Product Management's Sacred Seven: Economics

Published on 2025-03-11 by Mohd

3 Main Ways to Make a Profit

1. Cost Leadership

Commodities Examples: Gold, oil, wheat, pork, etc.

• The only way to keep prices low is to keep costs low.
• Economies of scale: Exploit volume discounts, negotiate better deals with suppliers, and increase production efficiency.
• Vertical integration: Owning suppliers to reduce dependency and costs.
• Race to the bottom: Only sustainable with a cost advantage that keeps expenses lower than competitors.

Key Metrics

| Metric | Formula |
|--------|---------|
| **Gross Margin (%)** | (Revenue - Cost of Goods Sold) / Revenue |
| **Operating Margin (%)** | Operating Profit / Revenue |
| **Cost per Unit** | Total Costs / Number of Units Produced |
| **Return on Assets (ROA)** | Net Income / Total Assets |

2. Product Differentiation

• Building a better product with competitive advantages that justify a higher price.

Example:

• Rolex – Watches exist for $10, but Rolex justifies a higher price with craftsmanship, brand value, and exclusivity.

Challenge:

• Maintaining differentiation; if differentiation erodes, you risk becoming a commodity.
• Example: Lyft vs. Uber – Similar services, but each tries to differentiate via branding, pricing, or features.

Key Metrics

| Metric | Definition |
|--------|------------|
| **Net Promoter Score (NPS)** | Measures customer loyalty and likelihood of recommendations. |
| **Brand Equity Score** | Measures consumer perception of brand value. |
| **Willingness to Pay (WTP)** | Maximum price customers are willing to pay for differentiation. |
| **Price Elasticity of Demand** | Measures how sensitive demand is to price changes. |
| **Formula** | % Change in Quantity Demanded / % Change in Price |

3. Blue Ocean Strategy

• Instead of fighting over an existing market, create an entirely new one.

Examples:

• Wii – Targeted casual gamers that Xbox/PlayStation ignored.
• Netflix – Started with mailing DVDs, then pioneered streaming.

Key Metrics

| Metric | Definition |
|--------|------------|
| **Total Addressable Market (TAM)** | Total demand for a product/service. |
| **Serviceable Available Market (SAM)** | Portion of TAM a company can realistically serve. |
| **Serviceable Obtainable Market (SOM)** | Market share a company expects to capture. |
| **Customer Acquisition Rate** | New customers / Total leads. |
| **Market Penetration Rate** | (Current Customers / Total Addressable Market) x 100 |

Profitability Metrics for Tech Companies

For tech companies, the most important factor for profitability is margins.

Customer Acquisition Cost (CAC)

• Formula:
  CAC = (Marketing + Sales + Customer Support) / Number of New Customers

Churn Rate

• Formula:
  Churn Rate (%) = (Customers Lost During Period / Total Customers at Start of Period) × 100

Customer Lifetime Value (LTV)

• Formula:
  LTV = (Profit per User per Year) × (Average Customer Lifetime)
  or
  LTV = (Annual ARPU) × (Gross Margin %) / (Churn Rate)

Where:

• ARPU = Average Revenue Per User
• Gross Margin = (Revenue - Cost of Goods Sold) / Revenue
• Average Customer Lifetime = 1 / Churn Rate

LTV:CAC Ratio

• Magic Number: 3:1 ratio is ideal.
• Below 1:1 → Losing money on customer acquisition.
• Above 5:1 → Underinvesting in growth.

Additional Metrics

| Metric | Definition |
|--------|------------|
| **Burn Rate** | How quickly a company is spending its cash reserves. |
| **Payback Period** | Time to recoup customer acquisition costs. |
| **Formula** | CAC / Monthly Gross Profit per Customer |
| **Viral Coefficient** | Measures organic growth from referrals. |
| **Formula** | (Number of invites per user) × (conversion rate of invites) |
| **Unit Economics** | Revenue and cost per user/unit. |
| **Formula** | LTV - CAC = Marginal Profit per Customer |

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