How much do you think it costs to make a pair of Nike shoes in Asia?

Food and clothing, anything with complex supply chains tend to be cost based pricing. As a rule of thumb, it's x3, maybe x4 for a well-branded item like Nike or Calvin Klein. Most innovations are on supply chain. E-commerce was such a big thing because it could cut out one middle man and lead to 30% price cuts or profit margins, and yet all these online shops ended up appearing in malls anyway.

Software is price based costing because there's no fancy supply chain. iPhones may be somewhere in the middle, hardware tends to have the worst of both worlds - high fixed costs and lots of middle men.

A McDonald's may have franchises and may own some restaurants internally, but they don't want to lose money, so they may base it on the lower profit margins - it makes no sense for a burger in one spot to be $4 and a burger in the franchise to be $5; both need to be $5.

Generally luxury brand do use more expensive parts, whether or not those parts add to the quality. And they do have higher profit margins. But the retailers, distributors, etc still take a 30% cut or so. And in the end, Louis Vuitton is still probably making lower margins than Plants vs Zombies.

So if you build a SaaS app, your company will incur a number of costs. You need to pay AWS for hosting, your support team, your sales team, your annual team retreat to Mexico, etc.

When you start measuring your profitability you then will separately measure the profitability of your product vs. your business.

The profitability of the product is your gross margin - essentially your revenue minus your cost of goods sold (COGS). Not all of your business expenses fall into here - only the costs that directly relate to supporting the product.

So… - Your annual team retreat won’t hit your gross margin: this cost isn’t essential to supporting the product - Your AWS costs will hit your gross margin (if you turned off AWS tomorrow, your product stops working) - Your Slack bill does not hit gross margin - Your product & engineering team normally doesn’t hit gross margin, but DevOps does (because DevOps is seen as essential to supporting the product while R&D is not)

Now in reality it does get a bit more messy. Businesses might allocate a % of engineering costs to GM to account for essential maintenance and bugfixes.

So the way to look at it is: what costs are essential to the continued delivery of the product and what are nice-to-have?

And then operating margin essentially considers all of the non capital costs. It’s a more comprehensive view of all the businesses revenue and costs.

For a smaller business it’s very normal for operating margin to be razor thin or even negative. Because just one or two engineers could cost more than your entire revenue.

But this entire concept is why software companies have historically been able to be unprofitable for so long. A business that’s losing a ton of money every month might only be losing that money because it’s investing very heavily in R&D. Or maybe it just moved into a new

As you scale the relative impact of a lot of those costs will go down significantly - e.g. your engineering team cost will stop being 300% of your revenue and will start being 20% (you don’t hire engineers linearly with growth).

So the theory is that if you can find a software that has: - a big market - great gross margin

Then with just some upfront cash investment you can provide the business enough runway to grow the revenue to the point where the impact of some of these expenses becomes very small. At a certain scale, a product with 50%+ gross margin will be producing so much cash that it can pay for the rest of your operational expenses without further investment.