Cost Accounting 101 For Freemium Startups

Every argument I have seen for the freemium model are based on marginal cost. What it costs you to produce and deliver a service is not relevant to your customers or to the price you can charge them.  For the latter case, costs matter only to the extent that you do not sell below what it takes to serve the customer and for you to at least break-even. While costs don’t dictate pricing, it is important to know the relevant costs for decision making.

The two most common costing errors I see are:

  1. Treating fixed costs as variable by allocating it over users: Just because you incur the cost periodically and you can  allocate a cost over each customer you serve, it does not become variable. This is especially important to digital media freemium startups because this can make the entrepreneur or the investor focus on the wrong metric – Gross profit. When costs are predominantly fixed costs, Gross profit (revenue less total variable cost ) is misleading in evaluating the profitability and the total value of the venture.
  2. Incorrectly distributing costs and revenues over all customers instead of doing incremental math: New costs incurred must be correctly matched only with the incremental revenue from serving new customers. If this new cost does not generate incremental profit then it should be avoided. This incorrect cost distribution combined with cost allocation will skew the true cost per customer lower that it actually is.

Let us take the case of Evernote’s data (which is now widely quoted in most outlets):

Costs per active user started at around 50 cents. Now, that has dropped to around 8 cents or 9 cents per active user. The variable expenses per user include infrastructure such as server hardware, software, hosting, networking, backup storage, and electricity usage. That adds up to about 21 percent of current variable expenses. The customer service salaries are 27 percent of expenses, and network operations salaries are 52 percent of expenses.

A cost is variable only if it is incurred by addition of that user. Let us say Evernote, with its current infrastructure, customer service, operations etc., can serve no more than N customers. To serve N+1 customers it has to add capacity.  If it can do so just for this one customer then it is variable cost. Most likely EverNote adds capacity in large chunks, to support n  customers. Let us say  that cost is C. So the N+1th customer has a variable cost of C, and those who come after her, N+2, N+3 etc to N+n have a variable cost of  $0.

Should they serve this N+1th customer at cost C? Stated another way, should they invest  C?  They should only if  they can generate a revenue of more than C from the added capacity. If they treated the costs and revenues as cumulative they may end up incorrectly adding capacity because the total gross-profit is still positive even though there is incremental loss.

If you were to do this incremental math before starting the venture then the questions become:

  1. What is the urgent customer need my product/service is addressing?
  2. What is the price customers are willing to pay for the product/service I offer?
  3. How big is the opportunity and how it changes over time?
  4. Can I serve these customers at a cost that is profitable?
  5. Is this a better investment over all other opportunities  of similar risk profile available for the capital?

For all practical purposes, all costs for digital media offerings should be treated fixed and the marginal cost of each user must be treated as $0. When the marginal cost is $0, the gross profit is not anymore relevant, instead the business has to be profitable after paying for all operational costs.

As I wrote before in my article on pricing digital goods:

Success in selling digital goods does not require a whole new way of thinking about business. Rather, it requires the same kind of smart managing and smart marketing that have always set apart the best companies. The real power of versioning is that it enables you to apply tried-and-true product-management techniques-segmentation, differentiation, positioning-in a way that takes into account both the unusual economics of information production and the endless malleability of digital data. [Quote: Hal Varian]

The road to profitability in any market goes through STP! That’s Segmentation – Targeting – Positioning. The rule does not change whether you are selling physical or digital goods.