How are you going to make money?
8x Entrepreneur, Author, Customer Development Expert
For virtual products, your cost of goods may simply be the cost of your engineers.
If you are an OEM, your product becomes another company’s cost of goods.
Lesson: Channels & Partners with Steve Blank
Step #3 Economics: How are you going to make money?
Let's take a look at the channel economics. In other words, how are we going to make money? Let's take a look at a direct sales example. You have a sales force and you're selling directly to the end consumer. So let's assume that the list price of your product is $100. So one of the first questions in thinking about how to come up with this $100 list price is to understand how much did it actually cost me to manufacture a product. Now in the web, it might be the cost of my engineers, but in a physical product it might be the costed bill of materials coming out of my factory. And so let's assume for the sake of discussion that that was $33, $33 to build my product.
Next, let's take a look at the cost of my R&D that is my engineering, the cost of my direct sales people, maybe commissions or direct sales, compensation, and then general administration costs, what it cost me to have leases and lunches and free snacks, and that might be another $20. And so right now, it's $53 just to keep the lights on in my building. Now something we should consider is that knowing user pays this price so let's assume that this area represents the discount from the list price, let's say 10%. That means your revenue to your company would not be $100 but $90.
So, wait a minute, you're getting $90 but you spent a total of $53 building the product and keeping the lights on, and that leaves right in the middle, how much profit you have. In this case it would be $37. So your selling costs that were embedded here, this was the commission or direct sales cost or whatever you were paying, your direct sales people, and you made $37 selling directly.
Now that we looked at channel economics for direct sales, let's go take a look at what the channel economics would look like if we were selling through an indirect channel, resellers. So, as you could see, we still have the same cost of goods to manufacture the product as before, $33. Now it's kind of interesting if we look at the R&D, selling costs, and general administration costs, our R&D might be the same and keeping the lights on the building might be the same but our selling cost are lower because we're selling through resellers. We still need a direct sales person, but this time, instead of them talking to every possible end user, they are actually talking to a few number of resellers.
So let's say instead of $20, our SG&A, sales, general and admin cost, plus R&D this time is $15 rather than $20. And that the total of getting the product out the door is now $48. Just like before, our list price is $100 and in the store, the end user expects maybe a 10% discount and so the revenue to the sales channel this time, not to us, is $90. But this time we have resellers, and the resellers don't work for us. They're the ones actually selling the product and they take the difference between $90 and let's say $70, which they're going to pay us. And so their profit is $20 for carrying, stocking, and reselling our product, and our profit is just $22 this time because we're selling through someone else. But remember, our cost were lower so one of the trade offs in using what's called an indirect channel, is that your selling costs are lower but you're giving a big chunk of your profit to other people not part of your company.
Let's take a look at channel economics, but this time assume you are an original equipment manufacturer and your product becomes some other customers' cost of goods. So let's assume this diagram on the top is a laptop computer sold through a computer reseller channel, and let's say this laptop sells for $3,000. And, like any other channel, the end user assumes they get a discount. The resellers taking a profit but the reseller was actually buying these laptops from a master distributor. Now remember, back here the manufacturer of the laptop had their cost of goods, sometimes abbreviated COGS, which include manufacturing costs, components, etcetera. And finally, they had their sales costs, their R&D costs, and their general and administrative costs. And finally, after all that, they make a profit.
So where do you fit? This is just a laptop manufacturer. Assume this is Apple or HP, but in this case you were a graphics chip supplier to Apple or HP, and you were just one single component on their mother board. Well, if you really think about it, you were fitting in here in their cost of goods. And now your cost of goods, your sales, general and administrative costs, your profit, and now your reseller costs. Now, in some cases, you might have been selling directly your parts into HP or Apple and you would not have reseller costs but you would have more direct sales cost. Remember, this stands for sales, general administrative cost, and so your profit is minuscule compared to what the laptop manufacturers are making but you might be selling millions of single chips and so that profit is multiplied by that high volume when you OEM a product.