Video: Creating cost model – COGS and marketing cost assumptionsCopy

Here Professor Hachikian discussed some basic principles of creating a cost model. She discussed COGS and marketing cost assumptions

https://youtu.be/6qhmP3bTnMo

Transcript

I want to switch over to the cost side because cost is another really important piece of this puzzle, and I just want to help you think a little bit about one of these. Sometimes when you’re developing at your cost people actually fail to think of costs that they put into their model. So, I’m going to kind of go through what some of the big cost buckets are so the things we most readily think of are the direct costs. Those are the costs that are going to be required to actually make your product or service come alive in the world, and those usually are materials or labor, and then the other people who do your service or the raw goods that go into making your product (if you have a product) maybe it will also be the labor to put it together to ship it; that kind of thing. So, materials and labor are usually the two big categories.

When you think about direct costs, it’s going to be more labor likely if you’re a service company, and more materials if you’re a product company. But, you know it’s a little bit of both. Another thing you need to keep in mind is the fixed versus variable. So, fixed costs typically don’t vary with the number of units. It’s like the machine, if you’re going to make widgets, you need one machine you could make one widget you can make a million widgets but you need one machine to make the widgets that’s a thick. The cost of that machine is a fixed cost.

Then there are variable costs and those are the costs that change with every unit. So, if you have one more unit, it’s going to be that you need one more. If you make one more widget, you need one more widget part, so each widget, the number of units you produce is going to be exactly equal multiplied by the cost of that unit. Sometimes, variable costs are funny, they, you know, when we think about widgets or you know, producing something like a can of frosting you know, you, um might have, you know, then like in the can of frosting. You might have sugar and oil that go into that, and every measure of sugar is going to cost you something, and every can of frosting you produce you take that, amount of one teaspoon of sugar times the can of frosting, and then you can think about “if I’m going to make a million cans of frosting I need a million tablespoons of sugar”. You can multiply that out by people so sugar comes in small increments in other, words but people don’t come in small increments; you can’t buy a tablespoon of a person, for example, so sometimes, when you think about a variable cost you to think about well one person is going to get me a thousand cans of frosting they’re going to be like the person who mixes the frosting and puts it in the container like a little bit silly to think about but you know what I mean.

If one person can produce a thousand cans of frosting, you don’t get to take a tablespoon in person now that’s not totally true because you can have part-time people and whatever but still you have to think. Sometimes, people in particular kind of fall somewhere between fixed and variable. They’re not really fixed because they’re not like one big machine, and that’s it, you need for every thousand units you need another person so they are a little bit variable over time depending on as your business grows. You just want to think a little bit about what some of those costs are going into and how variable they are. In other words how they grow depending on the number of units that you produce. So, those direct costs are going to be really important.

Sometimes, we call these direct costs also COGS or “cost of goods sold” that’s an accounting term. For a model like this, you don’t need to worry about fancy terms, terms like direct costs are enough. Usually, direct costs are at the top when we lay out our costs. They are like a model. We put all the direct costs and stuff that vary, that sort of tracks with the number of units, we usually put that at the top; and then at the bottom we put the other costs. We call these operating costs, and these are really about expenses that you have to grow your business. Creating new products doing Research and Development, you know, whatever that is all the ways in which you’re going to grow your business; new markets; that kind of thing.

There is the other big category. Here’s sales and distribution, so we want to make a distinction between people that actually produce your product or service; that would be in a direct cost, versus people who sell your product which is really in an operating cost. How many sales people do you need? What’s the cost per salesperson? Are you working through affiliates or distributors and what’s the cost of sales through your affiliates or distributors? You might think about advertising and marketing; and there’s lots of ways you can advertise and market; whether it is Google ads or you know, flyers, or in fact; signs that you might put up in a grocery store if you’re selling a product; you’re selling cans of frosting for example. All of those would be average new marketing costs.

Again, remember you should have a link between your revenue growth and how much you’re spending on sales and distribution and advertising and marketing. Those two things should be relatively linked. You need to invest in advertising, marketing and sales in order to get that revenue growth. A couple other things you know. One thing I think people often forget about is customer service. When your product breaks, or when somebody doesn’t like your service, who are they going to call? They’re going to call you the entrepreneur. Are they going to call a customer sales rep that you’ve hired? Like how is that going to work? What’s that going to look like over time? And then, all the other things? So, we plump everything else into general and administrative. So, that’s going to be your cost.

How much money are you going to make? Your finance person, you know, your lawyer sets up the contracts, you know, your office space, your telephone, your computers, your paper clips, like all that other stuff needs to go into general administration. You got to think through what all those categories are; I used to do this for a living I mean I would model companies, you know. One of the things I did when I worked as banker and worked in strategy, and I used to model out new business ideas, and something that really helped me as I was thinking through especially the cost side is; I would quite literally close my eyes and I would think about the experience that my customer was going to have and all the ways in which they would come into contact with something I had to pay for; you know? So, I thought about like okay, they walk into the, you know, into the grocery store and they see my advertisement, okay? That’s a cost. They go to the shelf, they see my product, okay, you know there’s the container that, you know, that the frosting goes and all the things inside the frosting. There’s all sorts of costs there, and I think about them calling customer service because they didn’t like my frosting or you know I would kind of close my eyes and think about like what does my office look like? How many people are there, what did those people do? That kind of thing. That really helped me visualize all the kind of costs that I needed to make sure that went into the model.

I just want to give you some examples. Now, so this is as you think about labor. So, this actually is what goes back to the pretty quick example; that subscription platform for booking salon appointments. So, here we have the roles. These are the types of people. She’s got it broken down into headquarters and then her technology team; this is a tech product, this is an online platform right? So, it’s a technology-enabled company so you got kind of both pieces here and then she’s got some estimates for salaries based on kind of market rates in Chicago; that’s where this company was headquartered. And then, you kind of see some of the assumptions so just a couple things.

One thing people often ask about is, you know, is there a discount for startups? And oftentimes, there is. So, you know, a lot of times, you know, the estimate on the salary will be a little lower if you’re a startup. But, you might then offer options or equity to kind of make up the difference. So, that’s part of what’s happening here. Sometimes we also in our assumptions are really thinking about, you know, what is the characteristic? So, this is somebody who, you know, this chief beauty curator is someone who’s got 10 years more, or, you know, and more other years of experience. So, you’re going to, you know, you try to think about your assumptions around, you know, what does that team person really kind of, you know, look like, you know, what are they really kind of characteristics am I looking for? And then, again, you know, these people are not all going to start on day 1 like that’s just, you don’t, you can’t afford that quite frankly. And, it’s just not going to happen. It’s not realistic.

So, you can also see she’s got growth assumptions built in about the way that these people will fold in overtime in particular, on the technology side, you know. In year 1, she wants to hire that chief architect and one specialist; in year 2, she’ll have the chief architect, the one specialist and then in year 3, she’s going to add another specialist and then go for another specialist, and, you know, sort of go from there. So, there’s assumptions about the layering in even on the marketing side in terms of this headquarters staff. You know, you’re not going to, so you might hire your marketing director first and then over time you hire your HR. director and then they hire your HR. manager and it kind of rolls in overtime. All the people don’t start on day 1. You’re going to think about the cadence of when they’re going to start