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Covid19 Crisis: Sharpen the Saw with Marginal Costing

When reality changes, it’s important for the firms to acknowledge and adjust to the new situation. This is the time to remember the mantra ‘Revenue is Vanity, Profit is Sanity, Cash is Reality’.

The Covid-19 crisis is much written about, debated and analyzed. If there is one thing everyone can agree about on the future, it is that there is no spoiler out there for this suspense. The fact is that no one knows the eventual shape of the business environment after the pandemic ends. 

When revenue momentum slows down or even hits a wall as it is happening in the current scenario, costs take centre stage even as every dollar of revenue becomes even more valuable for the firms. So, enterprises need an arsenal of strategic weapons to operate and survive, maybe even thrive, in this period of dramatic uncertainty. The same old-same old, push-push methods will not move the needle of performance. 

As an entrepreneur and CEO, I have always found the theory of Marginal Costing (MC) to be practically powerful over the years. Let me tell you why.

At the best of times, MC is a useful tool for strategic and transactional decision making. In a downturn or a crisis, it is vital for entrepreneurs and business leaders to look at their businesses through the MC filter to uncover actionable insights.

Using MC-based pricing, the firm can retain valuable clients, win new deals against the competition, increase market share in a shrinking market and enhance goodwill by demonstrating dynamism in downmarket.

As the firm continues to price its products based on MC, the idea is to continually attempt to increase the price to cover the fixed costs and get above the Break-Even Point (BEP) to profitability. However, this happens opportunistically and with an improving environment. 

Pricing for outcomes is more critical during these times and playing around with your costing models can go a long way in determining the most optimal outcome-based pricing approaches. 

Steps to Get the Best Out of MC:

1. Determine bare minimum Operating level

Estimate the bare minimum operating level or fixed costs you will need to bear to stay afloat and capitalize on revenue opportunities. This is the BEP of the business. This estimate can include:

  • Facilities, machines, materials, people and overheads. 
  • All R&D expenses required to support product development
  • Necessary support staff for deployment and maintenance of products/services.

2.  Ascertain the variable costs

Identify the incremental costs involved in delivering your business solutions to fulfil contractual and reputational expectations to both existing and new customers. These costs are the variable costs in your business model. Try to maximize capacity to flexibly hire, partner or rent variable costs as needed, based on incremental revenues.

3. Distinguish between fixed costs and transactional variable costs.

Take your fixed costs at your operating level as costs for a full P&L period. Let’s say, the fiscal year. Take your variable costs as what it takes to fulfil the Revenues that you can book. Make sure you only take the direct, variable costs. Note that if Revenues less Variable costs to fulfil the revenues is zero, then you are operating at MC.

4. Sweat the IP already created.

For every rupee or dollar you earn over and above the MC, you are now contributing to absorbing the fixed costs. Do bear in mind that all historical costs of building the IP are ‘sunk’, typically to be amortized over a reasonable period. Hence, it doesn’t figure in the current level of fixed costs. The idea now is to ‘sweat’ the IP already created. 

5. Peg the base price at marginal cost.

Start at the level of marginal cost, not fully absorbed costs. Then, try and increase the price to absorb more and more of the fixed costs. The goal is to get to BEP and beyond during the full P&L period. At the deal level, be wary of pricing based on the fully-loaded costs (variable and fixed costs, direct and indirect).

6. Close the deal to maximize cash flows

Price your product at marginal cost + whatever the client or market will bear to get the maximum possible advance or time-linked payments. This is a simple exchange of cash for margins wherever possible and an effective way to maximize the cash flows. Many clients, especially the larger ones, worry more about budgets than cash flow. 

Let’s look at a high-level illustration. 

Assume a software product company providing a learning and development platform to the enterprise marketplace. Let’s call this company Elldee.

Elldee has a SaaS business model that works well in terms of annuity revenues, steady cash flows and scale. Clients prefer the pay-as-you-model representing OpEx rather than CapEx. Investors love the SaaS space and have funded the company based on the future expectations of rapid scale and profitability.

However, given the ongoing crisis condition, Elldee needs to take a good re-look at the licensing model. By applying MC filters, it may make more market and financial sense to maximize upfront cash by doing a longer-term `licensing’ deal for the software-as-a-service at even a deep discount, with back-ended increments in price. The variable costs of on-boarding a client are similar to a SaaS deal yet the revenue converts to contribution to absorb fixed costs quickly to help survival and longer runway for future growth. So the client pays lesser than what they would have for a three year SaaS deal but Elldee is able to sweat its IP while maximizing cash flows.

Elldee can even move its existing SaaS clients to this model to capture more revenues upfront by being aware of MC and figuring out the right pricing models to get to the BEP of the business or product. Outcome-based pricing can also be designed to deliver margins beyond the MC, contributing to the absorption of fixed costs more aggressively.

Elldee is now in a position to address different types of markets, clients and alliances. It can calibrate higher and higher margins as the environment improves and client relationships deepen. Over the next two years, Elldee would come out stronger with a more loyal client base, higher market share and a growth trajectory aligned with its pre-Covid19 business plans.

Yes, this is a simplified example but many variations to the theme can be crafted, based on a firm’s unique context.

Remember that a strong tide lifts all boats but a downturn separates the men from the boys. Marginal costing techniques, when customized for sector-specific operating models, delivers a competitive edge at a time from which will emerge stronger winners and weaker losers. Be a winner.

About the contributor: Sam Iyengar is a PE investor, mentor and advisor focused on Innovation and Impact. He can be reached at [email protected].

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What is your company’s IP Score?

In the scramble to get to market, protecting the IP of your invention sometimes takes a backseat. This is a mistake and one that can have potentially damaging long-term effects. In this article we examine how developing a proactive IP Strategy can mitigate IP risk for a startup.

Startup Priorities

Most startups begin with a good idea and an identified solution that solves a key need in the marketplace. The idea may come to an individual as an epiphany or could be a group effort through a more thorough due diligence of the market place needs. Going from this idea to an actual startup usually involves several rounds of ideation and vetting.  It also results in  one or two champions of the idea ending up as the founders of the new company. Going from this stage to a functioning startup requires several intermediate steps:

  • (a) Assembling a core technical and business team that understands the problem that needs to be solved, and more importantly how the solution addresses the market,
  • (b) Completing a more thorough product due diligence of the market and competition and defining a viable business case for the product through validation from potential customers,
  • (c) Defining the first product prototype and a requirements specification that will help scope the efforts required for the same, and
  • (d) Preparing the necessary collateral to present to potential partners and investors to raise the initial round of investment.

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Once an idea advances to the stage where a successful startup is formed, one or more of the above steps will be iterated in various forms. In many instances the company has to repeat the steps with changes in various parameters – the so called ‘pivot’ – in terms of product definition, core team, market addressed, or business value proposition. Even a successfully funded company will continue iterating on some of the basic four steps identified above as it executes towards delivering its product, or prepares for a subsequent round of funding. All of the above steps are critical and require resources and money. At each intermediate step the company is often required to prioritize one over the other to balance and maximize their opportunity for success.

In most startups one of the missing, but known, pieces in the early planning, the ‘Elephant in the room’, is an Intellectual Property (IP) Strategy. An IP Strategy addresses questions like: How defensible is the technology behind the product? What is the differentiable and novel aspect of the technology that we can support? What are the key patents that lie close to the product that we are designing, or the service that is being offered? Who are the established and smaller companies with IP and products in the given space? How should the company go about identifying and protecting the White Space? What are the key steps the company should take now that will maximize the long term value creation associated with the business plan of the company?  What actions need to take place towards filing new patents?

Why IP Lacks Priority in Most Technology Startups

With the exception of startups in pharmaceutical companies (especially new drug development), medical devices, and certain biosciences domains, most startups in the high technology space tend to ignore the urgency of developing an IP strategy during early stages of the company.

There are various reasons, some of them justified, behind this trend. From my experience in my own startups and the startups I have worked with, the reasons for not addressing patents early-on seem to converge on certain themes.

  • Too busy fighting fires – Founders feel that they are too busy doing ‘other’ things – getting the engineering prototype going, refining the business and marketing plan, raising money, and building their team.  Worrying about IP Strategy is the last thing to enter their minds.
  • Lack of bandwidth of key resources – Startups can’t afford their main architect, or the CTO to be distracted from doing his/her current job. Typically there is one person, or very few in the company who understand the complete technology solution. These folks are typically so overloaded with responsibilities and requests for their time and knowledge, that having another assignment – to lie out an IP Strategy – may just be the straw that breaks the camel’s back!
  • Too expensive – The costs associated with completing this work, and the time it will require from key employees, (keeping them away from their regular work) are too high.
  • We don’t care or we will be long gone –  One of the most surprising reasons for startups to delay their patents and IP strategy work are: they don’t care, their investors don’t care, their customers don’t care, and the reason that tops it all – we won’t be around by the time we need to worry about the patents!

IP Score for Startups

Given the potential for damage, it behooves startups to evaluate their IP risk. This allows startups to objectively decide whether or not investing in developing an IP strategy is worthwhile for them or not.

In seeking to quantify the urgency of having an IP Strategy and patents for a particular company, we need to identify a few parameters that have an impact on the IP of the company in the context of its landscape.  Here are a few parameters, in no particular order of importance, that influence the overall IP Score of a company.

1.    IP Relevance for the Technology Segment (5 = Very Aligned, 0 = Totally Misaligned (the technology segment may not require a well thought out IP Strategy)

IP Relevance index for the technology segment reflects the importance of patents and Intellectual Property for a given company’s product segment. For example, typically, any pharmaceutical company would by definition have a very high IP Relevance index since the whole company’s success is based on a unique drug or molecular structure that gives the company an unfair advantage vis-à-vis competition. Some metrics that could help us refine the IP Relevance index are following:

  • Business Valuation, Core Technology Correlation Index – to what extent is barrier-to-entry based on first mover’s advantage vs. technology differentiation?
  • To what extent can the technology implementation help differentiate the offering in the market place?
  • Mature Companies’ IP Position – what is the IP position of established large companies in the product space of the given company?
  • Competitive Startups’ IP Position – What is the IP position of other competing startups in this space?
  • Licensing/Partnership Strategy Index – Has the company laid out a cross-licensing and out-licensing plan for key technology pieces?
  • Considering some of all of the above factors we can come up with an IP Relevance Index for a company or a startup. We could define a number between 0-5. An IP Relevance index of 5 means that the relevance of having a mature IP Strategy is very critical for the product, and a score of 0 meaning that patents may not play a big role in the success of company’s product strategy.

2.    IP Maturity (5= Very Mature, 0 = No IP Maturity)

Yet another related parameter to quantify IP Score of a company or startup is IP Maturity. IP Maturity refers to the work the company has already done, and how effective is their current overall IP Strategy in maximizing the overall valuation of the company. Following are a few things that have high correlation with IP Maturity.

  • Filed Patents, Patent Applications, Provisionals and Trademarks – A higher number here means higher IP maturity.
  • Founders or Core Employees with patents under their belt in relevant technologies. This is yet another indication of how mature the overall thinking of the organization is and points towards a higher score for IP Maturity.
  • Steps towards some kind of IP Strategy – Companies that have well defined core architecture or product requirement documents, well documented peripheral idea and even a sketch of product or strategy roadmap would score high for IP Maturity as well.

3.    Ease of Implementation of an IP Strategy (5 = Very Easy, 0 = Very Difficult)

This attribute defines the ease with which a sound IP Strategy could be defined or implemented within a company. Again, a score of 5 would mean it would be very easy to implement an IP Strategy and a score of 0 would indicate an uphill battle when we attempt to implement an IP Strategy.

  • Experience and Maturity of Core Technical People – Overall technical understanding and experience of the core technical team with patents is generally a good indicator of how easily patents and IP Strategy could be implemented.
  • Management Drinking the IP Kool-Aid – By looking at past track records of the company management, and their IP track record, we can get a fair assessment of how much importance and urgency the management gives to patents and overall IP Strategy.
  • Resource Availability – The amount of cash available or allocated for patents and access to key technical resources that can help in creating the IP Strategy also is an important factor.
  • Published White papers or technical papers by founders or key employees in closely related or relevant areas, or even past publications in related or unrelated topics is again a good indication of ability to get access to the technical details of the products for implementing IP Strategy.
  • Documentation of code, innovation, and other technical details within the company are necessary aspects for implementing IP Strategy. More documentation of code and Whitepapers related to product make the job of IP landscaping, white space scoping, and patent drafting much easier.

And the IP score is…

We define the IP Score as the average of the above three metrics  – IP Relevance, IP Maturity, and Ease of Implementation of IP Strategy.

This is a number between 0 and 5.0. A High IP Score indicates a well thought of IP Strategy and indicates the company has taken steps towards building a defendable and distinguishing Patent Portfolio.

IP Score = Average(IP Relevance, IP Maturity, Ease of Implementation of IP Strategy)

IP Score vs. Maturity/Stage of the Company

In discussion with a seasoned entrepreneur friend of mine we came up with another interesting way to look at the IP Score of a company. If we view the IP Score of a company vis-à-vis the maturity or the stage of the company, it reveals interesting things. The maturity or the stage of the company is related to its overall progress towards product delivery, revenue growth, and financial position. Plotting IP Score vs. Company Maturity helps us identify the urgency of IP Strategy for a particular company.

An example of a company with high IP Score and high company maturity (top right quadrant) is Pfizer. Pfizer has strong patent portfolio of drugs like Lipitor and is a fairly mature and successful company in the Pharmaceutical domain.  Pfizer may still end up having overall high need for continued investment in IP Strategy (since the IP relevance of the technology domain is very high) but it is a fairly mature company in its own right.

The companies that lie in the bottom right quadrant (Low IP Score and High Company Maturity) have great strategic risk profile and are the strongest candidates for defining their IP Strategy at the earliest possible opportunity.

The companies with High IP Score and Low Company Maturity (top left quadrant) are the ones that have a solid IP Strategy from the get-go.

The companies in the bottom left quadrant (Low IP Score and Low Company Maturity) are the one’s that have time to create a solid IP Strategy to win in the marketplace.

Where does your company lie in this map?