- Explain how companies generate revenue by profiting from 'free'
- Identify the drivers that affect revenue as well as cost


[SLIDE 1]

Skype is an example of a freemium model that provides the functionality to make Internet calls. Because of its lack of infrastructure, the costs of running Skype are minimal. It earns revenue by charging for a premium service that offers low rates for the ability to call cell phones and landlines. In 2011, Skype was acquired by Microsoft for $8.5 billion.

However, making free work financially is not without risks. If you are giving something away for nothing, you need to make sure you are still earning substantial revenues. The key to a sustainable freemium model is earning enough money on some part of the business to pay for the costs of supporting the free side of the business. 

The free newspaper Metro is a great example of a free business model that gives away a free product yet still makes huge profits. How? Its readership is aimed at wealthy commuters, on average 37 years old, or urbanites, who attract advertisers that pay generously to reach this target audience. The Metro is also paid to feature major events such as Wimbledon and other occasions. Second, editorial costs are low by keeping content short, punchy and easy to read -- just engaging enough for a quick 2—minute read on the train or bus to, or from work. Finally, it has developed its own distribution network by controlling news racks in train and bus stations where commuters can help themselves to the free publication. 

Lets take a look at two different types of free financial models.


[SLIDE 2]

Direct cross-subsidies refers to pricing a product or service above its market value to pay for the loss of giving away a product or service below its market value. For example, cell phone companies lose money by giving away handsets for free but cover the loss by charging high monthly fees. Some airlines advertise amazingly low fares, but make up the loss by charging for amenities like additional legroom, checked bags, or the ability to choose one's seat.

Cross-subsidization attracts customers by eliminating or reducing the upfront cost of a product or service. It then makes up the loss with subsequent charges which the company expects customers to be wiling to pay because they are pleased with the product or service and don't want to go through the hassle of switching. The added business gained by attracting customers with the below-market price generates more revenues for the firm through the cross-subsidy fees. 


[SLIDE 3]

A multiparty business is a type of free model that involves giving a product or service to one party for free, but charging other parties. The classic example is the ad-supported free content model so common on the Internet: consumers get access to the content for free, while advertisers pay for access. Similarly, some online dating services allow women to enroll for free while men pay to participate. Other examples include allowing job seekers to post resumes for free while charging employers for posting jobs.

The challenge for the multiparty model is to prevent costly overuse by those who get the service for free as well as making the business valuable enough to the party that does pay. 

Financially, the freemium model is often a viable option for web-based companies because of the low marginal cost of providing the service for free users: online storage and bandwidth are cheap. However, companies running freemium models need to be constantly focused on the average cost of running the service for free users as well as the rates at which free users convert to paying users. If the costs of supporting free customers grows too high or the number of paying customers is too low, the model will not work. 


[SLIDE 4]

It is tempting to believe that merely selling products or services will make you money, but more factors must be taken into consideration. Let's apply some key revenue drivers to the idea for a funky new coffee shop. The coffee shop provides unlimited coffee for free, but charges a per-minute flat fee for the amount of time customers spend in the café. 

The first revenue driver is customers. How many will come into the shop, and how much are they willing to pay to stay? How will you attract customers to the location?

The second is frequency. How often will customers come into the shop, and what incentives can keep them coming back?

Third is selling process. How much time will you be able to sell, and what kind of upselling or cross-selling opportunities can you find? For example, you might add snacks to sell alongside the coffee in order to generate more revenue.

The fourth driver is price. If you think your price per minute should be higher than what your competitors charge, what are the factors that increase the value of your product? If you raise or lower process, what will be the impact on your customer base?

You may be wondering: how can you determine your revenue drivers when the business has not even begun yet? By getting out of the building! Actively testing your assumptions and hypotheses is the best way of figuring out the underlying factors that will drive revenue for the business. For example, in order to ensure enough people will be attracted enough to the coffee shop to walk in, you might go to your local shopping mall and watch customers as they go in and out of different coffee shops. Do this on different days, and at different times of day. Record the busy and slow periods. This will give you a better idea of the volume of customers you might expect to walk in, and therefore the revenue you can expect to get. 


[SLIDE 5]

Understanding the factors that drive costs are just as important as understanding revenue drivers.

Two different types of costs should be taken into considerations -- cost of goods sold, or COGS, and operating expenses. While they are both types of expenses, there are some differences between them.

Cost of goods sold occur when a sale takes place. For example, for a t-shirt store, the costs are in how much money it takes to produce each t-shirt: the material, the design, the manufacturing, the packaging and so on. Once you know how much goes into production, you might think about ways to lower costs if you need to. For example, you might find a cheaper manufacturer or use less expensive material. Lowering the COGS means you could also potentially sell your T-shirts at a lower price to your customers.

However, there also needs to be a balance between reducing your costs and satisfying your customer. In other words, you would need to ensure that you are not devaluing your produce to the extent that it would reduce your customers' willingness to buy it at all. For example, if your customers buy your t-shirts because of the quality, it would be unwise to use cheaper material to save costs.

Operating expenses are the costs of running the business, including rent, utilities, administration and so on. These kinds of expenses are more difficult to reduce. Cutting operating expenses can yield beneficial short-term gains but it does not generally work in the long-run.

Imagine you have a retail store and wish to cut operating expenses. You might move to a cheaper, but less popular location to save rent, but over the long-term, revenues will be lower because you might not attract the right kind of customers. Instead, you might reduce employee salaries, but this could damage customer relations if there are not enough skilled, knowledgeable staff to drive sales.

Striking the right balance in the area of COGS and operating expenses can be tricky but does become more manageable over time. 


[SLIDE 6]

When your company is up and running, you will need some financial tools to help you measure the revenue generated and your company's profitability. The income statement, or profit and loss statement, is a financial report that measures the financial performance of the business on a monthly or annual basis. It subtracts the COGS and expenses from the total revenue to give you a net income figure which is either a profit or a loss. 

The income statement also reflects depreciation and amortization of the company's assets. Depreciation really means the cost of wear and tear of physical assets, such as machinery, equipment and the building in which you operate. 

When you purchase an asset that has a useful life of more than one year, you will not include the entire cost of that asset on the income statement in the year that it is purchased. Instead, you are able to spread the cost of that asset over a predetermined period of time; therefore, you record only a portion of the cost each year until the asset is fully depreciated.

Amortization works in a similar way but pertains to intangible assets such as patents, trademarks and copyrights.

The operating profit represents the amount left over from revenue once all costs and expenses are subtracted, Interest indicates the company's debt, as it is interest due on any borrowed money. Taxes are the last expense item before net income and include all federal, state and municipal taxes due for the period.

Net income is the company's real bottom line -- what is left after all costs, expenses and taxes have been paid. Over time, you can begin to compare income statements to chart trends in the company's financial performance.