Do software companies actually have good margins?

Software is expensive to design. To create a piece of software, you have to hire application designers and software engineers and various other expensive employees 1 who make mocks and write code and talk to prospective customers about the software you want to build. This costs a lot of money—sometimes many millions of dollars—and companies often have to spend it before they have a product that they can sell.

But once a software product is designed, it’s very cheap to manufacture and distribute. Twenty years ago, software companies would spend a few dollars replicating the master copy of their product—Microsoft Excel, the Oracle Database Appliance, RollerCoaster Tycoon, whatever—onto a CD-ROM and putting it in a nice box. People would then buy the box, install the CD on their own hardware, and run it themselves, at their own expense. Today, manufacturing copies of software applications is even cheaper—vendors create copies of their software on various servers around the world, and customers download that software over the internet, no CD or box required. Though these servers cost money to run—Google has to pay for the hardware that Google Docs runs on, whereas old versions of Microsoft Word ran entirely on customers’ computers—these costs are still far lower than the costs associated with designing the software, and far lower than the price that vendors can charge for the software.

In slightly more formal terms, the marginal cost of producing a new “unit” of software is zero. For example, last year, 320,000,000 people used Microsoft Teams every month. I was not one of them. If I had been, I would’ve added a bit more load to Microsoft’s servers, and their server costs would’ve gone up by a few cents. But their revenue would’ve gone up by four dollars. That’s a pretty good deal, for Microsoft. 

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