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.