Before cutting costs, find out why your customers pay you

Picture a grocery distributor with three branches in Cochabamba. At the end of every month, its owner goes through the income statement with a red pencil in hand. He strikes out a subscription, postpones maintenance on a truck, cuts the salesman's visits to the smaller shops. Spending falls. The margin barely moves. Two quarters later, some customers stop ordering.

The case is hypothetical, but the gesture is familiar: the cut is spread evenly, as if every expense were equally suspect. Behind the sentence "I sell, but I don't know whether I actually make money" there may be an account nobody has sorted out: what each thing handed to the customer really costs. Alexander Osterwalder and Yves Pigneur, in the Spanish edition (2011) of Business Model Generation, suggest looking at costs from a different place. Before deciding what to cut, you need to know what kind of business you have on your hands.

Two ways to build a cost structure

The authors describe two extremes. In the first, cost rules. The company hunts for the lowest possible spending, sells cheap, automates what it can and outsources a good part of its operation. Low-cost airlines such as Southwest, easyJet and Ryanair are the book's example.

In the second extreme, value rules. The priority is what the customer receives, and that is where premium prices and tailored service live. The book's example is the luxury hotel, with its facilities and exclusive services.

Osterwalder and Pigneur make two things clear. Every business should keep an eye on costs, and most sit somewhere between the two extremes. What changes is how much a low cost base weighs in the offer made to the customer.

The book adds a nuance about low prices: they drag the rest of the business along. Low-cost airlines did not adjust a fare: they designed the whole model so they could charge less.

An even cut punishes whoever sells service

Back to the distributor. Its customer is the owner of a neighborhood shop, with little time and little space to store goods. Besides rice and cooking oil, the distributor sells a complete order, delivered first thing in the morning by someone who knows the premises. That promise has concrete costs: a truck that does not break down, a salesman who stops by the shop, a safety stock so the best sellers never run out.

When the owner strikes out those lines, he saves money and also spends the reason the customer buys from him rather than from the competitor who charges a few cents less. A cut that protects the margin in a price business can damage it in a service business. If the same company competed on price alone, the same cuts would be reasonable. The tool is the same; the business model decides whether it helps or hurts.

The trap is that the even cut looks prudent. Nobody argues with a meeting that opens with "we have to tighten our belts." But an adjustment without criteria leaves the decision to chance: the expense nobody questions survives, not the one that performs best.

Two restaurants, one line on the income statement

Consider two restaurants with branches in the city. One sells a set lunch to office workers who have an hour to eat. The other hosts business meetings and long celebration lunches. Both have a line called "floor staff," and in both the owner feels it weighs too much.

In the first, trimming staff and speeding up service can be coherent: the customer expects speed and a low price. In the second, attention at the table is part of what the customer pays for. Cutting there amounts to lowering the quality of the food. The figure on the income statement is the same, but the customer reads it differently.

Fixed and variable: where each cost weighs

The book also separates fixed costs from variable ones. Fixed costs do not change with volume: salaries, rent, facilities. Variable costs rise and fall in direct proportion to what is produced or sold. The authors add economies of scale, which explain why the average cost per unit tends to drop as production grows, for instance when buying wholesale.

At the distributor, salaries and trucks are fixed, and the warehouse rent is paid the same in a good month as in a slow one. Merchandise is variable. In a business made mostly of fixed costs, results depend heavily on volume. If a cut loses customers, each remaining order carries a larger share of the rent and the payroll. This month's saving is paid for out of next month's margin.

What the customer pays for and what the customer notices

In their chapter on evaluating business models, the authors include a list of paired opposite statements so readers can mark where their company stands. Two of those pairs hit close to home for a mid-sized business owner. One contrasts charging for what the customer is willing to pay with failing to charge for things the customer would pay for. The other separates the company that collects before it spends from the one that must spend heavily long before it collects.

The second pair looks familiar: the supplier who charges at 30 days and the customer who pays at 60. The distributor finances that gap out of its own cash, even though no line on the income statement names it. No cut in stationery closes that gap.

Applied to costs, the first pair invites you to look at every line from the customer's side of the counter. Some costs the customer notices and pays for, such as punctual delivery. Others the customer neither notices nor would pay for, such as purchases nobody compared or duplicated paperwork. Those are the first candidates for the pencil.

What to do on Monday

You need a sheet of paper, last month's income statement and a quiet hour. The book proposes the business model canvas, nine blocks drawn on a large sheet with sticky notes; for this exercise a simple three-column table is enough: cost, type and what the customer sees.

1. Write down your company's key resources, activities and partners: trucks, salespeople, warehouse, suppliers. According to the book, once those are defined, costs are relatively easy to estimate.
2. Take the ten largest costs of the month and mark each one as fixed or variable.
3. Next to each cost, write whether the customer notices it and whether the customer would pay for it. Here is the test: would you bill it as a separate service? The punctual truck passes. The forgotten subscription does not.
4. Place your company between the price extreme and the value extreme. If you hesitate, look at why your best customers stay and why the last ones you lost left.
5. Cut first what the customer does not see. Test what the customer does see in a single branch for one month and compare repeat orders before extending it.
6. Count the days between paying the supplier and collecting from the customer. That gap costs money even if it never shows up as an expense.

If the income statement is not sorted by categories, start there. Without that list, any cut is decided by eye.

The red pencil is still useful. It is best used after you know what the customer buys when buying from you. A cut the customer notices in Thursday's delivery can end up costing more than the expense it removed.