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.

Cost Allocation Trap

Businesses, small and big are almost obsessively focused on allocating a portion of every cost incurred to every unit produced. The distinction between sunk costs and  marginal cost is lost on them. Costs that are incurred regardless of volume produced are spread over units produced. For example, a Cupcake business allocates a portion of the mortgage, insurance and other fixed charges to each cupcake.

The problem is complicated by the way these businesses set pricing, they simply tack on an artificial margin to come up with unit price

Cost Based Pricing: Unit Price = Unit Cost * (1+ % Unit Margin ) (WRONG!)

There is no logic behind the % Unit margin, it is either based on what competitors are reporting or a magic number someone comes up with. An arbitrary number that has no meaning and no indicator of absolute profit becomes the number everyone in the organization works towards. No effort is spared to protect  (and increase)  % Unit Margin leading to drop in absolute profit.

The net result is the business has no way of knowing what the market demand is and how the market will react if they were to change prices. Due to their fixation on protecting he % margin they end up selling at the wrong price and losing out on the absolute profit. Since the unit cost is wrong to start with the % margin leads to higher prices. In addition, in this method of cost allocation, any increase in volume will reduce unit cost and any decrease in volume will increae unit costs (because fixed costs are spread over more units).

Increasing market share requires them to produce more unit and it also helps with reducing unit cost. So they produce more, flood the market and end up discounting heavily, destroying the very margin they were trying to protect.

Businesses are reluctant to give up market share in favor of profit because producing less “eats into % margin”. When business have high market share and operating at near full capacity, the unit cost is at its lowest. Due to the incorrect cost allocation, higher market share is wrongly associated with higher % margin. So businesses spend all energy in defending market share.

If the demand shifts down (due to recession), businesses are reluctant to  reduce volume produced because the decrease in volume increases unit cost and hence “eats into % margin”.

This is the same reason businesses are reluctant to increase prices because any price increase leads to lower volume which affects unit cost and % margin.

What starts as cost allocation mistake leads businesses down the wrong path of protecting market share and % margin.

Relevant Cost – Do Not Ignore Opportunity Costs

In a talk  at Haas Alumni Luncheon Mr. Chris Anderson, the  author of The Long Tail and Free, talked about his new book Free. First few minutes into the talk he talked about his previous work, The Long Tail, and how the marginal cost of shelf space.  He said how physical goods (what he calls atoms) have a marginal cost to produce, store and sell and how information goods (what he calls bits) have declining marginal cost that approaches zero.

I will set aside my previous arguments on why costs do not matter with pricing and focus  on just what is marginal cost.  According to  Mr. Anderson, the definition of marginal cost is simply the cost to produce, store and sell one widget. That is the right definition if there are no opportunity costs. In his example he talks about how there is a marginal shelf cost to selling physical goods through Wal Mart. Why is there a charge? Because Wal Mart is looking at opportunity cost of storing your wares vs. someone else wares. If you look closely all shelf costs are sunk for Wal Mart, but still it charges a marketer a fee because of this opportunity cost.

Marginal cost is not about the widget you sell, it is the “relevant cost of serving one additional customer”. It is the higher of either the cost to produce/store/sell the widget and the opportunity cost of serving that additional customer.  The definition is easy to see for physical goods. For digital goods, for example music, the marginal cost is not zero (as Mr.Anderson says regarding digital music just because there are no CDs) but the revenue lost by selling this music vs. another or the future revenue lost by setting a very low reference price in the minds of customers.

Once you consider the opportunity costs you can see the deficiency in the definition and argument based on marginal cost being zero.