Cost-Benefit Analysis: Startup Decision Making For Geeks

Decisions make or break startups. So how do you decide whether or not to attempt that project with a lucrative markup? How do you decide between two different alternatives? Who should i marry July or Emily? Turns out that you can analyse the costs and benefits of your decisions, within a “Rough” framework to arrive at answers that make a little sense. The answers however are dependent on some of your assumptions about the variables within the frame work.

Standard Cost Benefit Analysis

In standard cost benefit analysis all one needs to do is make assumptions of the costs and benefits of a particular course of action.

For example if you want to do a cost benefit analyses for project X

First Costs……

Operating costs (Cost of resources used for project): 2000$/month

Fixed cost (Cost Of Project acquisition): 1000$

Opportunity Cost (Cost for opportunities you missed): 1000$/month

Then Benefits…..

Project Revenue: 7000$

Now Net Benefit/Cost (-) = (7000) – (2000*months + 1000*month + 1000)

If months = 1, then net benefit is 3000$ so you go ahead and take the project.
If months = 3, then net cost is 3000$ so you don’t take the project.

This is the bare minimum cost-benefit analysis framework.

Cost benefit analysis for geeks

Ok now onto the geek flavor of cost benefit analysis. This is something i developed and use, so pls do point out any mistakes you can find. Anyway the crappy thing about the above frame work is that there is no flexibility. Your guess for the fixed costs might be wrong and hence your whole analysis might be screwed. So in my framework i make room for uncertainty in the guessed values.

So instead of saying my fixed costs will be 1000$

i’ll say my fixed costs could be 1000$ with 80% probability, 2000$ with 15% probability and 4000$ with 5% probability.

So now the above equation becomes

Cost (-)/benefit = 0.8*((7000) – (2000*months + 1000*month + 1000)) + ((7000) – 0.15*(2000*months + 1000*month + 2000)) + 0.05*((7000) – (2000*months + 1000*month + 1000))

Hence the framework becomes.

Cost (-)/Benefit = (benefit1 – cost1)*Probability Of Outcome1 + …….. + (benefit n – cost n)*Probability Of Outcome n

The above two frameworks are only for cost-benefit for a project with a one time payoff.

What if the decision to be taken requires investment and the Return on investment is expected after many years? All you need to then is to use the time value of money paradigm, which is described in my post startup valuation for geeks.

So if you see any mistakes or have any doubts please do leave a comment. Bye

-Suman

PS: I know the post sucks and is humor less but lately my cost benefit analysis shows that its costlier for me to write a long post with attempts at slapstick.

Where Is Superman

Where is superman (Aka Suman) ?

1) Fighting the gargantuan zepholodi of neptune and trying to save earth.

2) Getting his new and better fitting unform for his laterally expanding waist.

3) Is stuck in an elevator in an old decrepit mine

4) Trying to log into his computer which uses face recognition as authenitcation and is refusing access because of its suspicious disposition.

5) Creating useless polls with ridiculous options

Leave Your comments.

BTW Superman(Suman) is expected back anyday now so hold onto your toothbrushes.

Why Google is dangerous than Microsoft!

Everyone loves the underdog, or lets say most people root for them. Microsoft was the evil empire hellbent on world domination and Google was the david; the only hero capable of felling the Microsoft Goliath Juggernaut. But just looking at the way Google is rapidly gobbling up startups or more specifically eating into lunches of other startups markets; Google has long ago lost its ‘Startup Badge of Honor‘. I still think the most awesome technology to come out of Google stables is its search technology; not that I dont love Gmail or its Desktop Search(still to use this one though!). Ok back to the point.

Every corporation is a hulking conglomerate of people (manpower, resources, experienced moronic bosses he he), hardware, software and ton loads of dollars. This hulk makes it an inevitable juggernaut and most companies do use this advantage to the maximum. But this bulk itself is its biggest hindrance to pace. So all they do gain on this lost advantage is by taking the M & A route. Thats a very simple top down approach to abuilding a company compared to a startup’s bottom up.

Think of it, a top down approach to corporation doesnt allow a company to go into a new niche area (which is not its strength) even though theres lot of money it; it simply cannot just change gears and shift focus so rapidly; that was the beauty of startups playing with the big ones; you know its a virgin market and there are no direct competitors and for any biggie to come to this play it still gives you a enough window of time to ship your product before they can change direction to accomodate this new money making opportunity.

Now, just look at this discussion.

HUFFINGTON: Whatever products Google (Charts) is developing, they are incorporating a 60 Percent to 70 percent failure rate. I find that utterly fascinating. Talk about that culture and how that translates into our lives.

MAYER: As we’ve grown, one of our challenges has been, How can we continue to innovate? We have a theory around failing fast. If you assume that one in five things you do will turn out to be really successful, and maybe two of five will be moderately successful, and the other two will languish, you want to do a lot of things. It’s all about being agile. Most of the teams at Google are three to ten people. Five people launched Google News. About five people launched Google Toolbar. They operate like small companies inside the large company. Google is a lot like managing a VC firm, because you’re placing bets on different teams.

Semco was probably the only other company that had this bottom approach. As is each of its smaller more specific functionality units spun off as a new company by its own employees. But then that was an extreme case of zero shittake in the company; but i digress.

With such a bottom up approach, Google no longer becomes our typical hulking conglomerate but a sprinting juggernaut! As the myth goes, think of every interesting problem that you want to solve and Google already has atleast one team of 10 folks working on it and looks like this might not be a myth at all! Google just probably became the worst startup nightmare. Look at the developments. Google releases API to enable vertical search and has almost instantly flattened out IP value being created there by the new emerging vertical search startups. And the number of startups it bought?!

Google just might be the beginning of a new nightmarish approach to corporation building. Lets petition with the almight market to stop Google for inducing such horrible nightmares onto startup entrepreneurs.

-kopos 

Understanding Smack Shopping – Deal of the day

The first thing that comes to your mind as soon as you read about Jellyfish’s Smack Shopping – Deal of the day is Woot. Woot was a very innovative concept which took the consumer market to a new paradigm. It was just a limited time, cant-miss deal, which had the users hooked for the one main reason – one product, great discounts. It made great sense to the wholesalers too, for one day their product is assured to be sold.

Since we dont have any details on the discount rates on items by the W00t retailer, lets just say W00t buys the products at some x% discount on the market price from the wholesaler. And then W00t sells the items to its consumers at y% discount on the market price. The final profit that W00t nets is (x-y)/100 * N * Cost of each item.
However, Smack Shopping Deal of the day (SoTD) makes this number game much more interesting. The main reason is the number of variables involved is more than two {x,y}. Lets now consider SoTD here. For instance, consider the statistics provided here. In the first three days, the lowest cost has risen from 0$ to 60$ to 100$ (agreed though that the items are different on each day!).

Because of the many different variables involved in this market, the major play is by the consumers, the questions im having are:

  • Is there a standard price at which the users might stabilize? Will the prices hit a plateau in the long run?
  • Can the system be gamed? Of course, in India, people would not go on a shopping spree and wait to buy the items for free.. he he.

Lets consider for a second how the mathematics might work:

First the variables.

  • x% is the percentage discount price that SoTD gets from the wholesaler. To make a profit on the deal, on average the item should sell for more than (100-x)/100*Unit Price
  • We dont have a y% here as the reverse bidding on the item starts from its Market Price.
  • Whats tough to quantify will be the users response; because here’s its the race between greed of one consumer and the wisdom of the community. In the general case, when the wisdom overwhelms the greed, there will always be customers who will buy the item for zero [Heres the point where Smack gets Gamed]. When the greed overwhelms the wisdom, the customers will buy the item for the least possible discount; maybe even for less than the y% discount price .
  • Mostly the average cost of item bought will mostly be the region where the consumer feels he has got the best buy. On Woot, we understand that 62% of customers buy 1 of an item, 14% buy 2, and 24% buy 3; i.e for every 100 users, the number of items they buy are 162 (62 * 1 + 14 * 2 + 24 * 3) implying on average every user buys 1.62 items to get a standard discount of y%. This unit price / unit profit made on W00t is not important to us; the point is can this statistics of user behaviour predict how it will extrapolate for SoTD? Can we without no useful data on SoTD, extrapolate that of W00t to SoTD? Can it correspond to that
    • 62% of the users buy the item in the first time slice.
    • 14% buy it in the second time slice and so on?
  • Also is there a pattern that will emerge to the number of items that SoTD puts on sale? I dont think the variation will be a lot, or that the numbers will be less. Mainly because if SoTD has to survive it has to get large numbers on sale to reap the benefits. An occasional rapid random decrease of the number of items on sale will keep consumer on their toes.
  • The SoTD market looks very much like the stock market, Im guessing that overtime, there will be a definite pattern that will emerge that will behave the stock market tendencies – rewarding consistent study and effort and punishing small time investors who follow the herd.

SoTD will emerge as a very interesting social experiment in the consumer space not only because the consumer deals with escalating discount but also with the uncertainity of the number of items involved in the sale. User patterns that will emerge will for sure show

  • How users react to uncertain buying deals?
  • On average, there will always be the high risk-high reward folks who wait till the end, which might actually be the 24% of W00t. The average buying pattern in general will be those individuals whose asking price on SoTD is marginally less than the discounts they get at other areas. This might consist of the 62% that W00t had. The losers might be the early birds who on getting a good enough deal buy it – that might be our 14%.

Other links:

More about W00t

PS

Though not an economist, I sometimes assume supereconomist role to the T. However, my excitement is at seeing a simple product like SoTD exhibits properties of many other markets mainly the free markets existing today – stock markets, job markets.

– kopos

Value vs Revenue for startups

Yesterday, we were having a discussion on a possible kiva-like play in India which will help connect two very disparate but mutually enriching communities and what kept us puzzled was inspite of the value being created, the revenue-generating mechanism for us was nowhere in sight. Taking any sizeable cut from either of the connecting communities would diminish the value being generated; however, without revenue mechanism there was no way we could keep surviving.

My intuition was to pursue the idea deeper mainly because:
1. It has the scope to generate immense value.
2. Can alter the dynamics of the current system, from marginal to a major extent.

Which bring us to this post…
1. Should startup entrepreneurs pursue an idea even if doesnt have a revenue generating idea now itself but creates value?
2. Occupies a niche field in an area where there is a lot left to be done and can help remove the pain points of customers.

My `opinion` is definitely a yes. Creating value creates fills a dichotomy: people who need it and people who benefit by filling up that need. Generally, a startup is expected to be the latter. However there are cases where the essential dichotomy exists between two subgroups in the former; i.e the role of a facilitator who takes care of bridging the gap between two people who need each other; but there is no way of getting to one another in the best way possible.

Google stands out as a best example of this gunning for value philosophy. They didnt have a business plan until they were about 2002. They had created an essential value of being able to bring search to unstructured data.

For all I know, if a product startup is not creating immense value, it will meet either of two fates, either getting trounced heavily by another player who does create value or will just go bankrupt.

Would love to hear your views on if value is the way to go for a startup (rest assumed that the ways for surviving till they have a business plan is chalked out). I will tackle the ways of value creation of a startup in my next essay ‘Big Guy vs Small Guy’.