 Hi everyone, I'm Eden and thank you for joining today's webinar, Economics 101 for Product Managers. In this session, we'll be talking about the core economic and financial ideas that you need to be in control of as a successful PM. The session will be longer than 30 minutes, maybe about 40 minutes. So if you don't have the full time, that's fine too because everything is going to be published for offline viewing on Product Schools YouTube channel. I can imagine that at least some of you are passionate about finance and economics, but maybe others feel a little edgy about these things and might be asking, what does this have to do with being a PM? I can tell you one thing. By the end of this webinar, you'll have little doubt as to why you should care about economics as a product manager, and you will also have a strong grasp of three key elements, profit, cost, and revenue. As for me, I live near Seattle in the US state of Washington, and I come from a background of computer science and business strategy. I started out as a software engineer and later lead, but for the past decade, I've been in product and people management roles across several well-known companies, and I recently joined Google to manage security and privacy experiences for devices made by Google. If after this webinar, you have any questions or any follow-ups, you're more than welcome to get in touch with me on LinkedIn, and let's get started. Our short economic tour will begin with what makes business tick. It's the strongest force in business and a central reason why businesses like yours and mine invest and hire people to create new products and services. The force that I'm referring to is profit, and profit is defined quite simply by how much money a business brings in minus the amount spent by the business. In other words, profit is the revenue, how much the company takes in minus expenses or costs. This is how we measure profit across an entire business, but we can do the exact same thing for any component or product line of the business. So you can think of profit for the Coca-Cola company. But if you manage just one brand, say Diet Coke, then you can apply the exact same concepts to that one brand or one product. When profit is positive, it means the business is generating income to its owners or shareholders, and if profit is negative, it usually means the business is depleting its assets because more is leaving the company than coming in, just like a household. We could be fine to spend more than we make for a while, but eventually, we may run out of money and that never ends well. So it is our responsibilities as managers of a part of the business to make sure that our products safely generate more revenue than they cost our organization. When we talk about profit, the key point to realize is that you can never have too much of it. We can blame greed for that, but in reality, it's not so much about greed. It has a lot more to do with the fact that investors expect to make a return, and let me try to demonstrate this through an example. Let's assume we have a company called Robot PM, and they have a product that can replace some PMs with robots for just a fraction of the cost. Obviously, as PMs, this would be our worst nightmare. They expect to make $1 million in profit for every foreseeable year. So Robot PM would be like a machine that's supposed to output or produce $1 million a year to its pool of shareholders. How much money is such a company or such a machine actually worth? Well, we need to remember that the $1 million that the machine should produce next year isn't worth as much as $1 million that I can have right now. It's not certain, it's not available now, and so we need to discount those future profits by a certain percentage. Let's use 10% as the discount rate, and if we do that, it means that $1 million of profit that Robot PM should produce next year are worth about $900,000 today, so that's about 10% lower. And likewise, $1 million in profit that Robot PM should produce in two years, now it's worth 10% less than the $1 million that they should produce next year, and that amounts to just a little over $800,000 in today's money. And we can go on and on and add up the expected future profits of the company and backdate them to today by discounting every year by 10%. Now, if we do that, all of these expected future returns, they don't sum up to infinity because every subsequent year is actually worth less and less and less to an investor today because of the risk and because that profit only exists in the farther and farther future. So a company like Robot PM is basically worth $10 million today because that's what happens if you keep adding these expected future profits and discounting them by 10% a year. Now, if Robot PM has 1 million shares, and investors generally agree with the assumptions that we've seen about the company's future profit and the discount rates, then every share should be worth about $10. But as we know, the world doesn't stay put. Over time, many interesting things can happen. We can have an inflationary cycle maybe in the global economy, as we have right now, or maybe interest rates are rising and investors can make a bigger return just by keeping their cash in the bank or investing their cash in securities that are far safer than Robot PM stock. And perhaps there's a new competitor in town and investors fear that the company's future profit projections have become a lot riskier. In any one of these cases, my friends, the discount rate, which we accepted as 10%, would have to increase. For example, if there's inflation on the rise, then $1 million that Robot PM will make next year is worth even less than we previously thought because by the time we get to that future, this money will buy us even less. And similarly, if a new competitor comes along, the expected profit of $1 million per year is now more risky because what happens if Robot PM loses market share and profit doesn't even reach $1 million in a few years' time? How do we account for this? Same thing, by using a higher discount rate, in this case, to compensate for the higher risk. And as you can see, if investors have to adjust their discount rate for Robot PM, in our example, only by 2%, so from 10% before to 12% now, then the company's valuation drops from $10 million before to just a little over $8 million. And this is happening even though the company continues to project and expect the same annual profit exactly as before, put differently. Discount rates can go up and they often do for reasons that companies don't really control. And the result of this can affect the company by lowering its value, which means lowering its stock price. However, there is something that companies should try to do to compensate for this and that's becoming more profitable. In this case, if Robot PM manages to improve its business and can convince itself and its investors that future profits will be not $1 million a year but actually $1.2 million a year, then all of a sudden its current valuation will go back up to $10 million, even though we're still using that higher discount rate of 12%, which as we said, this is outside of the company's control. To summarize, there are at least three reasons for companies to not just retain but increase their profit. The first reason is simply to uphold the company's valuation and share price when the economic conditions cause discount rates to go up. The second reason to increase profits is to retain the company's value if investors believe that future profits have become more risky. And this can be because of increased competition, perhaps slower sales growth, possible future regulation that can harm the company, maybe technological disruption or anything that can hurt the company's success in the future. And number three, if you've ever bought stock, you probably did it to sell it for more later. So as a shareholder, which makes you part owner of a company, you want to see profit go up over time so that your shares will rise in value. So now that we understand how profit works and why it matters, it's time to talk about costs or expenses. If we hold everything else equal, the higher our costs, the lower the profit will be. And costs are especially relevant because unlike revenue, every employee at every company affects costs. We cannot say, for instance, that every PM is expected or even capable of generating revenue or sales. What if you're a PM in HR or in IT, you're not responsible for charging a price necessarily for your product. But when it comes to costs, this is every manager's business. We're always responsible for costs because we direct how and what the company's resources are spent on. One common way I think to consider costs is to break them down by fixed costs and variable costs. Fixed costs, they're generally constant regardless of how much stuff the company makes ourselves. In tech and especially in the software world, we spend the same on R&D regardless of how many customers end up using our software. The marginal cost of producing one more unit of software is often zero. Doesn't cost anything to copy software and give it to one more customer. But beyond R&D, other fixed costs include management overhead. That's the various business functions that every company needs. The cost of our facilities, utilities, think of things such as office space and labs and the gradual loss of value of the company's equipment, which is what accountants call depreciation. If robot PM purchased lab equipment, for example, say for $3 million, and it's going to lose its value over 10 years gradually, then those initial $3 million are actually not considered a cost. They are considered an investment. However, we will be costing out this investment over 10 years. So every year, we're gonna recognize $300,000 of that or 10% as a fixed cost or what we call depreciation. So that's an important form of fixed costs. In tech companies, as it happens, fixed costs tend to account for the majority of all costs. But we should not be misled by the term fixed. Fixed doesn't mean that the cost cannot be adjusted. Whenever, for example, you hire people, you increase your fixed costs. In practice, being a fixed cost implies that you can easily increase the cost structure, the baseline spending of the company, but without necessarily contributing to more sales or revenue. And that's a caveat that we should keep in mind. It's very easy to increase fixed costs, but without increasing profit and in many cases decreasing them. But of course, some costs are directly related to sales. The more we sell, the more variable costs we have. Or vice versa, the more we spend on certain variable costs like marketing, the more we will likely sell. You can think of these costs of variable costs as costs that fluctuate month to month depending on business volume or on product usage. Let's see some examples of these things for the case of Robot PM. Let me start by telling you that my imaginary startup, Robot PM, is based in Atlanta and they have 29 employees. Their R&D team costs $4 million a year or an average of less than $300,000 per R&D employee. This is a payroll cost or what it costs the business to employ this workforce. It includes various business taxes, insurance policies, pension plans, paid leave bonuses and so on and so forth. Now, as a PM, I highly recommend to find out what this number is for your R&D team. Usually the financial analyst that works with your department will have a nice round number that they use to approximate the payroll costs per employee. When it comes to management or administrative overhead, these also comprise mostly of people's salaries but they also include an ancillary like business travel or hiring an external audit firm to ensure that your company complies with certain regulations. When you go out and you talk to your financial analyst about this, it's possible that instead of giving you a dollar figure, they might just tell you to add a certain percentage of overhead to whatever your R&D costs were. And this percentage approach could also apply to other fixed cost numbers like the next one. So you can see robot PM is spending $400 a year, $400,000 a year on their offices and their management is obviously frustrated when employees aren't showing back at the office. And even if everyone continues to work from home, a part of this expense should still be attributed to the PM's cost analysis. So this is a fixed cost, we have to account for it whether or not it's being used. For variable costs, robot PM uses an external vendor to provide customer support. And they have an arrangement where the vendor supports up to 10 customers for a million a year and for each additional 10 customers, they'll charge an additional one million a year. This means that support costs will generally scale up with the volume of customers. Another expense has to do with cloud computing. Robot PM uses a public cloud provider for hosting their SaaS platform. And that costs them about 20 grand per year for every customer. They're gonna wanna make sure that the way they price their product fully captures this variable cost as well as any other variable cost. Physical supplies come next. If you operate an e-commerce or retail business, this may be your biggest expense on cogs, cost of goods sold. That's how accountants call this. Last year, Amazon made about 470 billion in sales and spent more than 270 billion on cogs alone. This was what they paid for all the products they sold and the cost of sorting and warehousing and packaging and delivering all these goods to their customers. However, if you're in software like Robot PM, you probably have few of these costs because you have few physical inputs to the business. And lastly, sales and marketing can usually be seen, I think, as a variable cost. You can tune it on short order to respond to changes in the market or the broader business environment. And for Robot PM, they figured that it costs them about 120Ks in advertising and sales expenses to acquire one new customer. So this is the figure they're going to use. And here is what the costs look like for Robot PM when we chart them out against the number of customers. The blue line on the top, this reflects the total cost based on the number of customers. It starts out at about 10 million. This is the company's basic cost of doing business or just keeping the lights on, if you will. These are the fixed costs. But after this, they can service 10 customers without spending anything more, even beyond that. Their costs rise up very gradually, as you can see. So this is a business that can benefit greatly from scaling up its customers, which is what that green curve on the bottom tells us. The green curve shows us the average cost per customer. So with 10 customers, the average cost looks like about a million dollars. With 20 customers, this cost drops to 60% of that. And it keeps dropping as more and more customers join the platform. I should add though that fixed costs, they don't scale endlessly. More customers will eventually require new product features and additional investments in technology and business processes, which will lead to needing more permanent staff and therefore higher fixed costs. So just be aware that fixed costs scale, but not without limits. A great exercise for every product manager is to come up with a chart like this one, because it's gotta give you a very clear idea for the true costs of the product that you're building. Of course, the flip side of cost is revenue or sales. This means money flowing into the business from selling its products and services. Many are gonna have you believe that revenue is far more important because there is only so much that you can improve by optimizing and reducing costs, whereas revenue is potentially limitless. But in reality, an effective manager has to regularly balance between the two. How much weight you're gonna put on every foot will depend on how far your product is into its life cycle and some external conditions like competition. But the key point is that you can't manage one without considering the other. Another thing worth pointing out is that you usually have a lot of expense categories and comparatively just a few revenue streams. So if you think of a company like Ford, the car maker, they employ hundreds of thousands of people and they receive services from thousands of suppliers and vendors, but their revenue is much simpler than that. They sell cars to dealerships for a one-time fee and that's pretty much it. So it's vital that you strategize and design your revenue architecture very carefully because it needs to make up and exceed all of those myriad costs. And the way we do this will be through a combination of different business models, different ways to capture the value that we're creating. Each one of these business models will have its own pricing scheme attached to it. Pricing is outside of today's scope, but at the very least, we wanna make sure that we're charging at least as much as our variable costs plus a certain portion of our fixed costs because otherwise we'll be losing money on every sale and that's not only foolish, but believe it or not, in some cases, it's even considered illegal. So let's take a look at some of these common business models and as we do that, I want you to consider if and how this can apply to your current or future products. Let's start with the one-time sale, okay? This is basically the supermarket model, okay? You go, you purchase groceries, you pay for them and that's it. They're yours to keep forever and it can also apply with traditional software products where you buy a perpetual license to use the software as much as you want. That's a one-time sale. The next one, subscriptions, right? If you're a subscriber to anything from Netflix to a smartphone upgrade plan and they charge you regularly, then congratulations, you're part of this business model and the charm of it is that if your customer retention rates are high, you're almost guaranteed to a future revenue stream that takes very little effort and investors tend to favor businesses that know how to perfect this. Before we move to the next business model, please remember these options are not mutually exclusive. In fact, you're encouraged to find a combination of many of them, the more the merrier with some limitations, of course. Pay as you go. This is a relative newcomer in the digital age because it requires sophisticated billing systems that let you charge your customers based on exactly how much they consume of something. And it's typically how your utility, for instance, charges you for electricity. But increasingly, we're seeing this in newer domains like cloud computing and even how certain software licenses work. If your customers are amiable to this idea of having an open tab with you, then that's a great way for your business to reduce the customer anxiety and hesitation that usually comes with additional spending. But of course, you wanna make sure that there aren't any nasty surprises when the bill eventually arrives. A la carte, that's next and taken straight out of the world of restaurants. And this is the concept of pricing individual items differently and letting the customer order a collection of items that suits their needs and tastes. And this is what they get charged for. One of the nice things I think about a la carte is that it creates strong accountability. Why am I saying this? Because if somebody purchases an item, it means that item is providing value. Otherwise they wouldn't be paying for it. And if something doesn't sell, it means it probably isn't worth doing. So there is very strong accountability for every item on the menu. The razor blade model or freemium model is the idea that you give something for free or very cheaply. But then after a while you start charging the customer for using the initial product or for extending what you can do with it. So it's like a razor blade which you get for a very low price but then have to pay a recurring and heftier sum for the blades themselves. And this can be a great way to attract new cost conscious customers. But you also run the risk that you're investing in many customers who ultimately decide not to upgrade or not to spend money on extra supplies. So I recommend this but not as your only or main way to generate revenue. Ads, maybe I'll skip over ads because I'm sure you're familiar with the idea of monetizing on users' attention but let's talk about the next two. Affiliate and Commissions which are kind of similar. Here the idea is that your product helps another company or another individual generate revenue for themselves and then you get a piece of that. One contemporary example that I can think of is Substack which I think charges 10% or so from their creators on whatever revenue the creators subscribers pay the creators through Substack's platform. The good thing about this is that you have a shared incentive between your business that's providing the service and your customers who are getting the service. You both succeed or fail as one. And as you can imagine, this is more of a B2B model although Substack can also be seen as maybe a B2C. And last but I think most importantly is the bundle, the idea of bundling, multiple products being sold as one. If you think of Amazon Prime, a service that most US households are subscribed to, it's that the original and central promise of Prime is fast and free shipping for Amazon orders but Amazon also throws in a lot of other value bundled into this Prime package. And one such item is Prime Video, the streaming service that they don't sell separately. Amazon is investing billions every year in original and licensed content for Prime Video but they can't really tell if it's paying off because it has no price. It's not sold outside the bundle. And a lot of PMs manage products that fall into this category or features. You don't charge for them separately so it's hard to tell how much revenue they're generating and by extension whether they contribute to the company's bottom line to profit. And I'm not saying this is a right or wrong approach because there are strategic considerations here but one thing you can do and I encourage you to is to go through an exercise with your colleagues and customers if you can and genuinely ask how much would customers pay for this if we sold this product a la carte and it wasn't part of a bundle. I'm sure it takes time to do and you need a good sampling of not only current customers but also potential customers, maybe ones who didn't buy the bundle but would buy the standalone product if you offered it to stand alone. And doing this will give you an idea of how much value your product is generating and whether you should be doing more or less of it. Cool, so we have an idea of how and in what ways our business or product line will generate revenue and this brings us to forecasting which is estimating what that revenue is going to be. Notice that we forecast revenue but we don't forecast costs and that's because we plan costs. Costs are something that we have good control over or at least we should. It's endogenous to our organization and up to us. Revenue unlike costs is exogenous. It's caused by outside factors like the market which we can influence but we can't directly control and this means that estimating revenue is far more difficult especially if you don't have historical data to draw insights from. But challenging and flawed as it is, a forecast is essential together with an estimate of our costs because it tells us how much we need to sell to meet profit expectations. There are entire books on the topic of forecasting but I'll give you my top three tips on how you should approach this as a PM. And we will start by producing three forecasts. Each of them for the next two or three years. The first of these forecasts should be a pessimistic one. This is what your revenue would look like if the product struggles. It's not necessarily a total catastrophe but it should represent something quite disappointing. If your product hasn't yet launched and you don't have any committed customers then this is the scenario where in this scenario it's basically possible to have very few sales in your pessimistic scenario. Next you'll have your middle of the road forecast and this represents an okayish reality. Nothing terribly great or terribly bad. If you are an independent outside unbiased bookie having to make a bet on what's the most likely outcome this is the forecast you would go with the middle of the road forecast. And lastly put yourself in the shoes of an avid entrepreneur who's super passionate about the product and produce an optimistic forecast that shows what success looks like. Make sure it's optimistic but don't lose grip of reality. And when you have all three forecasts now you create a fourth and final one which is a weighted average of the other three. And I would suggest that if your product is new and unproven you use this 50-30-20 ratio in favor of the pessimistic scenario and that's because products fail at the far greater rate than they succeed new products. And after you're done making this forecast and you already know how much your business is spending you can derive a profit forecast. Of course profit is revenue minus expenses and with your profit forecast you can tell if A, you're profitable and B, how profitable you are relative to your revenue so you take your profit you divided by revenue and this is what we call the profit margin and you can check with your financial analyst what sort of margin is good or expected for your business. But what happens if you don't like what you're actually seeing or your manager doesn't really like these numbers? Unfortunately I don't have easy answers but I plead you not to make the mistake of ratcheting up your forecasts just to please the spreadsheet. The numbers that you don't like might hint at the fundamental problem with the business model and if we cover it up it's certainly not going to fix it so please avoid this temptation. Third, producing a forecast doesn't mean that our work is over because in fact now we have something we can go back to on a regular basis say quarterly and we can confront it against actual sales figures. This is critical because forecasts are always wrong and the only way to make them less wrong is to look back and learn what we missed and how we can correct for that in future quarters. So please make sure to compare expectations against facts and then calibrate your forecasts accordingly. Producing accurate forecasts which are within let's say 5% of reality takes time and practice and even then it's often elusive. So my bonus tip is to always be humble when it comes to forecasting realizing that a lot of unexpected events can rattle our plans but at the same time persisting through with forecasting because that serves as your good old compass in the middle of the high seas where you cannot see land and all you have is the compass, okay? No GPS, that's essentially what your revenue forecast is. You've made it almost all the way and I just gave you a lot of new information to process and I urged you to do things that maybe you've never considered as product managers. So let's take a moment and summarize the key takeaways and what this means to you as a product manager. As we've seen, businesses need to be profitable. This means taking in more money than they're spending on everything that costs money. Failing to do this, it's only gonna be a matter of time until lenders and investors will lose faith in the company and it will sadly run out of money to pay salaries. But barely eking out a profit or holding on to yesterday's profit is not enough. Businesses are inherently very risky affairs. Investors that look for a modest, predictable return on their investment, they usually have other places to go to. So when they buy ownership in a company, they expect to see profit rise over time and if that doesn't happen, just look at Twitter and Elon Musk to see what kind of trouble companies can get themselves into. As PNs, we have our own little kingdoms and in these product territories, we're the chief executives. That means that we're ultimately responsible for revenue, for costs, for of course profit. If in your case, revenue doesn't apply to your product, maybe because your product is a feature or part of a bundle or it's an internal product that doesn't really get paid for, then you're not charging for it, but you can and you should figure out what your customer or user would pay for it if they had to with real dollars and cents. Because ultimately, we are all in this profession of turning one plus one into something greater than two. And that's what it means to be profitable. We talked about fixed costs and in industries based on intellectual properties such as software, those are the lion's share of costs. This means that to be profitable, we have to have a good amount of customers and to capture the value through a mix of business models and prices that will make sense to our customers. We gotta cover our expenses. As product managers, it is we that need to discover and fine tune all these relevant business models that will let us capture the full extent of what we bring to the market. And last but not least, look, profits are the lifeblood of a business. There's no doubt about it. They're like a pumping heart in a human body. If the heart fails or if it starts beating irregularly, our survival is at risk. So we always want a healthy heart and we want to maintain it healthy. But having a healthy heart isn't the purpose of human life. Likewise, being profitable is fundamental to a business but it's not the core purpose. The purpose of a business is to serve all its stakeholders which includes customers, employees, the local community, the environment and more. Therefore, in our pursuit of generating profit and keeping the business running profitably, let's always keep in mind and look after those who make our business possible and successful. I hope you found this session interesting and valuable and thank you so much for your time. Thank you.