Have you ever worked with an artisan who came saying, “prices have changed”? Or failed to add an item(s) to the list of purchases? Often, it may seem like these artisans want to swindle you because they keep coming back for more [money]. Interestingly, they may be honest with their demands and had just done a poor cost analysis, which led them into a cost trap.
Unlike artisans, it’s near impossible for most businesses to renegotiate pricing once the deal is sealed.
What is a Cost Trap?
A cost trap occurs when a business burns out because it failed to identify and reduce business costs to maximise profits. In other words, a business falls into a cost trap when the cost of offering a service or producing goods is higher than revenue.
To avoid a cost trap, especially during the scaling phase, it is crucial to determine that a significant part of the intending target market like the idea and what they are willing to pay for it. Knowing the cost of developing the idea into a viable offering is a no-brainer.
There are two types of costs one must account for when developing an idea into a scalable business:
These are expenses incurred during the process of creating a new business.
Businesses are different, so they have different types of upfront costs. Usually, these costs are one-time investments for research and development to create a new business (product or service).
Other typical upfront costs include insurance, license, permit, professional/consultation fees, and technology (gadgets or software) costs.
These are your operating expenses or necessary day-to-day costs incurred while running your business.
Any cost that is not a one-time expense is classified as a running expense, but finance specialists may beg to differ.
Typical running costs may include rent, utilities (power, water), overhead, repairs and maintenance, professional/consultation fees, advertising/promotion, etc.
Upfront costs can be recouped, but operating ones can bleed you and lead to burnout or a cash trap.
In 2021, a part of the Kolibri business was shut down because the rates the niche market was willing to pay were 25% lower than the cost of offering the services.
Similarly, wellness startup, Arivale was created to change preventative health care, only to bankrupt a few years later because it couldn’t find a viable price point for its services.
There are several strategies to fix or avoid cost traps. In this article, we will consider three strategies that will help your business scale at a low cost.
Economies of Scale
Economies of scale is a proportionate decrease in costs gained by an increased level of production.
This is a skill Elon Musk excels at in all his businesses. Tesla’s massive success can be traced to the economies of scale of its two most important components: batteries and solar power generation cells, both of which are manufactured significantly cheaper in higher numbers.
Also, everything at Tesla is geared toward increasing the efficiency of “the machine that makes the machines,”.
If you’ve ever branded items, you can testify that the more quantity you brand, the cheaper the cost of branding per piece. Minimising the cost per unit by producing in large quantities is simply economies of scale.
Labour arbitrage is limited in its daily use but it is a strategy implemented by most businesses.
Some experts limit the definition of labour arbitrage strictly to taking work from one location to another with the same skill set but at lower costs.
However, other experts use a broader definition of labour arbitrage that encompasses multiple corporate policies that result in the lowest-cost labour. Your business can leverage this strategy to create models that don’t rely on top-tier talent.
As your business scales, finding and paying high labour will become prohibitive. The solution is to create offerings that can give their total value to clients even with average labour delivering them.
A common form is paying per project, other forms include the use of off-shore workers, where companies can hire workers in a foreign country and pay lower labour costs, and the use of cheaper subcontractors or contract staff in a company’s home country instead of full-time staff/employees.
Outsourcing helps startups execute faster because outsourcing providers already have everything in place to get the job done – people, processes, and technology. This contributes to greater efficiency and better customer experience.
Once you are able to answer such questions as: Do I want this done in-house or offshore? Which of these options allows for greater growth and efficiency? What do I stand to lose or gain? You are on the path of progress.
Use cases of outsourcing include Google in 2019, which had more outsourced workers than in-house employees. Microsoft is estimated to have similar numbers on both sides. Other companies that achieved significant success through outsourcing when they were startups include Slack, Skype, Opera, Basecamp and many more.
Commonly outsourced business units include marketing, sales, human resource management, accounting services, strategic communications, technical support, customer care, etc.
Scalable businesses are all alike because they all leverage some of the strategies earlier mentioned, but every unscalable business is unscalable in its way.
What makes the difference is anticipating and avoiding potential challenges.
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