Variable Cost Business Models and The Growth of Niche Markets

Early in the 20th century Henry Ford was among the first to understand the power of large scale industrial infrastructure. 

Ford's implementation of mass production methods to build economies of scale resulted in the rapid growth of Ford Motor Company.

Others embraced mass production techniques and soon most industries were dominated by large, vertically integrated corporations. 

After all, only big corporations could afford the large fixed cost investments required to build mass production facilities.

But by the beginning of the 21st century, controlling large scale infrastructures with high fixed costs was no longer required for business success in a a growing number of markets.  And in many cases, fixed costs had become a business liability.

New technologies had reduced the costs of starting and operating a business.  And outsourcing, partnering and business infrastructure service companies (UPS for logistics, contract manufacturers for production, Amazon on others for IT and web services, etc.) created the ability to start and operate businesses using a high degree of variable costs. 

Variable cost business models are having a major impact on the small business sector by greatly increasing the number and viability of niche markets.  Variable cost business models:

1.  Lower the capital costs required to enter and serve niche markets.  Lower capital costs also reduce the risk of serving niche markets.

2.  Provide niche producers cost advantages relative to their larger competitors. 

The chart above shows the classic cost accounting model for both fixed cost and variable cost business models.  Below the volume where economies of scale kick-in, variable cost business models enjoy a substantial cost and pricing advantage. 

The increasing use of variable cost business models is not the only trend driving the growth of niche markets. 

Customer are increasingly looking for good and services that meet their specific needs.  The Internet is allowing niche producers and customers to find one another more easily.  And technology is lowering the costs of serving niche markets.

Combined, these trends are making more and more niche markets economically viable. 

And we are seeing more and more examples of small businesses using innovative variable cost business models to exploit niche markets and out maneuver larger competitors. 

Comments

[Alex Francis]

I realize I am a little late to the discussion but I am doing research into fixed and variable cost price models. I own a distribution company. We have roughly 50 customers, our annual revenue was 600,000.00 last year with 20% gross. I am the only employee and I would like to hire some help but I don't seem to have enough money to do so. Between the 15,000.00 that I need to keep an inventory weekly and some of the monthly promotions I run there doesn't seem to be enough profit built in for me. Do you have any "formulas" that I can use to determine how I should be structuring my pricing?

[Robert Rogers]

It is interesting to see how these niche markets are affecting the larger corporations. Now many of them are setting up procurement offices just like the government and are outsourcing work to smaller companies that they originally would have done themselves.

[Curtis Gray]

And as costs to enter niche markets decrease so profits increase and the need to serve a larger market decreases as well. In other words, a business can do well with fewer customers.

For instance, as costs decrease to produce and distribute, say, high quality music, so music producers need fewer and fewer customers to make a substantial income. A small music producer with, say, 25,000 yearly sales of a $10 CD is bringing in $250K per year. If yearly costs are $15 - 25K per year that is a substantial profit with a very small following. Marketing for the music industry is being outsourced for a fraction of what it costs the big boys.

As for competitive advantage: we have to think of this a different way. Your competitive advantage is likely to be a personality trait moreso than a traditional fiscal or technology advantage. As more people become entrepreneurs (and that is happening in droves) the real differentiator is simply your attractiveness to a particular group.

- Curtis
http://ShipItOnTheSide.com - Build a software startup as a side job.

[Ken Kaufman]

Great post on the rise and competitive advantage of the variable cost business model, especially with growing niche markets.

One question - does the variable cost model reduce the sustainability of the competitive advantage?