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The Knobs

Four basic knobs make the wheels of economics turn. Learn em, and learn to twist em.

The Knoble pursuit of


business
You spend all day, every day, awash in the messages of
business: TV advertisements. Radio advertisements.
Billboards. Magazine inserts. Telemarketing calls. Software
package deals. Gas stations, tollbooths, convenience stores,
lunch counters, cell phone bills, credit card statements,
orders from your boss, emails from your clients.
Youre soaking in it.
But do you understand it?
Well, thanks to scores of psychological studies, I can say with
some certainty, No.

The Ballad of A Smart Guy Named


Bob explains why
Under the hood that is, the skull were all wired almost
the same. Thats why psychological research is the perfect
hobby for an entrepreneur.

As it turns out, psychological research studies have


something to say about this business soup were soaking in:
Lets take Bob, a smart guy a lot like you and me. Research
studies have shown that the more Bob is exposed to a thing,
the more familiar it feels to him. The more familiar it seems,
the more Bob feels he understands it. And, to top it o, the
more familiar it is, the more Bob will rate it as likely to
happen to him, or for him.
It doesnt matter if the thing in question is incredibly unlikely.
Or if its actually very complex, and Bob has never studied it.
That doesnt matter because Bob feels it in his gut. Like a
shining ray of capital-t Truth.
Bob, like all of us, is surrounded by business by-products
every day. He starts a business based on his gut feelings
about business. He knows hes doing the right thing.
The day he realizes that his feelings of condence were
nothing but greasy familiarity? Its already too late.

It happens to the best of us


Bob is not dumb; every one of us has been Bob. (Yep, even
me more than once, even!) What happened to Bob in this
story can happen to you. Maybe it already has.
You see almost nothing but business, business, business all
day, every day. Its part of your unconscious operating
system.
But you dont see the core structures behind the
business. You only see the messages of the business.
And that is a critical dierence.
Luckily, after all that doom & gloom, Ive got good news for
you.

The structure is simple


The structure of business is simple. You can absorb the
basics of Business 101 in an afternoon. Theres a simple set
of rules you can use to describe and analyze any business.

The Four Knobs: Demand,


Frequency, Cost, Revenue (DFCR)
Think of a product business as a machine. Youre creating a
business from scratch, so you have a world of choices ahead
of you. When it comes to the mechanics, youve got to know
the Four Knobs: Demand, Frequency, Cost, Revenue.

These knobs are, in short:

Demand - How badly your Audience wants your


product (and how many of them want it)
Frequency - How often your Audience buys your
product, be it a one-o sale, multiple sales, or
recurring sales
Cost - How much money a sales transaction costs
you
Revenue - How much money you take in on a sales
transaction, not counting any costs (gross revenue)

Theres a nite range of choice for each knob, and a nite


number of congurations for all four together. Thats why
its best to think of them as knobs. Demand, Frequency, Cost,
and Revenue are settings that determine the outcome for a
given product. They specify a formula that has a clear,
predictable outcome.

How to use the Four Knobs


Sadly, twisting the knobs doesnt change reality. You cant
create a product and then magically alter the Demand for it.
Instead, think of the Knobs as recipes.
First you choose the outcome you want. Lets say
$180,000 in yearly gross revenue.
Then you gure out which congurations of the Four
Knobs will get you there. The class title is a hint: to reach
$180,000 in gross revenue, you could sell $30/mo
subscriptions to 500 people a month, or $500/mo
subscriptions to 30 people a month.
Then ask yourself what youd need to do to make this
conguration work in the real world. How could you create
a $500/mo value for 30 people? For starters, youd have to

understand your Audience (and pick them wisely). Youd


have to craft a very compelling Oer indeed.
(And, of course, you also care about Cost if you earned
$180,000 but had to spend $179,000, you would not be a
happy camper.)
Then twist the Four Knobs to dial in a business you want.
Dene a product using a DCFR conguration that gives you
the outcome you desire. Think of the settings as
requirements for your end results.

Sussing out the DFCR


Lets take that $180,000 a year gross formula: either $30 x
500, or 30 x $500. Both add up to the same gross revenue.
But theyre not at all the same.
Lets say you needed to nd 30 people to buy your
product each month at $500/ea. Thats 30 people out of
the whole world of 6 billion. What type of Demand would
you need to support yourself, at that price? Pretty damn low,
in a global sense.

But what if there are only 50 potential buyers in the whole


world? Then your Demand setting starts to look a little
way. Youd need to be able to create a product with high
Demand to attract, & keep, 60% of the entire Audience.
What about Cost? To serve such a tiny market at a high
price, you might need to pour lots and lots of money and
time into keeping your 30 customers happy. That can drive
up your costs.
Of course, if it wasnt a subscription, youd have to nd many
more customers.
What about 500 people a month at $30/ea? Youd need to
target a much larger Audience than in the previous example.
But, globally speaking, to sell to only 500 people a month
requires only Low to Moderate Demand. (For comparison,
Cadillac sells about 60,000 of their luxury Escalade SUVs per
year.)
And for Cost? Well, a larger, more dispersed Audience might
cost more to reach but itd be easier to maintain 500
customers out of 10,000 potential customers than 30 out of
50 potential customers. And your they probably wouldnt

30 x $500 Requires
Demand

Low to High (depends on Audience size)

Frequency

Monthly (subscription)

Cost

Moderate

Revenue

$500 (Moderate to High)

$30 x 500 Requires


Demand

Low to Moderate

Frequency

Monthly (subscription)

Cost

Low

Revenue

$30 (Moderate to High)

demand as much hand-holding for $30 a month. Your Cost


could be pretty low.

$4.99 x 36,072 Requires


Demand

Extremely High

Of course, if it wasnt a subscription, youd have to nd many


more customers.

Frequency

One-o

Cost

High

But what if you wanted to make that same income o an


iPhone app? Well even if you charged a fairly high price for
iPhone apps, at $4.99 youd have to make 36,072 sales to
earn the same income in a year. Yes, thats thirty-sixthousand-and-seventy-two sales.

Revenue

$4.99 (Extremely Low)

And we know that your costs would start at 30%, because


thats what Apple takes as their cut. In the digital products
business, 30% overhead is nasty high.
Whats more, each of those 36,072 sales would have to be to
a new customer. Unlike subscription-based web applications,
iPhone apps are one-o sales.
That means youd have to capture extremely high
Demand to ever hope to make $180,000 o an iPhone
app. And, Cost-wise, youd probably still earn 10-20% less
than a web app with the same gross revenue.

Thats the iApp Paradox


Mobile apps are so appealing. Theyre sexy, theyre fun, and
theres more than a handful of rags-to-riches success stories
about megahit apps.
But, in reality, to get to a reasonable income, you have to sell
tens of thousands of copies.
You can earn the same income o a subscription service
with just a handful of customers.
When you run a subscription service, even a high customer
turnover still brings you ahead of a one-o sale. Even if 10%
of customer stick around from month to month, thats 10%
more than youd have with one-o sales.

True Monthly Frequency vs Nice to


See You Again
Your reaction to that last paragraph may have been: I've
bought more than one iPhone game from the same
developer! I've bought more than one screencast from the
same guy/girl!

If so, good for themthey're using your prior good


experience with them to sell more goods.
But, ask yourself, does the iPhone or screencast or book
have the next sale baked into the rst sale? If it's a series of
screencasts or gamestune in next time!then yes, it's got a
true Frequency thats higher than one-o.
If not, then it's a one-time sale, over and over again.

Unhappy combinations
Some congurations of DFCR go together better than
others. For example, wouldn't you hate to have these
settings describe your business?

Low revenue and high cost


Low frequency and low revenue

Naturally you would, but those types of businesses still look


very appealing from the outside. Unfortunately, their
attractiveness is only skin deepas many dedicated iPhone
developers nd.

If you love & adore a business that has these traits, you
don't have to give up. But you do have to admit it. Don't tell
yourself you're looking for a way to monetizegure out
how to charge more.
And then, looking at the reality of the situation, gure out
how you could alter the business model to lower costs,
increase revenue, and/or increase frequency.
Here's one quick way to avoid an unhappy combination:
Never look for ad revenue.

Advertisers don't count as paying


customers
Many poor, unsuspecting creative people have bought into
the idea of a free, ad-supported business. But the fact is, that
the revenue per customer transaction will always be $0.
Even if you get a decent rate per thousand exposures (CPM),
the click-throughs mean the customer is leaving your
service/app/web page.
It also means that if your goal is to make more money, you
must optimize the user's experience so he clicks on ads. If

you optimize for aesthetics, for usability, or any number of


other things, your revenue will drop, because your happy
customers will stay put.
There's a reason that if you walk into a store or a car
dealer, they don't oer to send you away to someone else
for 10. If you try to earn money from ads, you are literally
giving away your business for mere pennies at a time.
Even if only 1 person out of 1000 buys a car, the car
dealership will earn more money than if they were paid 10
per lead. Even if every single potential customer took the
adbait, the car dealerd earn only $100!
If you can't squeeze $100 out of 1,000 users over the
lifetime of your product, it's time to seriously re-evaluate
your business model.
Freckle, for example, brings in $1,280 per 1,000 users per
month, including inactive free accounts. And its ongoing
costs are very low.
This, by the way, is why it's stupid for a restaurant or caf to
put in a TV ad board, like many have begun to do in the US.
They are degrading their customer's experience for mere

penniesinstead of looking how to serve them better so they


buy more.

Look at the world as a set of knobs


Every real business that you see every day, the ones that
power your lifestyle & your business, all run on the same
structures:

Demand for the product falls somewhere between


"none" and "a lot."
It's either a one-time purchase, a purchase that
happens again sometimes, or one that happens
again & again like clockwork.
There are costs per transaction to consider, and
there must be an exchange of money.

No matter how innovative the product or the idea, the


business that makes it possible to get that idea product into
the hands of customers can be described in terms of these
four fundamentals. It's one conguration of DFCR, or
another. But however they may be set, they're always there.
And certain congurations have predictable outcomes.
When a grocery store has a 3-5% prot margin, it can survive,

because people shop there constantly; when Dell has a 3-5%


prot margin, it will lose money hand over st, because
people don't buy computers every week.
The most protable, easiest-to-run congurations have
recurring purchases built in, whether it's the next
screencast in a series, the next month of a subscription
service, the maintenance of a vehicle, ink for your printer,
blades for your razor, or dinner for your plate.