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Building a sustainable, high-growth business through effective cost management

February 2019

Read Time: 8 minutes

The practice of strategic cost management has been around for several decades, but only now is it starting to percolate into India’s rapidly expanding economic startup community; which, with over 5,200 start-ups, has emerged as the third-largest start-up ecosystem in the world. Driven by an influx of venture capital and growth equity to the tune of a staggering USD 26.8 billion in 2017 alone, companies and their investors were, until recently, often time satisfied by a steadily growing topline. 

Traditional thinking that led most people to assume that cost management is only necessary for companies that are large and scaled is now giving way to the paradigm that cost management is a core building block that entrepreneurs and management teams need to adopt early on, virtually at the development of the business plan


Cost management as business design

Young companies and entrepreneurs typically believe cost management implies a restructuring of business – this simply isn’t the case. The idea is to make it an integral part of the business design that indicates the company’s aspiration for capital efficiency. And this is particularly true in the start-up ecosystem, where “cash-burning” to achieve “growth” has often been touted as the magic stairway to success. 

As was evidenced in 2016 and 2017, these “cash burn” models have no magical outcomes. Once capital became scarce, these companies were forced to focus on EBITDA break-even and preserve cash. Not only were they forced to stop investing in value creating initiatives but had to implement drastic and immediate cost cutting measures to stay afloat. These cost cuts required significant revenue compression and headcount reduction. And these cuts could not be restricted to the ‘fat’ but had to be extended to the ‘bone’, that is essential costs. Several did not survive the surgery since it was too late; they were terminally ill.

As the early-stage ecosystem rebounds from this period of distress, the next generation of start-ups recognize the need to adopt principles of capital efficiency and cost management in their business model design.

An effective cost management framework

As in the case with everything else, it may be impossible to create a ‘one-size-fits-all’ model, however, entrepreneurs can adapt from larger companies and evolve their own frameworks. Experience from the Zodius Capital portfolio and the spectrum of emerging companies advised by Avendus suggests that such an approach could be premised on five fundamental principles: 

  1. Solving for business models that deliver requisite gross margins

    The gross margin (product or service margin, as the case maybe) serves as the primary determinant for all future cash flows and creates the spending headroom for a business. Without adequate gross margins, businesses are not sustainable in the long term – companies cannot undertake the spends and investments required for a scale-up. As such, it is imperative for start-ups to develop their proposition in a way that it generates sufficient gross margin and eventually, return on capital.

    Inadequate gross margins very often reflect incorrect pricing, which in turn is indicative of weaknesses in the business model and/or a poor industry structure. Other gross margin levers are sourcing, process design and technology.

    Pricing (including discounts) can be an effective tool for driving penetration and market development. However, as the Indian start-up ecosystem has witnessed over and over again, a proposition predicated entirely on price discounting attracts the wrong users and doesn’t lead to a viable business.

    And if the industry structure is poor with either high competitive intensity or excessive dependence on suppliers / customers, then there is a more fundamental rethink required. Unless the business model can be tweaked to create competitive advantage and pricing power, it may be prudent to exit and to focus on a new problem!.

  2. Identifying core business activities, building capabilities around them, and outsourcing the rest

    While it is probably something straight out of ‘Strategy 101’, the next generation of entrepreneurs should develop greater clarity on the ‘businesses they are really in’ and therefore, ‘what their core business activities are’. It is important for them to recognize that their growth journey will demand smart allocation of scarce resources. The bulk of these resources, not the least of which is capital, should be directed towards developing capabilities in core business activities and all other activities can be outsourced as a strategic cost management measure.

    Outsourcing of non-core activities should not just be restricted to support services such as payroll, finance and accounting, office space and technology infrastructure management. Often, direct business activities can also be entrusted to specialist organizations. For example, a digital lifestyle brand can outsource merchandize delivery and logistics, and a fin-tech start-up can farm out customer service. 

  3.  ‘Unitizing’ costs

    High growth businesses are constructed and staffed such that they can very quickly operate at much larger scale. This requires ‘investing’ in operating infrastructure well in advance of achieving the targeted scale. Adopting a high fixed cost model in the growth phase typically results in ‘unproductive’ cash expense, since the firm is spending on capacity and resources it cannot currently fully utilize. This model also leaves the business exposed to negative operating leverage, i.e. volatility in monthly revenues directly transmitting into volatility in monthly cash flows. For most firms adopting a high fixed cost model, this risk remains elevated until they achieve operating break-even.

    A clear mitigant to the inflexibility associated with a high fixed cost model is to tie in these costs to business activity or production volumes (i.e. converting fixed costs into variable) wherever possible. This ‘unitization’ of costs or linking the expense outflow to business activity or revenues enables firms to spend as needed, and to save on operating expenditure during lean months.

    The advent of the technology enabled ‘pay-as-you-go’ models (SaaS, PaaS, and IaaS) are now making it easier for start-ups to unitize their cost structures. Services such as managed IT solutions on cloud platforms can not only help companies scale faster but also save on expenses as they are directly linked to usage. And it’s not just software solutions, everything from office infrastructure, back-office and mid-office support services to employees can be available on an on-demand and unit basis. 

  4. Measuring and monitoring ROI on all spends

    Effective cost management is a business philosophy and it starts with fostering a culture of questioning and evaluating every dollar spent. The entire organization should be oriented towards measuring and monitoring the return on investment (ROI) on all costs and investments. Every spend decision should be driven by the expected outcome or ROI it will generate – a clear quantification of the consequences of the business expenses being contemplated. 

    There are several tools available today that enable companies to implement ROI based decision making. Several digital entrepreneurs have implemented tools such as Google Analytics to measure the effectiveness of their marketing spends. There are niche CRM tools that let small businesses measure Customer Acquisition Cost (CAC) and Customer Lifetime Value (CLTV). However, measuring ROI has to extend beyond CLTV to CAC ratios. It should permeate every organizational process, whether it is creation of infrastructure, hiring of sales personnel or selection of customer service vendors. 

  5. Focusing on cash flow and not just EBITDA

    The hype-led funding and the subsequent distress observed in the previous cycle has led the industry to place emphasis on EBITDA improvement along with revenue growth. However, an effective cost management framework should be more comprehensive in its approach and therefore, focus on cash flows.

    Working capital can be a significant cash expense for a growing business, especially in the B2B segment. Many a company has struggled to sustain, despite being EBITDA break-even, because it couldn’t meet working capital requirements.

    Several high growth businesses manage and forecast cash flow on a day basis, as against on a month basis. This leads to tighter control on expenses and serves as a better early warning system for a liquidity crisis. Entrepreneurs have also solved for liquidity and cash flow via changes in the business model, even if it has meant sacrificing some margin. Some have relied on partners in the value chain (well capitalized suppliers or customers) to fund their working capital. Others have switched from a post-payment model to a pre-payment model. 

Cost Management as a Core Value

In summary, every business has its own challenges, risks, and ways of doing things – but through it all, cost management remains a core value that can drive success. The differentiation and competitive advantage for a high growth business emanates from it’s ability to innovate. Effective cost management supports and supplements business innovation.  While there are no magic stairways in life or in business, embracing a cost management framework is a key step towards building a sustainable business. 

Author: Varun Laul, Managing Director, Zodius Capital

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