A couple weeks ago, we were assigned the following reading as part of our marketing course: http://www.firstmonday.org/issues/issue6_12/ilan/index.html. This article examines the assumption that production of software involves low marginal costs.

As someone who has started a software company that is in the process of developing its first product, I found this article fascinating. The traditional assumption in the software business is that once the money has been spent to develop a product, the cost of replicating the product is essentially zero. This implies that there are no *variable costs* associated with a software product.

The article referenced above challenges this assumption, by arguing that software distributed over the Internet has not been **produced** until is has been downloaded. For example – if there are no downloads in a given day, production is zero. If there are 100 downloads, 100 units of software have been produced. Further, the author argues that **distribution** of software is the process of driving traffic to the website where it can be downloaded.

By adopting these views, it is now possible to assign a Cost-of-Goods-Sold (COGS) to a software product. I think that the Internet Distribution Chain is especially useful in calculating the true cost of production and distribution of software. Simplifying the equations used, we end up with:

Cost per Acquisition = Total Cost / Number of Customers

Basically, you can compute the cost based on the total amount spent on driving traffic to a webserver divided by the number of customers acquired through these efforts. For example, suppose I spend $1000 on Google AdWords for 1,000,000 impressions. I get a 2% click through rate, or 20,000 hits. With a download rate of 5%, my product ends up being downloaded by 1,000 potential customers.

Of these 1000 downloads, 5% become customers, for a total of 50 customers. My total cost is $1000, and I got 50 customers. Therefore, I spent $20 to acquire each customer. This $20 is the variable cost of producing and distributing my software! If my product only sells for $19.99, then I might as well close up shop and go get a real job (or work for the government)!!

The key takeaways that I took from this article are:

- Sometimes the underlying assumptions of an industry need to be re-evaluated and challenged. This opened my eyes to a new way of looking at delivering web-based software.
- When determining how to price software delivered over the Internet, using the Internet Value Chain to estimate costs is extremely helpful. This will ensure that products are priced profitably.

As a final thought, in the calculations used above, if you can figure out a way to drive traffic to your site for zero cost, then the variable costs for distributing your product also go to zero!