Subject: RE: "I've got more programmers than you"
From: "Larry Augustin" <lma@valinux.com>
Date: Sat, 6 Oct 2001 06:38:41 -0700

> From: Christian Robottom Reis [mailto:kiko@async.com.br]
> Sent: Friday, October 05, 2001 11:08 PM
> To: Bernard Lang
> Cc: fsb@crynwr.com
> Subject: Re: "I've got more programmers than you"
> 
> I'm Brazilian, so take good measure of my words :-) This is all on an
"I
> think" basis.
> 
> On Sat, 6 Oct 2001, Bernard Lang wrote:
> 
> > Revenue  :  (I guess it is all the money that comes in)
> 
> Right, everything you make.
> 
> > Gross Margin:
> 
> Margin after you've paid off direct suppliers. In a grocery store, for
> instance, the what's left of the revenue after you've paid the farmers
> that sell you your vegetables. I'm not sure why EDS has so low gross
> margin here, though, so maybe I'm wrong.

This is one people often don't understand.  It's not just direct
suppliers (which is called "direct material cost" and the associated
"direct material margin").  It's the total cost of providing the good or
service.  (COGS == Cost of Goods Sold.)  It's not the cost of selling,
marketing, or developing the good or service.  Think of it this way.
You could spend the costs to develop, engineer, market, and sell the
product without anyone ever buying.  Once they buy, you have certain
costs necessary to deliver the good or service.  Those include the cost
of manufacturing the good (including labor), and the cost of supporting
the good or service.

Let's say it costs a services company $150K (salary) + $50K (overhead -
benefits, facilities, IT, etc.) = $200K per year for a consultant.
($200K to $250K per year is a fairly typical loaded cost per employee in
Silicon Valley.)  That services company then charges its customers $300K
per year for that consultant.  There are typically some additional costs
associated with providing the service.  Perhaps there is some
guarantee/warranty.  That cost is included on top of the salary.  Let's
say that adds another $50K per year to our costs.

So we have:

Revenue			$300K		100.0%
Direct Material Cost    $200K
Direct Material Margin  $100K		 33.3%
Other Costs              $50K
COGS				$250K
GrossMargin  		 $50K		 16.7%

Out of that $50K, we have to pay research & development, sales and
marketing, and other administrative expenses.  What's left is "operating
margin".  That's how much profit we would have made before things like
taxes, interest income, etc.  Operating income tells us the underlying
fundamentals of the business.

We use percentage of revenue to abstract away absolute dollars. You
should do this type of analysis for any business, regardless of size.
You can learn a lot from it.  With 16.7% of gross margin in the example
above, there's not a lot of room leftover to pay people to do something
besides consulting (e.g. pay them to do development).

I get the impression that many free software business models are
designed to make a good living for the consultant, but not have a
profitable business.  In the above example, the consultant is making a
good living, and if the company wants no profit there's probably enough
in the 16.7% gross margin to pay people to spend part of their time
writing free software. 

Individuals often equate "direct material margin" with "profit".  That's
because individuals often think of their own time as free (another
mistake).  For example, say you want a new PC at home, and after
shopping around on the net for a while you find then best deal on the
parts (motherboard, memory, disk drive, etc.), order all the parts, and
assemble test, and install the machine for yourself.   Assume the parts
cost was $1000, it took you two hours to do all that, and your time is
worth $150/hour.  If you sold that system for $1300, your direct
material margin would be 30%, but your gross margin would be zero.

Gross margin generally lets you know the value of the good or service to
the customer.  In the case of a services company, the customer could
consider employing the consultant directly (skipping the services
company).  Now there are additional costs to managing that, so the
customer is willing to pay more to the company to hire the consultant
because the company handles some of the management overhead.  However,
the value of handling that management overhead is small.  If the gross
margin gets too high, the consultant strikes out on their own, and is
able to sell themselves below what the company would charge.

If you are able to corner the market on some specific talent that is
high in demand, and those consultants stay loyal to the company, you can
charge higher gross margins.  You are offering a more valuable service.
You have cornered supply.  This is part of the reason McKinsey is a
higher gross margin business than EDS.  (The other part is value based
pricing, not cost based pricing, but that's another discussion.)  If you
want to find a very smart and experienced business process analysis
person, you can't go many places.  On the other hand, sysadmins are a
dime a dozen.

One of the goals of my posting was to encourage quantitative analysis of
free software business models.  You can't have a discussion about a
business without understanding the underlying economic model.  For any
free software business that is proposed, I'd like to see the underlying
economic model along with some defense of that model.

Larry