Cost is King

I recently listened to an a16z podcast about disruption theory. I’m a big fan of the theory and have been thinking a lot about it lately. The most important facet of the theory is cost.

Incumbents are disrupted because their cost model - typically measured by gross margin - is too high. When a smaller company devises a way to deliver the same value as an incumbent with a lower cost structure, disruption can occur. Thus the key to disruption is cost, or rather reducing cost.

Although we like to think about innovation in terms of novelty - think electricity, airplanes, or computers - the history of technological development over the course of human history can be more cohesively understood as a systematic removal of cost. Very few innovations were truly novel along a dimension other than cost.

For example, airplanes dramatically reduced the cost of long distance travel. However, human didn’t need airplanes to travel long distances. Millions of people travelled across large swaths of land and sea over the course of human history without planes. Airplanes just made long distance travel much more economical. I don’t mean to understate the power of this particular cost reduction - planes substantially changed how frequently humans could travel long distances, which has shaped every facet of business and personal life across the planet.

Even computers can be described through the same lens. Travel agents did what Kayak does. Telephone operators did what computers do. Analysts do what SaaS dashboards do. Uber drives do what computers will soon do. Because computers are programmed by humans, computers can only do what humans instruct computers to do. Through this lens, computers can be recognized as infinitely cheap “humans.” Electricity, silicon, and software costs pale in comparison to paying people’s wages - and thus mortgages, cars, meals, clothes, etc.

It thus stands to reason that the best businesses are those that methodically remove cost. Business cases to justify new innovations are by definition more compelling the more significant the financial impact of the innovation. For most companies, the largest source of cost is human labor. Thus the largest opportunities in business will be those in which technology can automate what humans used to do.

This notion that cost is the central challenge in humanity is perhaps best described by this quote by Jeff Bezos, founder and CEO of Amazon. “There are two kinds of companies, those that work to try to charge their customers more and those that work hard to charge their customers less. We will be the second.”

Cost is indeed king.