Explaining Potential Profits

Building products and monetizing them can be tricky and it is even trickier because there is no shortage of advice out there about how to go about monetizing products. Regardless of whether you are building a business or investing in one, understanding the dynamics of what the product is and how it will make money in the market is important. Too often I see all sorts of advice that contradicts itself and generally wastes business founders and investors time and very infrequently do I see advice re-iterating the fundamental concepts of business.

I attended a presentation last week (Forbes coverage of the event) by the founder of Pirq James Sun. It was over at Thinkspace’s new Mobile Innovation Hub and he made one statement that appeared to be difficult concept for the audience to grasp and one that I felt was a basic business concept. James was simply relaying the concept of marginal cost and revenue that is taught in any basic economics course. Having taken a bunch of economics course, I’ll be the first to admit that there are many silly concepts in economics that shouldn’t be basic knowledge. The concepts of marginal cost and revenue aren’t in that list. These concepts are well understood and accepted. Using these concepts basically allow the ability to calculate how the business will make money – although it is separate from describing how the product will be sold.

Marginal cost is essentially the cost per unit as the number of units scale. So it may cost $20 per unit to make a prototype and $1 to make 10,000 units. Marginal revenue is then the price that you can charge per unit as the number of units scale. If your market is 1m customers can you charge the same price for the same product to all 1m customers? I doubt it… more likely you will have more than one pricing mechanism and the revenue that you get from your first few sales will be drastically different than the revenue you will get from your one thousandth customer.

When you match these two up you can demonstrate where you will make a profit – in other words how much money you will make if you sell to a specific number of customers. I am not talking about there are X million smart phone users in the world and if we sell to 1% of them we’ll make $$$. I am talking about we can make $ per unit and if we are able to sell to X thousand customers our net income will by Y. You still need to address how you will sell to those customers – but valuing your business from the bottom up is much easier for an investor to get behind than valuing your business from the top down. It also exposes where in the competitive landscape you have room to change as your sales strategy changes.

Let me give a quick example. I have a startup that builds a product to manage rental tenants… think CRM for landlords. I have a product that I could sell to a pretty large market. I have a variety of options for monetization. Eventually I will have to explain to someone how I will be making payroll and returning value to investors as well. First, looking at cost – I have people, technology, some offices – most things are leased or amortized and my monthly expenses are $50k. For that $50k I am producing a single product that I am selling in three different ways – Individual Landlords (owners of 1-5 units), Management Companies (manage other people’s properties), & Property Owner/Managers (manage their own properties). The product is the same code base and just have different features turned on for different price-points. This means that my cost for the product is simply the cost divided by the number of customers (we won’t get into fixed & variable cost at the moment). Say that I am selling the product as I am developing it so my cost is essentially 50k per month for the product.

Now looking at the revenue side, the market will sustain a price point that is different for the three different categories. These three customers have different needs, evaluate the market in different ways, and base their decisions on different economic factors. So $19.95 per month for the individual landlord, $199 for the management company, and $129 for the property owner/manager. We’ll ignore the obvious option to charge per number of tenants as that just makes the equation more complex. I now have a revenue per unit for the three units and can equate things fairly simply…

If I sell 3000 individual landlords I will be turning a profit of $9850 per month or $3.28 per customer. If I sell 300 Management companies I will turn a profit of $9,700 per month or $32.33 per customer. If I sell 500 owner/managers I will profit $14,500 per month or $29 per customer. This is pretty revealing as it demonstrates where the margin is and it lends itself to determining a good strategy for making money. It may be easier to use a freemium model with individual landlords and attract 3000 or more. On the other hand I may have a strong salesperson on the team who can easily close property managers and the margin will be much higher for our core customers. The value here is that as an early stage company it is easier to start equating how the product is developing into where the potential profits will be in the future so that as the market conditions, team, or product evolve they can evolve into areas where profitable customers will be.

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