Services – A Traditional Business Model

The business model of Amazon in its early days – selling physical books over the Internet – is actually a traditional business model with a traditional cost structure. The fundamental cost structure of that is similar to other traditional business models that produce and sell physical goods – from breakfast cereal to jet engines – or that sell services that require high people costs (such as consulting services) or high people costs plus high cost of capital (think airlines).

The fact that Amazon uses the Internet for marketing and ordering was disruptive to established retail or mail order book sellers, but it doesn’t set up a company to become the next Microsoft.

Selling Virtual Goods over the Internet – A Digital Business Model

This is the eBay business model. eBay facilitates auctions of physical goods, but it never touches the physical goods. All eBay ever handles are bits and bytes: profiles of buyers and sellers, information about the auctioned goods and about the auction status, and payment processing. All the handling of physical goods – the logistics – are done by buyers, sellers, and providers of delivery services (postal services, FedEx, …)

Therefore, eBay’s business model is entirely digital and it has the typical digital business model cost structure.

Cost Structure and the P&L Statement

The difference in cost structures is obvious in the income statements, also known as Profit & Loss statement, or short P&L. If you are not familiar with income statements and cost structures, you can find a quick introduction in my previous blog post.

For the purpose of comparing cost structures across business models, I’ll focus on gross profit and operating profit.

I will not look at net profit here. Of couse, net profit is what ultimately matters to investors in a company, I’m not ignoring that.

But net profit is influenced a lot by the choices and circumstances of the individual company. Between two comparable companies with similar operating profit margins, the net profit margins can still be quite different, depending for example on the capital structure or the company-specific tax situation. That’s why net profit does not always expose the differences in cost structure that clearly.

Huge Difference in Cost Structure between Traditional vs. Digital Business Models

CostStructure_TradVsDigital_2013-02The table illustrates a fundamental difference between the cost structures of a mature traditional company and a mature company with a digital business model.

By mature I mean companies that have found their business model, are successfully executing on it – and that generate significant revenue.

The difference that I cannot highlight enough is in cost of revenue: you’ll notice that in the traditional model, the vast majority of revenue is spent on cost of revenue, such as manufacturing and distribution costs, or salaries for service personnel in case of a services-based business. In the digital business model, cost of revenue is much, much lower.

Traditional Cost Structure – High Cost of Revenue

For a traditional business model, cost of revenue in the range of 70% to 80% is common. That leaves only 20% to 30% of revenue as gross profit to cover all other operating expenses. Therefore, operating profit margin is usually in the high single or low double digits (say, 7% to 15%) and net profit (not shown here) is even lower, usually in the single-digit range.

For example, the range of operating profit margin for the retail industry is in the high single digits – in 2012, Walmart did less than 6% – while leading industrial goods vendors typically achieve low double digits, e.g. in 2012: GE > 12%Deere  > 13%

Digital Business Model – Low Cost of Revenue

Compare this with the digital business model: a mature company typically has cost of revenue below 30%, which leaves 70% or more of each revenue dollar as gross profit. This usually results in an operating profit margin in the 25% to well over 30% range, and net profits can reach 20% to 30% of revenue.

These profit margins are unthinkable in a traditional business model!

Pure Digital Business Models – Gross Profit Margins Can Get Close to 90%

For example, Adobe has a pure SW business model: unlike Google and Microsoft, there is no hardware business mixed in. And unlike traditional enterprise software vendors, Adobe does not have a lot of maintenance and support revenue.

So it’s really pure software, and a mature business – and it shows in the numbers: Adobe in 2012 made a gross profit of 3.92 B$ on total revenue of 4.40 B$. That’s a whopping 89% of gross profit.

Another example of a pure digital business model: LinkedIn in 2012 reported a gross profit of 846.79 M$ on 972.31 M$ of total revenue. That’s 87% of gross profit.

Digital Model Cost Structure – Low Marginal Cost

Cost of revenue is so low in digital business models because once the digital good (e.g. a social network, software, digital books, music, …. ) has been developed, there is very little cost related to manufacturing or distributing the product, or serving the customer. Keep in mind that the cost of ongoing R&D or marketing costs are not accounted as cost of revenue, they are counted among the more or less “fixed” operating costs.

There’s a technical term for this phenomenon: low marginal cost. Per Wikipedia: “Marginal cost is the change in total cost that arises when the quantity produced changes by one unit.”

Put differently, marginal cost is what it costs a company to serve an additional customer. If marginal cost is very low, taking on additional customers comes at close to no cost for the company.

In the examples from above: once Adobe or LinkedIn have their businesses up and running, it doesn’t cost them much more to serve additional customers.

Conclusion

Digital business models are characterized by low marginal cost. Before the emergence of digital business models, extremely low marginal cost was pretty much an anomaly. The digital revolution enabled this niche phenomenon to grow and to become an important part of the economy (and the stock market).

In that sense, when everyone got excited in the late 90ies and declared “this time it’s different” they were right: something new and different was emerging. But this does not apply to every company that does “something with the Internet”. It applies to those companies that have a truly digital business model.

The low marginal cost has very interesting implications – which will be the topic of my next blog post.

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2 thoughts on “How Digital Business Models are Truly Special – Cost Structure

  1. Pingback: How Digital Business Models are Truly Special – Funding Options | barbara hoisl

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