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Unit Economics and the Financial Model of the Business

Belle-V Kitchen is a consumer goods company I founded with several friends to bring to market high performing but beautiful kitchen tools. Although the products we make and sell are outstanding, at least in our opinions, the company has never been a wild commercial success. One of the problems with the business is that the unit economics and financial model are only marginally favorable. It’s sort of our own fault. From the outset, our analysis of the unit economics and financial model did in fact exhibit vulnerabilities, or at least reveal a pretty narrow path to success. This chapter may help you be disciplined enough to avoid a similar plight.

Every single business incurs some on-going costs associated with merely existing. For instance, virtually every business pays an annual fee to a government entity and pays something to maintain a postal address. Most businesses incur costs for insurance, telecommunications services, and accounting software. Many businesses rent facilities, pay utility bills, and hire administrative employees. All of these costs are called general and administrative costs or G&A under generally accepted accounting practices (GAAP). With a few tiny exceptions, all businesses also incur costs to generate demand for their solutions. I call these sales, marketing, and advertising costs or SMA. Technology-based businesses may also have significant research and development or R&D costs. Put together these costs are the on-going costs of operating the business, are incurred over time, and do not change immediately in direct proportion to the company’s revenue.

In order to achieve long-term financial sustainability, a company’s gross profit has to exceed the on-going costs of operating the business. Put simply, gross profit is the revenue customers pay the company minus the variable cost of delivering the solution. Here’s a simple example. If a bubble tea shop costs USD 120,000 per year to operate, then it must generate at least USD 120,000 in gross profit per year to remain in business indefinitely. If customers pay USD 6.00 for each serving of bubble tea and delivering each additional serving of bubble tea, including materials and labor, costs USD 2.00, then the shop must deliver 30,000 servings of bubble tea each year to sustain itself, or break even. That works out to an average of 577 servings every week.

Unit Economics

For a bubble tea shop, the selling price of USD 6.00 and the cost of delivering a serving of bubble tea of USD 2.00 are called the unit economics. Unit economics are the revenues and costs of a business measured on a per-unit basis, where a unit can be any quantifiable element that brings value to the business, such as a single quantity of a physical good sold, a single consulting engagement, or a single customer relationship. Analyzing the economics of a business at the level of a single unit informs managerial decisions about pricing and about the inputs to the solution and their costs. The unit economics also dictate the minimum number of units that the company must serve or deliver in order to break even. If the unit economics are not favorable, the overall economics of the business, which include its operating costs, can not be favorable.

Analyzing unit economics first requires selecting the unit of analysis. This selection depends on the characteristics of the business. Businesses vary on innumerable dimensions, including cost structure, distribution channels, frequency of transactions with customers, and the business’ role in a market ecosystem. These differences are reflected in the financial models of the businesses. Some require huge investments in research and development, but then enjoy high gross margins once the product is launched. Others operate on slim margins, but don’t require much selling expense once a customer is acquired. Still others offer an all-you-can-eat solution for a subscription fee. While no two businesses are identical, four different types of businesses emerge frequently enough and have distinct enough financial models that they warrant separate treatment:

Classic make-and-sell businesses (e.g., Belle-V Kitchen)
Low Marginal Cost Services (e.g., Quickbooks)
Social Networks (e.g., LInkedIn)
Marketplaces (e.g., Airbnb)

In this chapter, I describe these four types of businesses, the focal unit most appropriate for that type of business, and a common financial model associated with that type. Your business may fall between these categories, but almost certainly one of them will be pretty close, and will give you a template to start from.

Along the way I’ll introduce some more terms and concepts that are more generally useful, including these:

Gross margin
Marginal cost
Cost of goods
Target costing
Minimum viable scale
Customer lifetime value
Customer acquisition cost
Recurring revenue
Gross merchandise value
Take rate

Because I treat four distinct categories of businesses, this chapter is long. Life is short, so you may benefit from identifying which category is most relevant to your venture, and then focusing on that section below. However, I do introduce key terms and definitions as I go and don’t repeat them for each example, so if you are new to managerial accounting, you may benefit from reading the whole chapter.

1. Classic Make-and-Sell Businesses (e.g., Belle-V Kitchen)

Belle-V Kitchen is an example of a classic make-and-sell business. Such businesses simply produce a good and sell it to customers in a single transaction. The business may deliver a physical product like a bottle opener or a service like a restaurant meal. I write make-and-sell business, but some businesses are actually sell-and-make, in which the good is produced according to the specifics of a customer order, as with say Abodu Homes, a company providing prefabricated structures for use as accessory dwelling units in the United States. Regardless of sequence, these classic businesses follow a similar template.

The focal unit for a classic make-and-sell business is each instance of the product itself — the kitchen implement, the housing structure, a cup of bubble tea, or an excursion with a tour guide. In all cases, a classic make-and-sell business incurs significant marginal costs to deliver a unit of its solution to its customers. Let’s now drill down on the unit economics of classic make-and-sell businesses using the example of Belle-V Kitchen and starting with an explanation of the concept of marginal costs.

Cost, Marginal Cost, and Cost of Goods

The word cost is often shorthand for the accounting term cost of goods sold or COGS. These are the costs directly attributable to delivering the solution to the customer. In the case of Belle-V Kitchen, these are the costs associated with the manufacturing of the opener itself, as well as the costs of getting it to the point of distribution, fulfilling the customer’s order, and shipping the opener to the customer.

Belle-V Bottle Opener (Source: Belle-V Kitchen)

For classic make-and-sell businesses, costs are expressed on a per unit basis, but that unit cost typically assumes some batch quantity in manufacturing. For instance, Belle-V obtains openers from a factory in China that makes high-quality stainless steel kitchen implements for many premium brands globally. When ordered in quantities of 10,000 pieces per order, Belle-V can buy these openers from the factory for about USD 7.00 per unit.

Note that this factory price would be higher for an order of 3,000 pieces and lower for an order of 100,000 pieces. In analyzing unit costs, the entrepreneur makes an assumption about the approximate quantity that will be produced, often quantities that can reasonably be achieved in the medium time horizon, say after a year or so of operation.

That USD 7.00 factory price is just a portion of the COGS however. Here is the full list of elements that make up COGS, all expressed as USD per unit, assuming an order quantity of 10,000 pieces.

manufacturing cost 7.00
freight from factory to US warehouse 0.30
duties paid to the US government 0.28
labor to unload and store the inbound freight 0.02
materials and labor to process, pack, and ship openers to a retailer
(assuming a bulk carton of 36 pieces) 0.14
scrap and warranty replacements (averaged over time) 0.10

Total Cost 7.84 (USD/unit)

Each additional unit sold incurs an average cost of about USD 7.84. This is called the marginal cost of the delivering the solution, because it is the additional cost “at the margin” of delivering one more unit.

Again note that marginal cost analysis implicitly requires an assumption about the quantities that will be ordered or produced. The business’ marginal cost might be a bit lower if it could order in much higher volumes in the longer term, and would be higher if it had to make openers just a few at a time, say while testing the market. For planning purposes, a financial model should explicitly state the embodied assumptions about order quantities, and analyze several scenarios, say for the modest expected quantities in year 2 and for larger expected quantities in the longer term, say in year 5.

Target Costing

For classic make-and-sell businesses, an important analysis is called target costing, which forces the manager or entrepreneur to bring anticipated selling price and estimated unit cost into coherence. This is the part we didn’t do so well with Belle-V Kitchen.

We planned for the Belle-V opener to be sold as a luxury gift and we originally expected it to be priced at USD 50 per unit in the store. We set this price by looking at other items in the store intended as nice gifts and by thinking about what the buyer’s alternatives for other nice gift items might be. We considered price points from USD 19 to USD 59. Setting your prices should be a deliberate exercise, and in established companies is usually coordinated among the business manager, marketing and sales managers, and the product manager. I’m not sure we were right in setting our price at USD 50. That’s a lot for a bottle opener, even a really nice one. In later years, we adopted a direct-to-consumer model at a lower price point. More on that below.

A target costing analysis works back from the price the product would sell for in the store to what the cost must be at the factory in order for the economic system to work for everyone.

Let’s first consider a typical retailing model, in which Belle-V sells on a wholesale basis to a store, that in turn sells to an individual consumer.

We anticipated a retail price of USD 50. However, the consumer isn’t giving us, the brand owner, 50 dollars. Instead, they’re paying the retail store 50 dollars. In order for the retail store to be in business, the retailer has to buy the product from us for quite a bit less than 50 dollars. In the Belle-V case, in which retailers are mostly specialty gift boutiques like museum stores, the retailer’s gross margin is typically 50 percent. That is, the retailer sells the opener to the consumer for USD 50, but pays us just USD 25. So, the retailer makes USD 25, or 50 percent of the selling price.

Now we have to work back from the price we get from the retailer to what our target cost would be. To do that we need to think about what we as the brand owner need for gross margin. Let’s assume for now that our target gross margin is 40 percent. That is, on average we want the gross profit on each unit to be about 40 percent of the revenue we get from a sale of that unit.

Since we get USD 25 in revenue for each unit, the price the retailer pays us, we need to pay no more than 60 percent of that figure for the goods, or USD 15, in order to leave 40 percent gross margin, or USD 10.

Fifteen dollars is the maximum cost of goods we can pay in order for us and our retailer to earn reasonable margins and to sell the product to the consumer for USD 50. This arithmetic simply works backwards from the selling price to the consumer through the distribution channel, and accounting for the required margins at each step, in order to arrive at the maximum cost we could pay for each unit and still remain in business.

Incidentally, for consumer goods sold through specialty retailers there is a short-hand “rule of 4” that the end consumer price is four times the cost to get the product into the original brand owner’s possession. It’s a pretty good quick way to check the feasibility of making and selling a consumer good. A rule of 4 corresponds to two parties in a supply chain each earning 50 percent gross margin.

I want to now drill down on two additional points. One is the arithmetic to calculate gross margin. The second is where those gross margins come from — and what values are reasonable in practice.

Gross Margin

Gross margin is defined as the price minus the cost, divided by the price. This is always taken from the perspective of the entity that’s selling the product. So for instance if USD 50 is the price the museum store offers to the customer, and they pay us USD 25, then their gross margin would be 50 percent. That is, 50 – 25 (which is 25) divided by 50. And if instead they paid us USD 28, then their gross margin would be 44 percent – that is, 50 – 28 (which is 22) divided by 50.

Note that gross margin is not the same as mark up. Mark up is defined as the price minus the cost, divided by the cost. So, if the retailer buys the opener from us for USD 25 and sells it for USD 50, then the mark up is 50-25 (which is 25) divided by the cost (which is 25) or 100 percent. Some industries use mark up and some use gross margin. Of course these two metrics are related arithmetically as follows: gross-margin = mark-up / (1+ mark-up), so you can convert from one to the other. I find it easier to always start with price and cost and then calculate gross margin or mark up from those two values as needed. From here on, we’ll use gross margin, as it is the more common term and because it directly drives an important metric in a company’s financial statements, gross profit.

What determines a reasonable gross margin for a retailer? First of all, volume. All else equal, the lower the volume of the retailer, the higher the margin the retailer requires in order to be able to stay in business. Just consider the difference between a grocery store that moves hundreds of thousands of dollars in volume every week compared to a jewelry store that might only sell one or two items a day. The jewelry store will require higher gross margin.

Second, the higher the price, the lower the gross margin, all else equal. Consider the difference between selling a new automobile and selling a hammer. The automobile will have a lower gross margin percentage.

The third factor is differentiation. All else equal, if your product is so special that you’re the only source of supply, then your gross margin will be higher than for a product with a lot of competitive alternatives.

The final factor is the costs that are required for the retailer to sell your product. Characteristics that increase the costs for a retailer selling your product are seasonality, service requirements, and the intensity of the sales process. The higher these costs, the higher the required gross margin for the retailer.

Now to put this all together just consider the difference between construction materials and luxury cosmetics

Construction materials exhibit relatively low differentiation with relatively stable demand at relatively high price points in high volumes. Thus, they are going to be sold at quite low margins, maybe only 10 or 15 percent. Luxury cosmetics are the opposite on all of those dimensions, and thus retailers of those goods will likely expect margins of greater than 60 percent.

To give you a sense of a typical range, retailers of most consumer goods require margins of between 35 and 55 percent, but extreme examples, say building materials and luxury cosmetics may be outside of this range.

Now let’s turn to the question of what your target gross margin should be as the manufacturer or the brand owner.

A very similar set of factors drives the typical gross margin requirements for manufacturers. Higher gross margins correspond to some combination of high R&D costs, high selling expenses, high levels of differentiation, lower volumes, and high seasonality.

Manufacturers of consumer goods would expect to operate with gross margins between about 30 and 50 percent, but at the high end a brand owner for fashion apparel might have a gross margin of 75 percent or higher. And at the other extreme, auto makers might operate with gross margins of under 20 percent.

One good technique for estimating margin requirements is to study the income statements of public companies selling products similar to yours. These financial statements will give you their average gross margin, a useful benchmark.

Selling Direct

Often when the target cost analysis reveals either margins that are too tight, prices that are too high, or required manufacturing costs that are too low, the entrepreneur thinks, “No problem. We’ll cut out the intermediary and sell directly to consumers!” This is rarely a solution to lousy unit economics. That’s because in direct-to-consumer models, you can’t typically assume the other parameters for the business remain the same. There are three reasons selling direct is almost never a cure for marginal costs of production that are too high.

First, your unit cost will increase. For Belle-V Kitchen, here is how the unit cost changes assuming we sell direct to the consumer in individual quantities, and that we pay for the outbound freight associated with “free shipping.” Recall that our unit cost when selling to retailers is USD 7.84.

manufacturing cost 7.00
freight from factory to US warehouse 0.30
duties paid to the US government 0.28
labor to unload and store the inbound freight 0.02
labor to process, pack, and ship a customer order (usually just one opener) 3.00
carton, packing material, tape, and label (single unit) 0.40
outbound freight paid to ship the opener to the end customer (single unit) 6.50
scrap and warranty replacements (averaged over time) 0.10

Total Cost 17.60 (USD/unit)

Second, your volumes will likely decrease. The whole point of using a retailer for distribution is to make your product easily available where your customers expect to find it, and where they can see and touch the product. A bottle opener sold in the “big box store” Target will, all else equal, sell vastly more units than one sold only on a website of a start-up company. With lower volumes, your marginal cost of production may increase, which must be reflected in your analysis of the unit economics.

Third, you may incur higher selling expenses. You have to find and acquire the customer when you sell directly to consumers. For e-commerce retailers this often means paid advertising, which can be very expensive. Acquiring customers for consumer goods can cost USD 50 per customer or more depending on the level of competition for keywords used in advertising.

If we wanted to sell the opener directly to consumers for USD 29 and maintain a gross margin of say 60 percent to support our higher selling expenses, then our unit cost must be less than (1-0.60) x 29.00 = USD 11.60. That’s clearly not going to work, as our marginal cost of delivering an opener is USD 17.60. At that unit cost and a selling price of USD 29.00, our gross margin would be only 39 percent. That’s not enough for a direct-to-consumer housewares business. A price of USD 39.00 is closer to feasible, leaving a gross margin of 55 percent, still not wonderful. The reality is that Belle-V Kitchen couldn’t quite get the unit economics to work for this opener when selling direct to consumers.

Minimum Viable Scale

Most pro forma financial analyses for start-up businesses are fantastic fables, representing a big success scenario. It’s good to have hopes and dreams and to envision paradise. However, I believe you also benefit substantially from knowing what the business looks like at its minimum viable scale. By minimum viable scale, I mean the number of units sold or customers served per time period such that you can achieve positive cash flow. At least two factors tend to dictate this scale.

First, what is the minimum required level of staffing and business services that you need to operate. For instance, you might need a minimum of a general manager (perhaps you), a customer service representative, a sales and marketing person, and a production or fulfillment staffer or two. You might need a physical location and to pay some rent. You will likely need an internet connection, some insurance, utilities, and bookkeeping services. Add all that up and that’s the minimum on-going operating costs of your business. Now, what is the number of units sold or customers served per time period (e.g., month or year) to break even relative to those operating costs. That is one indicator of the minimum viable scale.

Second, are there some natural minimum batch sizes and order frequencies that are required to sustain the business. For instance, for Belle-V kitchen, we need to buy a minimum of 3000 pieces per order from the factory and we need to place an order at least annually to sustain that factory relationship. Therefore, it’s not really possible to imagine the business surviving if it can’t sell at least 3000 units per year.

Put those two factors together to estimate what the business would need to look like to remain in operation and to sustain positive cash flow. Every business is unique and every entrepreneur has a different threshold for what is truly minimally viable. Still, by considering these two factors you can estimate a minimum viable scale for your situation. The resulting scale is of course not your goal. It’s instead a realistic assessment of what level of success you must achieve in order to live to fight another day. I like to think about the entrepreneurial journey as a long ocean swim. You’re setting out from the beach on a sunny day. You can see what you believe to be a beautiful tropical island off in the distance. That’s your goal. But, what happens if the wind picks up, or the water gets choppy, or your leg cramps? Is there a smaller island where you can rest and recover? How far out is it? That’s your minimum viable scale.

Putting Unit Economics Together in a Financial Model for Classic Make-and-Sell Businesses

Here’s a process for understanding your unit economics and creating a financial model for a classic make-and-sell business.

Decide on your distribution and channel configuration (e.g., direct to consumer vs. selling through retailers).
Set a target price to the end customer based on the competitive situation and the value of your solution to the customer.
Estimate your target cost by assuming gross margins for you and for your distribution channel. For a good first estimate, base these gross margins on typical margins for similar companies in your industry.
Check your costs to be sure your marginal cost of production is well below your target cost estimate.
Estimate the on-going costs of operating your business, and then use your gross-margin estimate to do a break-even calculation for the number of units you need to sell per time period to sustain your business.
Prepare a pro-forma income statement for what the business can look like if you are successful. Also create a second pro forma income statement for the minimum viable scale. These two financial models represent your goal as well as your fall back position should things go much worse than planned.

2. Low-Marginal-Cost Services (e.g. Quickbooks)

Many important businesses deliver services with very low marginal cost, sometimes close to zero. For example, a business that sells templates for legal documents may deliver its solution as a digital download. The marginal cost of delivering ten documents per day or ten thousand documents per day is essentially the same, and essentially zero.

One warning. Be careful about assuming your cost of goods is zero for all digital goods. For instance, content businesses like Netflix deliver a digital good, but they pay the original content creator for that content, often in proportion to the number of times it is delivered. In such cases, the marginal cost of delivering a solution is significant. In a second example, many AI-based businesses require expensive cloud computing resources each time a customer makes a query. These are real marginal costs of production.

Two approaches to analyzing unit economics for low-marginal-cost businesses are common. First, if the solution will be used infrequently by the target customer, then the unit of analysis may be the product itself, say the delivery of a single document template. In that case, the unit of analysis is a single transaction and the gross margin is nearly 100 percent. Breakeven calculations can be done exactly as with make-and-sell products, considering how many transactions must be completed to generate enough gross profit to cover the on-going operating costs of the business. The only difference from make-and-sell businesses is that the gross margin per unit is essentially the sales price per unit, as there are no significant marginal costs of production.

Second, and perhaps more typically, products with low marginal costs are priced on a subscription basis per customer, or possibly per user when there are multiple users per customer. This is especially true for products that are consumed intermittently but repeatedly over time. Examples of such products include Zoom, Adobe Acrobat, and Quickbooks. They are all priced on an “all you can eat” subscription basis. Most of these products are delivered over the internet as software as a service or SaaS. For simplicity I’m going to focus on SaaS products in further elaboration. For SaaS products, the unit of analysis is most commonly the customer, not each use of the product.

Customer Lifetime Value (LTV or CLV)

The most important metric in SaaS unit economics is customer lifetime value (LTV, or sometimes CLV or even CLTV). LTV in turn is driven by just two factors: churn and revenue per unit time.

Even a very sticky product like Quickbooks experiences some loss of customers over time. This loss is called churn, and is expressed as a percentage of the customer base that is lost in a given time period. Put another way, over a given period of time — say one year — what is the probability that a customer will cancel their subscription for use of the product? Some products, like Quickbooks, have very low churn, say less than 10 percent annually. Others, like video streaming service Disney+ have very high churn, perhaps 10 percent each month. (Admit it, you’ve subscribed just to watch a new series, only to quickly cancel when done.)

Churn can be thought of empirically and retrospectively — what fraction of our customers cancelled subscriptions last month, or it can be thought of as a probability about the future — what is the chance that a customer cancels in the coming month. Either way, churn is expressed as a percentage per unit time, say 15 percent per year, or 2 percent per month, using whichever time period best matches the pace of the business. Enterprise SaaS companies tend to use years and consumer SaaS companies tend to use months.

Note that the average duration of a customer relationship is simply 1/churn. So, for instance if your churn is 10 percent per month, then the average customer is with you for 1/0.10 = 10 months.

Revenue per unit time is just the average subscription fee your customer pays, say USD 15 per month. Armed with churn and average revenue per unit time, we can calculate LTV. In fast-paced environments like SaaS, the LTV calculation is usually kept pretty simple. Just multiply average duration times average revenue per period. If the average customer is with you 10 months and if subscription fees are USD 15 per month, then LTV is 10 x 15 = USD 150.

Of course, if the customer relationship lasts a really long time, and if pricing is expected to change over time, then LTV can be calculated as a net present value. A simple way to do that is with a spreadsheet in which the columns represent time periods out into the future. For each time period, consider the expected fraction of the customer that will still be with you (1-churn x the expected fraction of the customer you had in the previous period) and the expected subscription revenue. Then, discount the expected cash flow to the present using a discount rate (usually your opportunity cost of capital). More complex models of LTV can include factors such as additional products or services that a customer will buy on average in the future.

We’ve considered LTV in the context of low-marginal-cost goods offered on a subscription basis, but LTV can also be used for other settings in which a customer makes repeated purchases over time, say for a neighborhood coffee shop, where the average customer may make one purchase per week and where the churn is 2 percent per week. In such cases, the revenue per time period is not a subscription fee. Rather it is the average gross margin per transaction times the average number of transactions per time period. For example, if the coffee shop earns USD 3 in gross margin per transaction, thus generating USD 3 per week in gross margin, and keeps customers for an average of 1/0.02=50 weeks, then the LTV is 3 x 50 = USD 150.

Customer Acquisition Cost (CAC)

In a world of perfect information you could line up all your customers and know for each customer how they learned about you and what factors caused them to give your product or service a try. Then, you could estimate what you spent to create each of those factors, thus estimating for each customer their customer acquisition cost (CAC, pronounced “cack”).

In reality you rarely know this information with much precision. Sometimes all you know is what you spent on sales and marketing for some time period, say a month or quarter, and how many new customers you acquired. You can then do a simple quotient to calculate your CAC. Say you spent USD 10,000 for the month and acquired 200 new customers. In that case, your average CAC is 10,000 divided by 200 or USD 50 per customer.

Often you can get a more useful estimate by identifying how many customers were acquired via a particular mechanism and what that mechanism cost. For example, if you can discern via the analytics associated with an e-commerce site how many customers were acquired by pay-per-click advertising and you know what you spent on such advertising, you can estimate average CAC for the pay-per-click channel. This more refined estimate by acquisition channel allows you to take managerial actions to increase spending on more efficient channels and reduce spending for those that are less efficient.

Ratio LTV/CAC

In theory you could stay in business with LTV just barely exceeding CAC. But, most businesses aim to acquire customers at a cost of less than a third of LTV, and preferably much less. For example, for MakerStock, a business I co-founded that provides materials and services to designers, fabricators, and creators more generally, the customer lifetime value is about USD 300 per customer and we aim to acquire customers for an average CAC of less than USD 50, giving us a ratio of LTV to CAC of 6.

I believe that there are at least two reasons that in practice the target ratio of LTV to CAC is set to be at least three, and preferably much higher.

First, managers and especially entrepreneurs tend to be optimists, and reality rarely proves as rosy as their forecasts. Perhaps by setting a high bar we are more likely to achieve sustainability. If the target ratio of LTV to CAC is 6, then maybe we’ll hit 4 in reality, which would still work out.

Second, most measures of CAC are averages across a large number of customers. Averages hide the fact that some customers are much more expensive to acquire than others. By using a low average value for CAC as a target, we can be more confident that the most expensive customers, our marginal customers, are still being acquired for less than what they are worth to us.

Some other heuristics are useful in managing unit economics for businesses with repeat customers. Randy Goldberg, co-founder of Bombas, a direct-to-consumer apparel company known especially for great socks, told me that he aims to break even on a customer’s first order, so that CAC is less than or equal to the gross margin on that order. (A link to that interview is in the notes at the end of the chapter.) Then, all repeat business contributes gross margin above and beyond the acquisition cost. Of course we can conjure up examples in which that heuristic is not great (e.g., it won’t work if there is little repeat purchase), but it’s quite useful in its concreteness, simplicity, and ease of measurement. What did we spend to acquire customers? How many new customers tried our solution? What was the gross margin contribution of those new customers? If the gross margin from new customers is greater than what we spent to acquire customers, then we are probably not spending too much on sales, marketing, and advertising.

Recurring Revenue

Investors love SaaS businesses because of their recurring revenue. The product is usually delivered as an “all you can eat” solution with a per-period subscription fee. For instance, at this writing, the small-business accounting solution, Quickbooks, is priced at USD 30 per month for the basic, single-user plan. The beautiful thing about this business is that once customers have been acquired and are using Quickbooks, they are unlikely to stop subscribing until the business changes substantially because of winding down, acquisition, or enormous growth and the adoption of a more comprehensive solution. Because delivering the solution requires almost zero marginal cost, the leaders of Quickbooks can just think about subscription revenue as gross profit. (There are some marginal costs of the solution, such as operating the customer service function and some data hosting and computing requirements, but gross margins for such businesses are so high, often 90 percent or greater, that revenue is a reasonable proxy for gross profit.)

Recurring revenue is usually expressed as annual recurring revenue (ARR) or monthly recurring revenue (MRR). Recurring revenue, particularly ARR, is commonly used as a basis for valuing SaaS businesses in mergers and acquisitions or initial public offerings. ARR and MRR are usually calculated simply as the revenue per period from customers that are enrolled in subscription-based services and thus pay recurring fees. In businesses with extremely high churn, this revenue will of course not recur if nothing is done to replace those customers that churn in each period.

Putting Unit Economics Together in a Financial Model for Low-Marginal-Cost Businesses

Here’s a process for understanding your unit economics and creating a financial model for a low-marginal-cost businesses, particularly SaaS companies.

Set a pricing guide, probably including different categories of customers. Many SaaS businesses offer free options and then set pricing tiers based on features and service levels. These are called freemium models.
Estimate the average revenue per period per customer. This may require estimating the fraction of customers that will fall into each pricing tier.
Estimate churn, either based on existing customer behavior, or based on benchmarks for similar businesses. Using this value for churn, calculate the average duration of customer engagement as 1/churn.
Calculate LTV as the duration of customer engagement times the average revenue per customer per period. (If your business does have significant marginal costs of production, then use average gross margin per customer per period instead of revenue.)
Estimate your CAC, either based on experiments you have done or on benchmarks from similar businesses.
Check that LTV/CAC is greater than three, and preferably much greater. If LTV/CAC is not much greater than three, then you likely don’t yet have a feasible financial model.
Estimate the on-going costs of operating your business. For SaaS businesses, software development costs and sales and marketing expenses are likely the largest elements of on-going cost. Use your estimate of revenue per customer per period to do a break even calculation for the number of customers you need to serve to sustain your business.
Prepare a pro-forma income statement for what the business can look like if you are successful. Also create a second pro-forma income statement for the minimum viable scale. These two financial models represent your goal and your fall back position should things go much worse than planned. For SaaS businesses, you can also estimate ARR for this scenario, which will likely be an important measure of the value of your business.

3. Social Networks (e.g., Instagram)

For social networks, the economic model is rarely as simple as for a classic make-and-sell business in which a discrete unit of product or service is provided in exchange for cash. Instead, two broad methods of monetization of the network are typically adopted.

First, the operator of a social network charges members a time-based subscription fee for use of the network. Because social networks increase in value with the size of the network, the initial fee to join the network is usually low or possibly zero. Then the provider charges a fee for continued use beyond a trial period or for additional features. Such monetization methods are called freemium models, because a free option induces joining and initial use, and then premium option are available as an upgrade for which a user pays a subscription fee. For instance, joining LinkedIn is free. To enjoy the ability to send messages to those outside of the members’ immediate connections requires a paid subscription.

A second monetization model is the sale of access to the social network to other businesses for complementary purposes. The most common complementary purpose is advertising, for which a second category of customer, usually businesses, may pay to reach members of the network with advertising. This is the primary monetization model for Facebook and Instagram. Complementary purposes other than advertising are also possible. For instance, data generated from the network may be valuable to third parties who will pay for access to it. Businesses may pay for direct access to members of the network, as when recruiters use LinkedIn to identify job candidates. As the saying goes, if you as a user are not paying to use a solution, you are not the customer — you are the product.

The unit of analysis for a social network is primarily the active user. There is no standard definition of active, but some common variants are daily active users, weekly active users, and monthly active users, which typically include those users of the social network who have engaged with the product in the specified time period. Secondary units for the purposes of understanding unit economics may be the paid subscriber and/or the business customer that pays for complementary solutions like advertising.

The unit economics for monetization via subscription are similar to those of SaaS businesses. What is the average revenue per customer per time period and how long does the average customer pay a subscription fee? The average revenue per customer is the fees paid in each subscription tier, weighted by the fraction of customers in each tier. For instance if there is a free plan and a plan for USD 15 per month, and if 80 percent of customers are on the free plan and 20 percent pay subscriptions, then the average revenue per customer per month is 0.80 x 0 + 0.20 x 15 = USD 3.00. Average customer duration, as in SaaS, is simply 1/churn. So, if 5 percent of active users churn each month, then the average duration of paid customer engagement is 1/0.05 or 20 months. Putting that together, the customer lifetime value (LTV) would be 20 months x 3 USD/month-user = USD 60 per user. Monthly recurring revenue (MRR) would simply be the number of active monthly users times the average revenue per customer per month, so if the network has 100,000 monthly active users, then MRR would be 100,000 active users x 3 USD/active-user-month = USD 300,000 per month.

For start-ups, estimating the fraction of active users that will pay a subscription fee is probably the result of an educated guess at first. However, the rates are typically quite low, often less than 2 percent. This fraction is likely a critically important parameter, so some benchmarking of subscription rates in the freemium models of related businesses will be highly informative.

For the second monetization method — businesses paying for complementary products and services — the unit of analysis will be the paying third-party customer. For this scenario, the unit economics are exactly as for a low-marginal-cost product like SaaS. You may price per unit of use, as with advertising, or you may price as an all-you-can-eat subscription. In some cases, as with display advertising, the revenues paid by third-party businesses may depend on the number of active users in the social network. In this case, you may be able to express the potential third-party business revenue as a value of each customer in the social network.

Putting Unit Economics Together in a Financial Model for Social Networks

Here’s a process for understanding your unit economics and creating a financial model for a social network.

Decide on a primary monetization model — user subscriptions or third-party fees for access to the platform, such as advertising. In the long run, you may use both models, but typically one or the other will be your initial focus.
If your primarily monetization model is user subscriptions then your user is your unit of analysis. If your primary monetization model is third parties who will pay for access to members of the social network, or for data related to the network, then your third-party customer is the unit of analysis.
Establish price tiers. Estimate the fraction of users or customers that will fall into each price tier, informed by industry benchmarks.
Estimate the average revenue per period per customer, based on a weighted average of the prices for each pricing tier.
Estimate churn, either based on existing customer behavior, or based on benchmarks for similar businesses. Using this value for churn, calculate the average duration of customer engagement as 1/churn.
Estimate LTV from average revenue per period per customer and on average duration of customer engagement.
Estimate your CAC, either based on experiments you have done or on benchmarks from similar businesses.
Check that LTV/CAC is greater than three, and preferably much greater. If LTV/CAC is not much greater than three, then you likely don’t yet have a feasible financial model.
Estimate the on-going costs of operating your business. For social networks, software development costs are likely the largest element of on-going cost. Use your estimate of revenue per customer per period to do a break even calculation for the number of customers you need to serve to sustain your business.
Prepare a pro-forma income statement for what the business can look like if you are successful. Also create a second pro-forma income statement for the minimum viable scale. These two financial models represent your goal and your fall back position should things go much worse than planned. For SaaS businesses, you can also estimate ARR for these scenarios, which will likely be important measures of the value of your business.

4. Marketplaces Connecting Suppliers and Consumers, Sometimes Accompanied by Related Solutions (e.g., Airbnb)

Airbnb is an example of a marketplace, connecting suppliers of short-term housing with consumers of short-term housing. Other examples of marketplaces include eBay, Stubhub, and OpenTable. Marketplaces are also called two-sided markets because they serve two very distinct sets of customers: suppliers of goods and services and consumers of those goods and services.

Sometimes a marketplace is a component of a larger service offering that the organization provides directly. For example, the SaaS company Shopify provides software for operating an e-commerce storefront, but it also provides an app store with third-party solutions for merchants, such as freight calculators or sales tax collection systems. The core solution is the e-commerce SaaS, but a key element of that solution is a marketplace connecting suppliers of specialized application software to merchants who use that software as part of Shopify’s solution.

Occasionally a business that is primarily a marketplace will also directly offer ancillary services. For instance, Doordash is a marketplace connecting restaurants with hungry consumers, but it also directly operates a delivery service (“dashers”) that pick up and deliver the food. In such cases, the company may actually be operating a three-sided market (e.g., the restaurants, the diners, and the freelance delivery people).

Gross Merchandise Value and Take Rate

For marketplaces the unit of analysis is usually the transaction. The sum of all transactions over a time period is called the gross merchandise value (GMV). The marketplace charges fees to sellers, and sometimes buyers.

For most marketplaces, GMV is not a GAAP-compliant measure of revenue, as it does not reflect the actual amount of money that the marketplace earns from transactions. GMV may be used as a supplemental metric to indicate the size and growth of the marketplace, but it should not be confused with revenue. Revenue is the amount of money that a marketplace actually receives from its customers for providing goods or services.

The fraction of GMV that the marketplace retains as revenue before passing on the revenue to the supplier is called the take rate. For example, Airbnb’s GMV for its homes segment in 2023 was USD 29.4 billion, but its revenue from that segment was USD 7.3 billion, corresponding to a take rate of 7.3 / 29.4 = 24.8 percent. Note that Airbnb’s transaction fee on the booking is closer to 15 percent, but it charges several other fees to both hosts and guests so that when taken together the take rate is closer to 25 percent.

Take rate is largely determined by the market power of the platform. Marketplaces have very strong network effects, which can create huge sources of competitive advantage. Airbnb essentially crushed its rivals VRBO, Homeaway, and others in the period 2010-2020 becoming the dominant marketplace for temporary housing. This gives Airbnb substantial pricing power and allows it to earn a take rate of 25 percent. The Apple App Store charges a 30 percent fee for all transactions associated with digital goods made with an iOS app. The fees are lower for small businesses, for physical goods, and for multi-year subscriptions. However, put together, Apple’s take rate is also close to 25 percent. These values of 25 percent or a bit more are about the highest exhibited in practice. Marketplaces with less pricing power or dealing in physical goods have much lower take rates. For instance, eBay’s take rate in 2022 was about 13 percent. The practical range in take rates is typically 10 percent to 30 percent, with most marketplaces operating in the range of 15-20 percent.

Putting Unit Economics Together in a Financial Model for Marketplaces

The basic financial model for marketplaces is comprised of the GMV, the take rate, COGS, and on-going operating costs.

Identify the two sides of your marketplace, likely suppliers of goods or services and consumers of those goods or services. Decide which side will pay for access to the platform, or possibly if both sides will pay. Use competitive benchmarks and a subjective evaluation of your relative pricing power to estimate your take rate, expressed as a percentage of GMV.
Estimate your cost of goods, the direct costs of executing transactions, which may include fraud protection, customer service, and computing resources. For most virtual marketplaces, COGS is a small percentage of revenue. For example, Airbnb’s COGS for 2022 were $1.5 billion, which included expenses such as payment processing, customer support, trust and safety, and host insurance. Airbnb’s gross profit for 2023 was therefore USD 6.9 billion, 82% of its revenue.
Estimate the on-going costs of operating your business. For marketplaces, software development costs and sales and marketing costs are likely the largest element of on-going cost.
Revenue is simply GMV times take rate. Then, gross profit is revenue minus COGS. To achieve financial sustainability, gross profit must exceed on-going operating costs. The breakeven value can then be estimated in terms of GMV, which can be translated into a number of transactions by assuming an average transaction value. Calculate the break even number of transactions and associated GMV you will need to achieve per unit time to meet your on-going operating costs.
Prepare a pro-forma income statement for what the business can look like if you are successful. Also create a second pro-forma income statement for the minimum viable scale. These two financial models represent your goal and your fall back position should things go much worse than planned.

Notes

Fader, Peter, and Sarah E. Toms. The Customer Centricity Playbook: Implement a Winning Strategy Driven by Customer Lifetime Value. Wharton School Press, 2018.

Interview with John Geary, co-founder of Abodu Homes.

Interview with Randy Goldberg, co-founder of Bombas.

Commercializing a Physical Product as a Solo Inventor

About once a week, a student, alumnus, or member of the general public reaches out and says something like, “I have an idea for a new physical product. I just need to find a manufacturer. Can you help me?”

First, let me be clear and succinct about a few points. First, an idea is rarely worth much unless combined with the will, effort, and tenacity to develop that idea into a product that is available to customers and that meets their needs. Second, if all you have is an idea, then you do not just need to find a manufacturer. You need to apply your will, effort, and tenacity to the process of transforming your idea into a specification of the solution that will both delight your customers and that unambiguously communicates the details of the solution to a manufacturer. That transformation is not easy. Thankfully, there are many concepts, tools, and methods that can help you achieve your goals and to avoid wasting time and money.

In this guide, I provide an overview of what you will likely need to do and I provide links to other more detailed resources relevant to your pursuit.

May I suggest that before you proceed any further, you view these videos I made describing my attempts to create a new physical product (the Belle-V Ice Cream Scoop) and to take it to market as a solo inventor. (Note that I did not remain solo for long, and had a lot of help from talented partners in the middle phases.)

Belle-V Ice Cream Scoop – Part A

Belle-V Ice Cream Scoop – Part B

OK, now you get the idea and hopefully understand that the process is not trivial, even for a seemingly simple product like an ice cream scoop. Next, let me provide more detail on the key steps:

Develop a solution concept using the triple-diamond model.
Create a prototype that really does the job.
Design the to-be-manufactured version of the product.
Make and sell 1000 (or maybe 100 if possible).
Refine your go-to-market system.

I’ll also include some content related to these important financial and competitive concerns:

Can I actually make money from this entrepreneurial opportunity?
What about patents?

By the way, if teaching yourself this material is daunting to you, please consider enrolling in my on-line course Design: Creation of Artifacts in Society (via Coursera) from which some of this content is derived. Last I checked, a version of this course was available for free. (Of course, if you are a Penn student, you could also take my course OIDD 6540 Product Design.)

Develop the Solution Concept Using the Triple-Diamond Model

The Triple-Diamond Model

Diamond 1 – Jobs Analysis

Diamond 2 – Understanding User Needs

Diamond 3 – Developing a Solution Concept

Create a Prototype that Really Does the Job

Here are the videos from my Coursera Design Course on Prototyping.

Design the Product

Once you have a prototype that works very well for you, and perhaps for a few potential customers, you can actually design the product. Huh? What do I mean by design the product? I already have a working prototype. Sure, but that working prototype is not typically implemented in an economical and reliable way, and you have not fully specified the artifact in a way that a factory could produce it.

It’s possible that you can take your prototype to a factory that produces similar goods and that their employees can create the production documentation (e.g., computer models and drawings) required to actually make the components of your product. However, more typically, you need to do this specification yourself. Furthermore, the detailed specification of the product comprises your own intellectual property, and so you may wish to control it fairly closely. In that case, you will need to find someone who can create the documentation (e.g., drawings and models) that represent the production-intent version of your product.

There are lots of different types of skills that may be required for this task. I’m not able to detail them all here. A good next step may be to consult with some independent contractors via platforms such as Upwork to understand better your options.

Make and Sell 1000 (or even 100)

In all but the most time-critical competitive environments, at some point sooner rather than later you should just start making and selling your product. Ideally you would find a way to make and sell just a few — say 100 units. This will teach you so much more than doing further research and development. These first 100 units will not be very good, but hopefully they will be good enough that a few brave customers will buy them and give you feedback. The challenge is figuring out how to make just a few units that are both good enough that someone other than a family member could figure out how to use them and tolerate the inevitable warts on the product and that can be produced at reasonable cost. You shouldn’t expect to make any money on these units, but hopefully you won’t lose ridiculous sums either. In some cases you may need to find the resources to make 1000 units — when, for example, the production economics are such that it is just not possible to reasonably produce 100 pieces. Lots more to say about this, but hopefully this quick advice gets you started.

Find a Manufacturer

Here is a video on my own experiences finding a manufacturer in China. You may find it helpful.

Patents

A patent can be a useful element of a plan for developing and commercializing a product. However, it is not really a central element of that activity. Patenting an invention can wait until many of the technical and market risks have been addressed.

A patent by itself rarely has any commercial value. (An idea by itself has even less value.) To extract value from a product opportunity, an inventor must typically complete a product design, resolving the difficult trade-offs associated with addressing customer needs while minimizing production costs. Once this hard work is completed, a product design may have substantial value.

In most cases, pursuing a patent is not worth the effort except as part of a larger effort to take a product concept through to a substantial development milestone such as a working prototype. If the design is proven through prototyping and testing, a patent can be an important mechanism for increasing the value of this intellectual property.

Licensing a patent to a manufacturer as an individual inventor is very difficult. If you are serious about your product opportunity, be prepared to pursue commercialization of your product on your own or in partnership with a smaller company. Once you have demonstrated a market for the product, licensing to a larger entity becomes much more likely.

File a provisional patent application. For very little money, an individual using the guidelines in this chapter can file a provisional application. This action provides patent protection for a year, while you evaluate whether your idea is worth pursuing.

Here are a couple of videos with examples and details. (The textbook chapter I refer to in the first video is from Ulrich, Eppinger, and Yang — Product Design and Development.

Can You Make Money?

In the short run, do you have gross margin and can you acquire customers efficiently? Here are a couple of resources that may be helpful in answering these questions.

Go to Market Systems

In the long run, do you possess the alpha assets to sustain competitive advantage? Read this to learn more about alpha assets and the five flywheels.

Competition and Product Strategy

You may believe that you have identified a unique opportunity to create value with your new business. You’re probably mistaken about the unique part. Others have likely tried to do this job before, and some scrappy entrepreneurs just getting started elsewhere in the world probably share your hopes and dreams. Even if your insight is unique, it can’t remain a secret for long. If you are able to grow your business and achieve profitability, you will effectively be publishing the location of a gold mine to the public. Competition is a central, unavoidable characteristic of entrepreneurship. But, competition is not necessarily a bad thing, particularly at the dawn of a new market. Competitors can teach you a lot about what works and what doesn’t, spur you to innovate and move quickly, and share the burden of educating potential customers about an emerging market.

Many aspects of competition are unpredictable and so entrepreneurs should probably not spend inordinate time obsessing over rivals. Still, some attention to competition can result in smarter strategic choices in product positioning and in refining the definition of the beachhead market. Furthermore, potential investors will want to see that you have identified and analyzed the competition and have made sensible decisions about how to direct your efforts given the competitive landscape. As a way to organize this chapter and to avoid unnecessary theory, let me start with an identification of the key questions most entrepreneurs need to answer and the associated decisions they need to make. Then, I’ll illustrate several key concepts, analyses, and ways of presenting information that are most useful in addressing these questions and decisions.

What Questions are You Really Trying to Answer?

Three questions relevant over three different time horizons are usually most pressing.

First, is there really a gap in the market? This is the immediate question relevant to the decision to pursue an opportunity. Entrepreneurial opportunity is born out of disequilibrium, and for start-ups that disequilibrium is usually either (a) some technological change that has given rise to a new solution to an existing job to be done, or (b) some new job to be done that has emerged because of changes in attitudes, preferences, demographics, regulation, or other external forces. A closely related question is how big is the gap in the marketplace in terms of TAM and SAM.

Second, given that an opportunity exists, how should the specific attributes of your solution be positioned relative to the alternatives available to your potential customers? Positioning concerns both the decisions you make about the substantial features of your solution, as well as what you emphasize in your marketing efforts. This question is answered as you develop your solution, refine its characteristics, and craft a message for communicating your value proposition.

Third, how likely is your new organization to be able to sustain competitive advantage in the long term? In most cases a start-up’s most valuable assets relative to larger rivals are speed and agility. But, if you are successful, you will likely become bigger and a bit more sluggish. Existing and new companies will come for your customers. How can you thrive when that happens?

In order to answer these three questions, you’ll first form a hypothesis about the job to be done, the beachhead market, and your solution concept. If you are following the process in this handbook, this hypothesis is developed with the triple-diamond model. In any case, to consider the issues in this chapter you should have at least a preliminary decision in these three areas. In many cases, these preliminary decisions are the key elements of the description of the entrepreneurial opportunity.

With a hypothesis about the opportunity in hand, here’s a process to assess the competition, position your solution, and articulate how you will sustain competitive advantage:

Identify the direct, indirect, and potential competitors and research their solutions and marketing strategy.
Refine and articulate your value proposition by Iteratively refining your product positioning and by mapping your solution relative to those of direct competitors on the dimensions of product performance that most influence the value you offer to your potential customer.
Develop your advantage thesis by articulating your alpha assets, the moats and barriers that you possess or hope to develop over time.

Identify Direct, Indirect, and Potential Competitors

In broad terms, competition is comprised of the organizations that deliver a solution that customers can select to do the job you have identified as the primary focus of your business. These rivals can be categorized as direct competition, indirect competition, and potential competition.

Direct competition refers to organizations that deliver essentially similar solutions to the same customer segment you are targeting and more or less addressing the same customer needs — the Coke and Pepsi of the soft drink market, UPS and FedEx for ground parcel delivery, Nike and Adidas in athletic shoes. Direct competitors are usually the most obvious and visible sources of competition.

Indirect competition refers to organizations that offer a substantially different solution to your segment for addressing the same or closely related customer needs. For example, Peet’s Coffee and Red Bull are indirect competitors for morning stimulants.

Potential competition refers to organizations that do not currently offer solutions to the focal customer segment, but who have the capability and incentive to do so in the future. For example, Amazon and Google are potential competitors in many markets where they do not currently operate, such as healthcare or education. Potential competitors are dormant, but may substantially pollute the attractiveness and sustainability of an opportunity given the possibility they may enter the market later.

Once you’ve identified the direct, indirect, and potential competitors, spend some time learning what you can about them. Devote the most time to direct competitors, but also investigate the indirect competitors; it’s possible they are more aligned with your beachhead market than you think. Your time is probably not best spent going deep on all the companies that could potentially be competitors — too much uncertainty clouds their role in your future. For the most relevant competitors, read white papers and articles; listen to podcasts; watch video interviews; try out their products; talk to their customers. These competitors, as a result of their marketing efforts, have effectively all run experiments out in full view of the public. You should take advantage of whatever information you can glean from what is working for them, what has not worked for them, and what weaknesses are revealed about them by their current efforts.

Refine and Articulate the Value Proposition

When you developed your solution concept, you probably used a concept selection matrix to compare alternatives. (See the chapter on Concept Development.) The criteria you used for comparison included the key customer needs for the beachhead market. Now pull out that list of needs again and revise and extend it until you have 6 – 10 key customer needs that will mostly determine the value that your solution can deliver to your customer.

Needs are usually expressed in the language of the customer, not as technical specifications. At this point you may wish to elaborate the metrics that most closely match each customer need. For instance, if the customer need for an electric vehicle is “has sufficient range for my daily needs” then some metrics might be “range at 50 kph average speed” and “range at 100 kph average speed” which would capture both city and highway driving.

Once you’ve compiled a list of needs, organize them in a table, along with the key performance specifications. Then, fill in the values for your solution and those of your direct — and possibly indirect — competitors. For example, Mokwheel is a relatively recent start-up company entering the electric bike market with the Mokwheel Basalt model.

Mokwheel bike solution concept. Source: Mokwheel

Here is a table showing the comparison of the Mokwheel Basalt relative to some of its competitors.

Customer Need	Metric	Mokwheel	Rad Power RadRover 6 Plus	Juiced Bikes CC X	Niner RIP E9 3-Star	Lectric XP 3.0	Ride1UP 700 Series	Aventon Level.2
Range	Miles per charge on test course	60	45	30	30	25	30	40
Affordability	Price (USD)	$1,999	$1,999	$2,499	$6,295	$999	$1,495	$1,800
Weight	Kilograms	35.9	34.3	25.0	23.5	28.6	24.5	28.1
Ride comfort	Suspension type	Front fork suspension w/ lockout. Fat tires.	Front fork suspension and rear coil-over suspension w/ lockout	Front fork suspension w/ lockout	Full suspension w/ RockShox ZEB Select fork	Rigid frame/fork w/ fat tires for cushioning	Front fork suspension w/ lockout	Front fork suspension
Payload capacity	Rack weight limit (Kg)	82	45	N/A	N/A	N/A	N/A	55

The hypothesis for Mokwheel is that an affordable, rugged electric bicycle with very long range and huge cargo capacity will be well received in the beachhead market, even if the weight of the vehicle is relatively high.

Product Positioning on Key Dimensions

Competitive positioning is often boiled down to just two dimensions to allow visualization with a scatter plot. For this example, let’s assume that the two attributes of electric bikes that seem to best describe differences in products and in preferences in the market are weight and range.

Given two dimensions, we can then draw a map of the landscape of possible solutions. You could very reasonably object to this oversimplification. You’re right. In virtually any market, we oversimplify by representing the competitive landscape in two dimensions. Still, it’s done all the time, and has an obvious benefit for visualization. Recall that you have already captured the other dimensions that matter in the value proposition table from the previous section. You can experiment with which two dimensions are both important to customers and reflect meaningful differences among competitors.

Note that you can sometimes sneak in a third dimension, say price, by labeling the data markers in the scatter plot, as I’ve done with price below.

In using scatter plots for communicating product positioning, a distinction between two types of attributes is important. Weight and range are largely more-is-better or less-is-better attributes. Everyone can agree that — at least for reasonably foreseeable solutions — more range and less weight are desirable. All else equal, customers would prefer a product located in the upper left corner — low weight and high range. However, cost and technical feasibility likely make that position overly optimistic. In contrast, imagine you are designing a chocolate bar and that the two attributes of greatest importance to customers are (1) intensity of chocolate flavor and (2) crunchiness. For the chocolate bar domain, each customer likely has an ideal point — a combination of intensity of chocolate flavor and of crunchiness that they prefer. The producer can position the solution pretty much anywhere, as most positions are technically feasible at similar cost. Reinforced by these examples, we can probably all agree on some basic principles:

All else equal, a product should be positioned where there is demand.
All else equal, products should be positioned where there is little competitive intensity.
- For more/less-is-better attributes, cost and technical feasibility constrain the position of your solution, and you likely will face trade-offs among competing attributes.

By the way, many of you have heard about or read the book Blue Ocean Strategy – that’s all the book really says. Put your product where there is demand and where there’s limited competition. Much of the field of quantitative market research is devoted to increasingly precise methods for measuring preferences and optimizing product positions in a competitive landscape. There’s nothing wrong with that logic or that approach. However, I want to warn you about two ways this approach to product positioning could lead you astray.

First, not every location in this space is feasible. Imagine, we were applying the same process, but for cameras, and our axes were image quality and size. There would be a big open area – a so-called “blue ocean” in the region of very high quality images and tiny size. Yet, the optics of photography introduce a fundamental tradeoff between size and quality, for a given imaging technology. This suggests that product strategy and product positioning in technology-intensive industries are cross-functional challenges, and that engineering breakthroughs are what allow for differentiation. For instance, the advent of computational photography, the use of image processing of several images in order to create one excellent composite image, which underlies much of the power of photography on today’s mobile devices, allows some loosening of the connection between camera size and image quality. In the electric bike market, advances in battery chemistry, motor efficiency, aerodynamics, and tire performance may allow for competitive positioning that beats the basic trade-offs reflected by existing competitors and solutions.

My second concern is probably more substantial. If you find yourself drawing two dimensional maps of your product landscape and debating the fine points of position, or if you find yourself building elaborate mathematical models to estimate market share in a crowded market for products in which a few attributes dominate consumer preference, you are probably not in a dynamic industry with abundant entrepreneurial opportunities. Rather, you are in a stagnant industry in which tuning is done by product marketing managers, and often based on mathematical models and consumer data. The goal is a few additional points of market share. If this is your situation, my advice is to find a way to make this industry less stable, to shake it up, and introduce some new dimensions of competition.

In fairness to the authors of Blue Ocean Strategy, shaking up the industry is more the essence of their message. Avoid head to head competition tuning product parameters within a highly evolved product landscape. Instead, look for a way to introduce new attributes to the competitive landscape. For example, in the chocolate bar space, consider the FlavaNaturals bar, which is made with cocoa that is super concentrated in flavonoids, which have been shown clinically to increase memory. Or consider the KIND bar, which cleverly blurs the boundary between candy and health food. It tempts the consumer with chocolatey flavor while presenting an image of wholesome goodness with the obvious use of nuts and seeds. Those are both competitors that have shaken up the more traditional dimensions of competition in the candy bar market.

Develop an Advantage Thesis

I’ve written a lot about competitive advantage elsewhere. (See Alpha assets and the Five Flywheels.) But, in sum, advantage always arises from controlling or possessing some resource that significantly enhances your performance in doing a job and that your rivals can’t easily get. I call those resources your alpha assets.

A unique solution is usually the start-up’s initial alpha asset. In a few rare instances, the solution will remain hard to imitate for a long time. For instance, in the pharmaceutical industry a new molecular entity can be patented, and what is patented is what eventually receives government approval. Thus, rivals can not offer the approved compound without infringing the patent. Given the typical time requirements for commercialization, such patent protection may offer 10 or even 15 years of exclusivity. But, outside of the biopharmaceutical industry, patents rarely provide strong barriers to imitation for very long (Ulrich, Eppinger, and Yang 2019). Your unique solution combined with your speed and agility probably give you a few years of advantage, at which point you had best have developed other sources of advantage. The most likely are brand and the scale economies enabled by a large established customer base.

Why Can’t Google Do this?

One of the most common questions that entrepreneurs face from investors is “Why can’t Google (or Apple, Meta, Amazon, et al.) do this?” This question reflects the concern that Google, or any other large and powerful company, could enter your market and offer a similar or better solution than yours, using their vast resources, capabilities, and customer base. The “Google question” is common enough to consider specifically. The answer varies depending on your industry, market, and product category. For example, consider how the answer may differ for two start-ups, one pursuing on-line dating and one pursuing cloud-based video services. Although these examples are specific to the competitive threat by Google, they are illustrative of how an entrepreneur might think about competitive threats from any large, powerful incumbent.

Google could enter the online dating market and offer a similar or better solution than a start-up, but it is unlikely that they will do so for several reasons. First, online dating is not aligned with Google’s mission, which is to organize the world’s information and make it universally accessible and useful. Second, the online dating market is fraught with privacy concerns. Google may face legal and ethical issues if it enters the online dating market and uses customer data for matching purposes. Third, online dating is a highly competitive and dynamic industry. Google may not exhibit sufficient agility to keep up with changing customer preferences and needs, as well as the emerging technologies and features in the online dating space. Putting these reasons together, one could argue that Google is not a serious potential competitor in the online dating market. In sum, Google could do it, but Google won’t do it.

Google could also enter the market for cloud-based video services and offer a similar or better solution than the start-up. They might credibly do so for several reasons. First, cloud services is their core business and competency. Google already offers a range of cloud services products such as Google Cloud Platform, Google Workspace, Google Cloud Storage, etc. It has the incentive and interest to enter a niche or specialized segment of the market in order to stimulate demand for Google’s core services. Second, cloud services is a technologically complex industry. Google has the resources and capabilities to enter the cloud services market and offer a high-quality and reliable solution that meets the needs and expectations of customers. Third, cloud services is large and growing industry. Google not only could do it, but Google likely will do it, and has the opportunity and potential to enter the cloud services market and capture a significant share of customers and revenue. If you are in the directly path of a company like Google in its core business, then you will likely need to make an argument about the importance of speed and agility, and some important alpha asset — such as network effects — that can be developed in the two or three years it will take Google to recognize and respond to the opportunity. You may of course also argue that Google would more likely acquire your start-up than build its business from scratch. Such arguments are weak, in my opinion, unless you can make a credible argument for why your start-up will have significant alpha assets within a few years, and in that case, whether or not Google would acquire the company, you have built something of substantial value.

Wrap-Up and Common Pitfalls

Your business plan or “pitch deck,” whether for investors or just for your own planning, should have a section on competition. Everyone expects that, and for good reason. You’ll usually have a table showing how your solution stacks up against the rival solutions on a handful of key customer needs. You’ll likely show your product position relative to direct competitors on a two-dimensional plot. You’ll devote some space to an articulation of your planned sources of long-term competitive advantage.

Do those things and at the same time avoid these rookie mistakes:

Do not claim that you have no competitors or that you are better than all of them. Every job to be done has been around in some form for a very long time in society. Your potential customers were getting that job done somehow before you had your bright idea. The pre-existing solutions are competitors.
Do not be dismissive of competitors. If there is an existing company doing the job you are setting out to do, then that company is more accomplished than you are at the time of your analysis. Show some respect and learn from that company’s experience.
Do not argue that you are the first mover, and that this is a source of competitive advantage. There are rarely first-mover advantages, except sometimes when the market exhibits very, very strong network effects. Consider that Google was not even one of the first ten companies to enter the internet search business.
Do not cite patents or “patent protection” as a significant source of competitive advantage. Unless you are a bio-pharmaceutical company, patents are at best a low picket fence around your solution. They are not typically a significant barrier to entry.

Notes

Karl T. Ulrich, Steven D. Eppinger, and Maria C. Yang. 2019. Product Design and Development. Chapter “Patents and Intellectual Property.” McGraw-Hill. New York.

Karl T. Ulrich. Alpha Assets and the Five Flywheels. Working Paper. The Wharton School. 2018.

Kim, W. C., and R. A. Mauborgne. 2005. Blue Ocean Strategy: How to Create Uncontested Market Space and Make the Competition Irrelevant. Boston: Harvard Business School Press.