May 23, 2020
Wealth comes from profits. But where does profit come from?
Before we answer that, we need to know what profit is.
# What is profit?
If you ask anyone on the street what profit is, they will give you the definition of Accounting Profit, which reflects the formula
profit = revenue - cost
There's also another profit, called Economic Profit, and has the formula
profit = revenue - financial cost - opportunity cost
But what is the opportunity cost variable, and why does it matter?
Imagine we owned a piece of land, which can grow onions and corn. For the current season, we must decide what to plan on this land. How to make that decision? We would run a simulations, or projections, for each of these vegetables. We would estimate the costs and the price at which we would able to sell them later. We can't grow both on the same squared meter, although it should be possible to plant both if we were to divide our land in sections. Still, we would need to decide the ratio of squared meters to plant onions and corn. If we plant corn we can't plant onions. If we plant onions we can't plant corn. This is the opportunity cost.
It's possible to have accounting profit but not economic profit.
Let's say we planted corn.
Come harvest time, the sell the corn for a monetary amount
greater than the cost of planting it.
That means we have acocunting profit, where
revenue > cost.
This is great, right? Well, maybe.
We talk to our neighbors, who had planted onions instead,
and learn that with the same amount of land,
they have made double the revenue that we have.
Although making accounting profit is good, it's not great.
What is great is to make economic profit.
In this case, it would have meant to have planted corn instead.
# How to make Economic Profit
Economic profit relates to optimizing the use of limited resources. What are the resources we, Software Engineers, have at our disposal? Our main resource is obviously time. Time is as valuable as it's limited.
As we have seen above, to optimize the use of our limited resource, we need to run simulations or projections.
Here are some scenarios I have prepared for us. The constant here is the resource. It assumes an investment of 40h/wk of our limited resource time.
The scenarios are:
- We get a job paying $130k/year
- We work as consultants charging $200k/year
- We build a product that generates revenue
We can see that working in a job, in our industry, pays well. Starting our own consultancy company pays even better. Now, why is the Product line a curve?
This simulation shows us that the market is not fair. Profit is an event that may or may not happen. Hence, a whole year of hard work with nothing to show for. On the second year, things start picking up. Still, how come have we reached $1MI in the following year?
Remember, economic profit comes from optimizing the use of our limited resources. In our case, time. Working at a job or as a consultant gives us revenue proportional to the investment. That is, the ratio of time invested to revenue is constant. That is not the case with digital products.
How much more time do we need to invest to sell our product to our 1,001th customer? Certainly less time that it took us our 1st. Hence, the ratio changes. We start being able to invest less time for the same amount of revenue. In the scenario above, we are using this spare time double-down our investment into our product, looking to increase the angle of this exponential curve.
We need to be aware of a product's life cycle. Nothing lasts forever. But after building the first, we'll have time, money, and know-how to build the next one.