Go West Young Man
“Go west young man!” This was eloquently stated by Horace Greely, editor and founder of The New York Tribune. He was romanticizing the settlers who braved the new frontier during the westward expansion in the 1800s. In today’s mobile application market, the rallying cry might be: “Build apps young developer!” Apple, Google, and Microsoft are beckoning legions software developers with the fantasy of going viral and striking it rich by building mobile software applications and selling them in app stores everywhere.
Stuck on Stupid
Understanding neither probably nor statistics, mindless masses of people play state lotteries failing to realize they have a better chance of getting struck by lightning multiple times than winning the lottery.
Likewise, fueled with visions of dollar signs dancing in their heads, armies of smart nerds eager to win the app lottery fail to understand the economics of the situation and the probability of their success.
The app fantasy started with Apple’s App Store. “The App” predicates Steve Job’s concept of minimalism: Do one thing really well. This encompasses the idea that a small software application would become the technological equivalent of a can opener: Simple, elegant, and functional. Small pockets of functionality delivered a price point of only $0.99. Consumers can pick and choose the app that provides the basic functionality they needed without the requirement of buying an expensive software package containing Swiss Army Knife functionality that they neither needed nor desired. Then when they need different capabilities, consumers could simply buy another $0.99 application. This new way of thinking effectively opened a new market for independent software developers and created an environment that was perfectly competitive. With almost no barriers to entry and exit, any software engineer can enter the app market and have the possibility to become a Microsoft or an Apple giant.
There are two billion PCs on the planet. 96% of them run some form of the Windows Operating System. With the advent of the smartphone and the tablet, this opened up the market to a whole slew of devices. Gartner estimates there will be 26 billion connected devices by the end of 2020. Apple was the first to implement an app store, but Microsoft and Google quickly followed suit to take advantage of the opportunity.
The Casinos: In the mobile application market; Microsoft, Google, and Apple rake a percentage off the top of each application sold in their application store. They also charge the developer a certification fee for the privilege of having the “casino fence their app.” Apps are rated by consumers and sophisticated algorithms based on the ratings and number of downloads in a twenty-four-hour period to determine the visibility of top rated applications. To be considered a top tier app worthy of elevated visibility, an application must be downloaded 80,000 times in a twenty-four-hour period. Conservative estimates for consumers who own smartphones in the US market alone are 234 Million. However, less than 1% of apps ever achieve “top tier status” by receiving 80,000 downloads in a twenty-four-hour period.
Software Econ 101
All this begs the question: What would incentivize a smart group of people like software developers to invest resources in creating a software application; when the chances of striking it rich with success are so small? The answer lies in the economics of software firms. Software is complex and extremely resource-intensive to produce. When looking at economics we know the following are true:
- Total Costs (TC) = Variable Costs (VC) + Fixed Costs (FC)
- Marginal cost (MC) of production is the increase in total cost that results from producing one more unit. So Marginal Cost = Change in Total Cost / Change in Quantity.
- Average Total Cost (ATC) = Total Cost / Quantity Produced
With software, the production cost is the development of the software. Within lies, the key: Software only involves the production of a single unit. Once the software is produced, it can be sold over and over again with no more cost of production other than the cost of the single original unit. Its marginal cost will be zero. Moreover, the Average Total Cost (ATC) is near zero as well. ATC is said to be near zero because there are negligible costs to redistribute the software. Software is not subject to economies of scale, and likewise they are also not subject to diseconomies of scale.
Companies that produce software are often called natural monopoly businesses because they are not subject to diseconomies of scale. A natural monopoly exists when the ATC of a product declines over the course of market demand. Most software companies have gone to digitally providing software, which means it is copied and distributed at very little cost even as quantities increase. ATC is steep during the production of the first and only unit, but would then drop dramatically to near zero. Its curve would continue to asymptotically approaching zero for millions of copies. This is why software and internet companies tend to produce very wealthy founders.
The Real Economics
With the upside so phenomenal and barriers to entry so small software developers are eager to take a chance and enter the app market. As the CEO of a software development and consulting business, I see “entrepreneurs” who have just an “idea” for a piece of software, but do not possess the skills to build it. They come to my firm with dollar signs in their eyes. However, they do not understand the economics. Many of them ask us to develop the software for a “cut” or percentage of ownership. I always ask them: “What are you bringing to the table?” They say, “The idea.” I tell them unless they can implement it they have nothing. Then I must educate them on the economics of building a mobile application.
Doing a simple break-even analysis for an app in each of the three app stores is telling. It can show you just how many downloads you have to get just to break-even when thinking of developing an app. It isn’t pretty.
In the Apple market, the average selling price of an application is $1.04. However, Apple takes a 30% transaction fee of $ .321. Additional studies have shown that it takes $1.20 of marketing dollars per app sold to achieve awareness of your application and garner the “top 100 app status.” This means you are effectively selling your application at a loss for the first 80,000 downloads. Your variable costs exceed your selling price at $1.04. This means your break-even number of units sold is: 656,560. To become a millionaire and achieve 1M in profit, a developer would have to capture .87% of the smartphone market and sell 2M apps. You can see the odds are not very promising that a developer will hit it big.
In Part 2 of this series, I will share how I calculated these numbers. Moreover, you can use them to evaluate your mobile app idea. Additionally, we will discuss what you can do to make your mobile app a success.