The price of a typical gadget reflects two factors: the cost of making it and the price its inventor is charging for the intellectual property in it. Often the second can be many times the first (as in the case of an Intel processor chip, for example, which costs just a few dollars to make but can sell for hundreds of dollars).
But if you don’t charge for intellectual property, gadgets can get a lot cheaper, and potentially reach a much larger market. That’s the philosophy behind “open source hardware”, and it’s something I’m practicing in one of my side projects, an aerial robotics community/company called DIY Drones that does autopilots and autonomous blimps (one of our blimp controller board shown above). We give away all the intellectual property (schematics, PCB files, firmware, software, assembly instructions, etc) but sell the completed units, charging only a set markup on the cost of the hardware itself, which we disclose.
But what’s the right markup that leads to the lowest cost for consumers and still makes money for us? That’s what we set out to find out. With the help of some open source hardware experts (Lenore Edman, Limor Fried and Phillip Torrone, plus this good overview), here’s the business model we settled on:
The Forty Percent Model
This model is based on a simple rule: transparency about costs and a choice between paying us to make the product or doing it yourself.
The basic process is that we list all the components and other costs of our product (an autonomous blimp in this case) and links to where you can buy them yourself, along with instructions on how to put them together. If you want to do it yourself, or perhaps already have some of the parts and don’t need ours, go for it!
But if you want us to make it for you (guaranteed to work), because it’s easier, safer, quicker, etc, we would charge you a 66% markup, which give us 40% profit.
(Aside: People often confuse markup and margin. Think of it this way: if a product costs $1 and you mark it up to $1.66, you have a 40% profit margin. $0.66 is 40% of $1.66.)
Let's say you want to make your own company and compete with us, charging a lower markup to undercut us in price. Excellent—consumers win! All of our source code and PCB/schematic files are open source and licensed to allow commercial use, and if someone else is making the products, it costs us nothing. If you can make it cheaper or better than us, that’s great—the market will grow and we’ll have more people using our stuff. The only requirement of the license is that you credit us for the design and link back to us.
The Third-Party Catch
Okay, the above is a great model when you’re just selling from your own website. But what if you want your product sold through third-party retailers, who can collectively have far greater reach than any one company? Then the economics get a little more complicated because you need two 40% profit margins, one for you and one for the retailer.
So the markups now go like this: $1 –>$1.66 –>$2.76. Furthermore, you must avoid “channel conflict” by undercutting your retail partners, so you need to charge pretty much the same price everywhere, including your own site. So your $1.66 product must now be priced at $2.76, which is a 64% profit margin for direct sales.
We thought that was too high and would feel like a ripoff when we disclosed all the costs to our customers. What to do?
The answer came in limiting our pricing transparency—we wouldn’t disclose our volume discounts. Because we buy in bulk, our costs are actually much lower than the single-unit costs that we post and would be available to a DIYer. So it’s not total transparency, only as much transparency as we can practically offer given the fact that those discounts change from order to order and suppliers don’t want the exact size of those discounts made public.
So we’ll post single-unit prices available to all, even though we actually pay less for most items. We can’t disclose how much less, but it should average about to 30-40%.
The final model: Semi-Transparent Pricing
This is what we settled on:
- Disclose the prices for components in single-unit quantities and link to sources people can buy from, but do not list our volume discount prices.
- Set our direct sales price as the sum of the single-unit prices (call that “apparent cost”) plus 66%. However, our actual costs are lower due to our volume discounts, so our actual margin is higher. The point, however, remains: we will only charge 66% more than it would cost you to DIY.
- Our wholesale price is the apparent cost, allowing retailers to add the 66% markup for themselves. Our own profit comes from the difference between the apparent cost and whatever our real cost is with volume discounts. The harder we push on those discounts, the more money we make.
You model seems like a viable one, but only if your R&D costs are close to zero. How do you expect recoup the sunk costs incurred to develop this product? Let’s say a hypothetical product has a marginal cost of $1, but you spent $1 million developing it (wages, test PCBs, lab equipment, electricity, etc.). Let us further say you hope to amortize this cost over the first 1 million units sold. This would price the item at $3.33 ($1 marginal cost + $1 share of sunk cost + 40% profit margin).
However, you have chosen to make the hardware open source. Someone else can (almost) immediately enter the market and price the item at $1.67, since they don’t have to recoup the sunk costs. In a perfectly competitive market, you will loose out to this entrant who is producing an identical product and charging less, or you will be force to re-price downward toward $1.67. Either way, you have a $1 million bill that will be tough to pay off.
Posted by: Ken | January 12, 2009 at 09:59 AM
@Ken
The whole idea of open source is that a lot of the innovation is outsourced, right? Most of the costs involve maintaining ties with a community of people outside of the firm, and figuring out which contributions have the potential to bear fruit.
So it may be that open source hardware would result in less direct investment in R&D, but that doesn't necessarily mean that there will be less innovation as a result.
Posted by: Adam | January 12, 2009 at 01:09 PM
Yes, what Adam said. Open Source hardware (and software, for that matter) only works when people are willing to donate the R&D. Possibly not the best way to invent a cancer drug, but it works great for the kind of stuff we're doing, where the total R&D required is measured in a couple person-months spread out over many people and months.
Posted by: Chris Anderson | January 12, 2009 at 01:16 PM
@Chris,
At the risk of being a contrarian, I'd say that there's even an argument to be made for making cancer drugs this way. We've seen examples where open collaboration made the difference in the medical world, such as with SARS. It doesn't seem implausible to me that a pharmaceutical company could actually come up with new medicine if they attempted to draw on the medical community and left the rights for the resulting product in the public domain.
But that's a whole other discussion :)
Posted by: Adam | January 12, 2009 at 05:45 PM
Regarding the medical field. The entire economic dynamic of the medical field relates entirely to government control of the approval process, and the fact that all medical treatments and care are entirely controlled by governments in major countries.
Thus, you can't just make some drug for rheumatism and start selling it. The entire economic model of pharmaceuticals relates to gaining FDA (in the Usa) approvals, the now-formalised "testing" milieu, and so on.
Casual thinking about "open source medicine" is valueless unless it relates to the central reality of pharma, which is simply that there is a "government-pharmaceutical complex" and all costs and economic aspects relate to that.
(If you posit a completely libertarian system where medicine and pharmaceuticals are completely not-controlled by government, then sure you can ask questions like "what business model blah blah research blah blah." But all of that is utterly irrelevant in the current world mileu of a "government-pharmaceutical complex" .. all pharma and medical pricing and economics is entirely and totally about working within the government-controlled situation.)
Regarding the open source blimps:
Chris, you seem to be trying to get a the "real" ("supply side", if you will) "price" of something, what it "actually costs" or is "really" "worth."
Is that right?
For instance you talk about the costs of parts (say $4), the cost of paying a worker to assemble (say $6), the cost of packaging (say $5), the cost of delivery (say $5) for a total of $20 and then a "markup" of $5 for a price point of $25.
But does this have any reality?
There is nothing, whatsoever, at all, in the world that is based on the "real" "what it costs" cost. Nothing, ever, not once, has been sold, there has never been a Sale of any one particular thing made, based on "supply side", "actual" "value".
For instance .. what's the most expensive thing you own and/ot have ever bought? I'm guessing it's a piece of real estate, say a house.
The "actual" cost of a piece of land (presumably, the cost of building a wire fence and some paperwork) is trivial (say $2000), but an acre of land can be worth $100000s, even millions. The price purely depends on one and one thing only, of course: the demand. (The demand divided by supply, if you like.)
If you tried to apply your type of calculation above to a "piece of land", nothing would make any sense, there is no starting point.
And this applies to Every Thing ever sold form a carrot in 1300 to a antigravity boot in 2300. New GM and Ford station wagons sitting at the docks are now very cheap and getting cheaper by the day. To make them cost a certain amount in a pension fund (a few thousand bucks), a certain amount to meet government compliance (a few more thousand bucks), purchase of some steel (few hundred bucks) and so on, leading to some total "$x".
But that total, "$x," has zero, absolutely no, nothing, none whatsosver influence over the price the Suburbans are sold (or not sold) for today in shops. That "$x" figure is of no more importance than astrology. It's just an "interesting figure" that you happened to arrive at through some (completely irrelevant) process, the details of which mean nothing.
If you offer the product at $200, and ... nobody buys it, one and only one thing can happen, the price will come down, let's say to $100, and then people will buy it.
If the product sells incredibly well at $200, someone will just buy them all from you and sell them at $400.
The price can only be, what it is ... the natural price set by the market.
(Nothing is more "open source" than price setting! the biggest corporation in the world has utterly no, zero, none whatsoever, power over setting prices.) (Putting aside situations in which government is involved, of course.)
Could it be that you have been completely wrong-minded in your "supply side" calculations? ie, issues like the "actual" cost, markups, etc, mean utterly nothing in determining the price of a sale: price is and can only be determined by the market, with absolutely zero reference to any 'supply side" facts (or indeed to anythign else).
Johnny
Posted by: Johnny | January 14, 2009 at 10:06 AM
Wow Chirs, love the idea.
And Adam - yep I buy the Cancer idea. Johnny - Man that is hard core, and yes I agree.
But back to the cancer idea.
Let's talk more about open source cancer solutions, and let's call them solutions at this stage. The Closed innovation system is run by the Pharma/biotech model which is astronomically expensive, massively risky and rarely produces long term sustainable positive health outcomes.
An open sourced model would include natural western methods and Indigenous (Chinese Indian,African) medicines.
These medicines are in effect already open sourced!
The only cost is the cost of the ingredient, which is usually a natural or semi manufactured ingredient. Interestingly, these 'solutions' are often as effective if not more so than Western oncology solutions and are mostly safer - with over thousands of years of 'clinical' evidence. Albeit not in a form that we may be prepared to accept.
So the real issue comes back to the challenge all open innovation models come up against. How can they survive and flourish when the incumbent (Pharma/Govt regulators) has so much to lose?
Posted by: Mike J | January 21, 2009 at 02:13 AM
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Posted by: zhuqian | January 21, 2009 at 08:53 PM
Interesting read but the idea still has a long way to go.
Posted by: Penny | January 29, 2009 at 12:58 PM
It is amazing how quick margins get out of hand as they get doubled. I made the comment on a item manufactured in China (a bicycle) A $300 retail bicycle costs the retailer $180 and he nets 5% =$15. The Wholesaler pays $108 and nets 3% 180 = 5.40 . The retailer nets 5% and the wholesaler nets 3% = and the manufacturer nets 5% of 108 $5.40
Wholesaler and retailer both in the US make 4 times as much profit as the manufacturer...
Posted by: Rick Netten | February 09, 2009 at 09:26 PM
On a slightly different but not unrelated tack ... Asus offer a sub-notebook at about £290. If you choose Linux, you get 20gb solid state memory but if you choose Windows XP you only get 12gb. Now, Linux takes up less space than XP ... so the reason for the difference can only really be the Microsoft licence cost ... VIVA OPEN SOURCE!
Posted by: On the Money | February 12, 2009 at 12:17 AM
On a slightly different but not unrelated tack ... Asus offer a sub-notebook at about £290. If you choose Linux, you get 20gb solid state memory but if you choose Windows XP you only get 12gb. Now, Linux takes up less space than XP ... so the reason for the difference can only really be the Microsoft licence cost ... VIVA OPEN SOURCE!
Posted by: On the Money | February 12, 2009 at 12:17 AM
On a slightly different but not unrelated tack ... Asus offer a sub-notebook at about £290. If you choose Linux, you get 20gb solid state memory but if you choose Windows XP you only get 12gb. Now, Linux takes up less space than XP ... so the reason for the difference can only really be the Microsoft licence cost ... VIVA OPEN SOURCE!
Posted by: On the Money | February 12, 2009 at 12:17 AM
Johnny wrote:
>Could it be that you have been completely wrong-minded in
>your "supply side" calculations? ie, issues like the
>"actual" cost, markups, etc, mean utterly nothing in
>determining the price of a sale: price is and can
>only be determined by the market, with absolutely
>zero reference to any 'supply side" facts
>(or indeed to anything else).
Well, just a minor note: usually the sellers want
that selling price > supply side price, otherwise
they cannot run that line of business for very long.
And that was one of the points of the original blog post
as well.
Posted by: Antti K | February 22, 2009 at 03:02 AM
This model is based on a simple rule:
transparency about costs and a choice between paying us to make the product or doing it yourself.
Posted by: Website Design by A2zdesignwork | March 12, 2009 at 11:50 AM
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http://2gbmemory.net
Posted by: Joannah | March 19, 2009 at 02:26 AM
Chris,
Perhaps you picked it up already (or even know them directly). But you should check out this initiative, and the guys behind it:
http://antipastohw.blogspot.com/2009/03/introducing-open-source-hardware.html
Seems like you guys are on the same road to viable open source hardware business models.
Good luck, and thanks for your insights in general.
Posted by: anderS | March 19, 2009 at 06:40 AM
An open sourced model would include natural western methods and Indigenous (Chinese Indian,African) medicines.
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Posted by: منتديات | July 09, 2009 at 10:04 PM
Closed innovation system is run by the Pharma/biotech model which is astronomically expensive, massively risky and rarely produces long term sustainable positive health outcomes
منتدي
Posted by: منتدي | July 09, 2009 at 10:06 PM
From my experience the only cost is the cost of the ingredient, which is usually a natural or semi manufactured ingredient.
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Most of the costs involve maintaining ties with a community of people outside of the firm, and figuring out which contributions have the potential to bear fruit.
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