Defining Product/Market Fit

Startup Pyramid

Product/market fit has an incredibly abstract definition with the widely held view holding a number of fallacies and that has meant it has become impossible to quantify it. In this essay I am looking to define what it is, make it quantifiable, and therefore know how to measure how a startup company is performing.

Product/market fit is a term generally attributed to Marc Andreesson with this definition:

“Product/market fit means being in a good market with a product that can satisfy that market”

It is also described in more detail by Carlos Eduardo:

“Product / Market fit can be loosely defined as the point in time when your product has evolved to the point that a market segment finds it attractive so that you can grow your product / company scalably”

There are attempts on how to measure if businesses have achieved product/market fit but I see these as (potentially bad) litmus tests rather than definitive methodologies. Some of the notable examples are:

Sean Ellis: “The achievement of product/market fit can be measured according to a specific metric: when, in a survey, at least 40% of users say they would be “very disappointed” without your product or service.”

David Cummings 5 rules:

  1. 10+ customers have signed on in a modest period of time (e.g. 3 – 9 months) and they haven’t been friendlies (people you already knew, favours you called in, etc.)”
  2. “At least five customers actively using the product with little / no product customization (e.g. the product is valuable and mature enough that heavy development work isn’t required for each new customer)”
  3. “At least five customers have actively used the product for over a month without finding a bug (no matter how great the product is people always find issues with it, which is natural for this beginning stage)”
  4. “At least five customers use the product in a similar way and achieve similar results (early on you find that customers use the product in ways you didn’t imagine, which is great, but the goal is to find consistent, repeatable patterns)”
  5. “At least five customers exhibited a similar customer acquisition and on-boarding process whereby they bought and went live with the product in a timeframe that was consistent with each other (e.g. had a two month sales cycle and took a week to get the product running)”

The universal agreement between these interpretations is the strong level of desirability a business’s own customer base should have for the product.

I contest that this is both deceiving and only half the story for a startup. It is deceiving because a business could have 80% of its customers raving about its product but this could be a poor representation of the market. When it starts scaling, and bringing the customer representation more in-line with the market average, the response to the product could change revealing the deception of the assumption.

It is also only half the story as anybody can create high levels of desirability within their product by simply offering it for free, or even paying people to use it.

Therefore I am re-defining the understanding of the expression as:

“Product/Market fit is when it becomes possible to monetise a product, at a scale, that makes the business sustainable.”

I also need define what I mean by ‘product’ that, in my slightly unconventional view, is the entirety of the business that influences the resonation with the market it is targeting. For an e-commerce business, this includes, merchandise, operations, marketing, brand and the website itself. Namely the entire business apart from the internal business services like finance, HR or catering etc.

THE RELATIONSHIP BETWEEN CPA, CCM AND SCALE

Using this re-defined view of what product/market fit is, in achieving sustainability, means that it is possible to build a method of measurement using economic modelling. This starts with the relationship between ‘Cost per Acquisition’ (CPA), ‘Customer Contribution Margin’ (CCM) and ‘Scale’.

Achieving sustainability, by creating net profit, can be described as when cumulative gross profit of the customers is larger than total operating costs. Using contribution margin analysis you can represent achieving this as:

contribution margin analysis - total cost equationWhere ‘x‘ is the Customer Contribution Margin (CCM – Total revenue generated less all cost of sales assocaited for that customer) and ‘n‘ is the number of customers.

This is also simplistic. If we are basing margin on a per customer basis, rather than per sale, we should attribute marketing costs, both direct and indirect, of acquiring the customer as a variable.

Therefore:

contribution margin analysis - gross customer profit breakdown

This can be extrapolated further to:

Contribution margin analysis - gross customer profit equationWhere ‘y‘ is the cost per acquisition of an individual customer (CPA)

N.B. For the remainder of this essay I am stating that cumulative CCM – cumulative CPA, as described by the left side of the equation, as the gross customer profit (GCP).

We can now identify that there are three simple measurable variables that account for making a sustainable business, CCM, CPA and the number of customers (Scale). I am treating administrative costs as a constant for the purpose of this discussion.

Building a sustainable business is a two part process around these three variables. The first stage is achieving a sufficient average CCM over average CPA. The second stage is to scale whilst sustaining this.

In summary; if Product/Market fit is achieving a Product/Market resonation that allows for the possibility of creating a sustainable business, if scaled, then it is also when the potential GCP is larger than the administrative costs of the business.

This is important because GCP and administrative costs are measurable and understood as per the previous formula:

Contribution margin analysis - gross customer profit equation

First summation equation (using ‘x’ as the fucntion)= CCM and the second (using ‘y’ as the function) = CPA 

This allows us to quantify product/market fit using the variables within the formula, CCM, CPA and Scale of which the relationship can be modelled.

First; my assumptions:

  1. The total market size is finite and I am defining its limit as the addressable market size.
  2. The product has a variance in desirability over the total range of addressable customers. This affects the situation in two ways if product remains constant:
    1. CCM – Different customers will generate different revenues. Thus the CCM of each customer will be different.
    2. CPA (of the Customer) – The cost of acquiring customers will also differ dependant on the desirability of the product. Essentially if the product is ideal for a customer cohort then it will be cheaper to bring them on-board and vice versa.
  3. The number of competitors is constant. Therefore if market share is increased the level of competition for remaining customers increases. This directly correlates to an increase in CPA of each customer as market share is increased.
  4. For the purposes of this theory I am assuming that marketing is 100% optimised. Customers who resonate with the product most will join first.
  5. I am also assuming that the customers who resonate with the product most will have the highest CCM. Thus giving an indirect relationship between CPA and CCM.
  6. Scale does not affect desirability of the product. Essentially this graphical representation does not represent P2P (peer to peer) marketplaces like eBay which are reliant on scale to appeal to customers.

THE PRODUCT/MARKET FIT MODEL

Below is the graphical representation of the relationship between the three variables, the curvature and steepness of the lines are for example purposes only.

relationship between cost per acquisition and customer contribution margin

This graph represents a company with a product that can produce profit until it has reached ~30% of market share. If the business scaled to the same number of customers as the profit growth ceiling, as represented by the dashed yellow line, then the gross customer profit is shown as the area shaded in green. This would be equivalent to one side of the Product/Market fit formula:

Gross customer profit modelling equationWhere ‘n’, the total number of customers, is denoted by the point of the yellow vertical line (profit growth ceiling)

If this is larger than the administrative costs then the business is sustainable.

To show the effect of increasing the desirability of the product within the Market, I have taken the example above and used my assumption that desirability directly effects both CCM and CPA. The market remains constant:

Change to Contribution margin and cost per acquisition during product improvment

Increasing the desirability (resonation) of the product within the market means a reduced CPA and increased CCM. This in turn increases the potential profit ceiling to near ~60% of market share and the total profit that the business can create with scale.

To therefore quantify if a business had achieved product/market fit it needs to measure the Customer Contribution Margin (CCM) and Cost Per Acquisition (CPA) and the level of deterioration as it scaled.

The fallacy in this method is that this is assuming the product remains constant as you scale. In reality this is not likely to happen. In reality you have the ideal startup product journey, this is expanded upon in part 3 of this essay.

In summary: product/market fit is defined, theoretically quantifiable and therefore measurable. To read how this can help reducing the cost of scale please read the next section of the essay THE REALITY OF MARKETING.

 

This post is the first part of a 5 part essay about reducing the cost to sustainability when developing a new product. Total parts are:

  1. Defining Product Market Fit
  2. NEXT: The Reality of Marketing 
  3. The Ideal Startup Product Development Journey
  4. The Product Formula
  5. Reducing the Cost of Scale – The Planned Pivot

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