Contribution margin: why Netflix uses it for their most important decisions

Contribution margin is a key metric for management

Our US contribution margin structure is set mostly top down. For any given future period, we estimate revenue, and decide what we want to spend, and how much margin we want in that period. Competitive pressures in bidding for content would lead us to have slightly less content than we would otherwise, rather than overspending. The same is true for our marketing budget. The output variable is membership growth that those spending choices influence.

This is what Netflix tells their investors in the long-term view (the wording has slightly changed just a few weeks ago but this is how it read for a long time until then).

With this, you know they are using the contribution margin metric in one of the most important business decisions: investing in content.

That is why we are covering the topic of contribution margins: it is one of the most important metrics and decision making tools for many companies like Netflix (I have an example from Lyft’s recent IPO filing at the end).

It is also a crucial tool in the break-even analysis (i.e. finding out when you start making money).

Today we will expand on the in-depth knowledge that you have already gained about Netflix in my previous articles.

Let’s get started!

Contribution margin vs operating margin vs net margin

First, let’s be clear that contribution margin is something different than operating or net margin. Below, you can see the period between 2001-2008. I have chosen this period to show that Netflix made a contribution profit in 2002 but made operating and net losses in the same year. Contribution profits will be always higher than operating profits by definition.

Both metrics are linked via the operating leverage that I will cover in this article as well.

Netflix-DOM-contribution-margin-prior-2008 — Netflix’s contribution margin vs operating and net margins [data source: Netflix annual reports]

I am starting with this to avoid any confusion between these measures.

Managing towards a target

Netflix-US-segment-consolidated-contribution-margin — Netflix makes the first mention of the contribution margin starting in their 2012 annual reports. From about 2015, it looks very well managed towards a clear target range [data source: Netflix annual reports]

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Contribution margin: definition

Contribution margin (CM) s the selling price per unit minus the variable cost per unit. “Contribution” represents the portion of sales revenue that is not consumed by variable costs and so contributes to the coverage of fixed costs.

Some people think that the contribution margin is only useful for firms with high fixed costs. But that is not the case. Netflix’s fixed costs are in the ~12% range (which is low) and, yet, they use this metric to manage their content expenses (which is a variable cost).

Netflix-US-streaming-segment-contribution-margin — For Netflix: Contribution profit = revenue – costs of revenue – marketing [data source: Netflix annual reports]

Or in numbers (from their 2018 annual report for the US streaming segment):

	As of/ Year Ended December 31,
	2017		2016		2015
	(in thousands, except percentages)
Contribution profit:
Revenues	$	6,153,025	$	5,077,307	$	4,180,339
Cost of revenues	3,319,230		2,855,789		2,487,193
Marketing	553,331		382,832		317,646
Contribution profit	2,280,464		1,838,686		1,375,500
Contribution margin	37%		36%		33%

Contribution profit = revenue – cost of revenues – marketing;

Contribution margin = contribution profit / revenues

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How to calculate contribution margin

Now, let’s look more broadly on how to calculate CM:

Contribution profit = revenues – variable costs (also called “contribution margin”)

Contribution margin = contribution profit / revenues (also called “contribution margin ratio”)

(The ambiguous use of terminology doesn’t help. But I’m sticking with the definitions in bold above.)

Depending on how your accountant builds up your financial statements you can derive this easily or may need to apportion parts of certain line items to fixed vs variable costs to calculate your contribution profit/loss.

Variable costs

Variable costs are costs that change with output, think of the cost of all parts and labour that is required in manufacturing a car. Variable costs have corresponding revenues, i.e. make profits (to the extent that the units produced are being sold).

Netflix lists out as variable costs as:

Costs of revenues
Marketing costs

Cost of revenues

Typically, cost of revenues (=sales) are composed largely of variable costs. They generally also include the traditional cost of goods sold and some other expenses directly associated generating the revenues.

For Netflix, cost of revenues include (annual report 2018, pg 19):

Amortisation of the streaming content assets,
expenses associated with the acquisition, licensing and production of streaming content,
streaming delivery costs (including cloud computing),
customer service,
payment processing fees
and some other, smaller, expenses

Marketing

A lot of Netflix’s marketing is for the purpose of making people aware of upcoming new show/movies and thus stimulating consumption. Even if their revenues would not be immediately impacted if people don’t watch Netflix for a while (or watch less) they will eventually cancel their subscription. Equally, marketing is one of the key contributors to new subscription thus revenue generation as well as triggering word-of-mouth propaganda.

Fixed costs

Fixed costs typically are independent of output and units sold. Variable costs can be avoided to some degree if fewer units are sold, i.e. no revenue is generated. Fixed costs, on the other hand, tend to be more sticky and hit your bottom line even if revenues dip.

For Netflix we have the following fixed costs:

General & admin – a typical fixed cost
Technology and development – a discretionary fixed cost

Netflix-fixed-costs-vs-variable-costs-v2 — Operating income = revenue – variable cost – fixed costs. Contribution profits need to pay for the fixed costs in order to make an operating profit. I am showing the overall contribution profit which Netflix as such doesn’t list out as they measure contribution profit by business segment. But the total is simply the sum of the individual segments [data source: Netflix annual reports]

Operating income =

revenue – variable cost (=contribution profit/loss)

– fixed costs

With this, you know what the contribution profit does: it helps to pay for the fixed costs. What’s left after this is the operating income. Capital-intensive companies have high fixed cost attributed to the ongoing depreciation charges (operations and maintenance) of the capital-intensive assets.

High contribution margins are a measure of high operating leverage. It means that sales revenues translate into profits at a faster rate.

Now that we know the definition the fun can start. Let’s see how this concept can help us manage our ideas, innovations and companies.

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Understanding costs

In this context it is important to understand the duration of your costs:

Many firms are working hard to make fixed costs more exitable than in the past. One example is leasing instead of buying real estate (though, lease durations tend to be multi-year as well but Twitter, e.g., has subleased >25% of their headquarter in 2016 when the business wasn’t performing well)
Equally, variable costs cannot be completely avoided to the degree that they may not be required. That is because most companies enter long(er)-term contracts (or minimum quantity) contacts in order to obtain lower pricing. Manufacturers of durable goods can put their items into inventory (though this also comes at a cost and potentially requires large discounts to eventually sell the goods). Malleable items can’t be stored for a long time. And this does not only hold true for perishable goods (such as foods) but also for digital goods. If a “blockbuster” movie flops in the first few weeks/months it won’t recover the revenue loss over the following years. Digital goods, too, have an ageing curve. This can be more or less pronounces as in the case of evergreen items (“Casablanca” or “Friends” anyone?)
Subscription business models for digital items that allow unrestricted access to all items, like Netflix, have to pay licensing fees to their vendors irrespective of how many people watch the respective content. This is why it is so important for Netflix to understand viewing patterns in order to not overpay
Things are different where digital items are paid per download. Think of the iTunes store. Apple doesn’t pay artists/labels anything until the items are sold and then collects a commission on each item sold (this is the platform business model). This is very different from Netflix

Contractual obligations

Just to not create a wrong impression: the contract duration has nothing to do whether a cost is fixed or variable. Irrespective of the type of cost, always make sure you understand the duration of your key contractual commitments. You will most likely not be able to avoid long-term commitments within your variable costs, simply because it will help you to bring costs down.

Here is a listing of some of Netflix’s contractual obligations (pg 26, annual report 2018):

	Payments due by Period
Contractual obligations (in thousands):	Total		Less than 1 year		1-3 years		3-5 years		More than 5 years
Streaming content obligations (1)	$	17,694,642	$	7,446,947	$	8,210,159	$	1,894,001	$	143,535
Debt (2)	9,048,828		311,339		627,444		1,761,465		6,348,580
Lease obligations (3)	737,378		101,987		193,815		162,606		278,970
Other purchase obligations (4)	544,933		253,443		220,181		46,590		24,719
Total	$	28,025,781	$	8,113,716	$	9,251,599	$	3,864,662	$	6,795,804

We are mainly interested in streaming costs obligations which are the key driver of the variable costs. To be more accurate it is the amortisation schedule of the content cost by reporting period that goes into the income statement thus constitutes the variable costs – not the payment schedule. But the payment schedule is when the cash walks out the door, thus it is the driver of another key metric that we will look at in near future: free cash flows.

(For the accounting buffs here, you can get a great overview of how Netflix accounts for their streaming assets here: Netflix, pdf. Also, you can get a high-level overview of digital streaming accounting standards here: Ernst&Young, pdf. Content costs are the biggest costs in Netflix’s business as I have shown in our recent article. )

With this understood we can now look into how to plan our business better.

What is it useful for?

This is really the fun part and highly useful!

When do we turn a profit? How much sales (=revenues) do we need for this to happen? This is one of the questions we can now answer.

Break-even Analysis

Break-even in revenues = Fixed costs / Contribution margin

Graphically, it looks like this:

Break-even-analysis-v5-innovationtactics-com — You must know this for your business! And it’s much easier than it might look at first glance. We are looking at our costs and profit/loss depending on the number of units sold within one financial year. We have fixed costs which stay the same irrespective of how many units we sell. Add to that the variable costs which increase with units sold. That are our total costs. Our revenues go up with the number of units sold. There will be a break-even number of units sold that tips you from unprofitable for the year to profitable. You need to know this number for your business planning! Understanding the contribution margin will help you to calculate this number

Innovation and business management

Rather than calculating a break even point I find it more interesting to simulate possible outcomes for the next financial year. That is what I have done for Netflix for 2018 based on the 2017 data. This way I could make sure that there is little speculation as the 2018 results have been published a month ago. Here is how such a simulation could look like (the simulated data has the [sim] marker).

Simulation-Netflix-revenue-growth-and-operating-income — This is how it looks: huge revenues (dark green) and slim profits (thick light green). Break-even occurs at about 15% revenue growth from 2017. I am assuming a variable cost of $11.5b for this scenario (this compares to $12.2b that Netflix incurred in reality in 2018). The assumption is that Netflix proactively would manage variable costs if they saw, say, a bad first quarter. The simulation is very accurate (surprise given hindsight, hey?) for the actual 2018 results: 35.08% revenue growth YOY and a simulated variable cost of $12.31b as opposed to the $12.34b that really occurred (dare to ask me for a simulation for a 2019 simulation and I will come up with this and we can check the accuracy in Feb 2020 when the 2019 actuals become available) — Update 17/03/19: shout out to my reader Sai Teja who has asked me for this update! I have added the FY19 simulation below [data source: Netflix annual reports, simulation: innovationtactics.com]

I have used revenue instead of units sold. Netflix has managed to increase revenue per subscriber year-on-year (2017-2018). This would add another variable to the simulation. I would suggest to keep revenue per subscriber constant for our purposes and take any upside as an opportunity to exceed operating income targets. I will elaborate more on customer metrics next time including revenue per customer.

Simulation-Netflix-revenue-growth-and-operating-income-detail — Lots of curves, hey? Don’t worry. It is largely the same as the above but zoomed in. I have subtracted the previous year’s revenues and costs to give a better feel into the numbers. I have also added one other curve: the blue line which shows the operating profit margin for a simulated revenue growth. E.g. a revenue growth of 30% leads to an operating margin of 7.5% (only slightly up from 7.17% in 2017, somewhat ouch). The steepness of this curve is the operating margin leverage. Growth below 30% leads to operating margin reduction(!). This is only possible due to the anticipated growth in the international business. If Netflix was in a mature phase, they would manage variable costs differently – fascinating, heh? [data source: Netflix annual reports, simulation: innovationtactics.com]

This is very exciting, isn’t it? We can do a lot of useful stuff with this to manage our ideas.

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Contribution margin at different stages of the firm

Well done so far! There is just one more thing we need to understand.

We already have mentioned that the range of the contribution margin varies a lot with the industry that we are in. Capital-intensive industries will have different CM ranges compared to capital-light industries. But even within one firm, CMs can differ depending on the business segment, product line or where they are in their innovation lifecycle.

The last few diagrams were company-wide metrics. But different parts of the business are in different stages:

International: early growth
Domestic streaming: maturing growth
Domestic DVD: retiring (sunset)

(1) Mature / retiring product

Where we use relative metrics, such as ratios, we need to look at them in the absolute context as well. Compare the contribution margins of the streaming business with that of the DVD-by-mail business and it will look as if the DVD business performs better. E.g., pg 22 of the 2016 annual report shows the DVD segments contribution margin sitting at 55%. Great, hey? Well, it is not really great if you look at the rapidly falling revenues.

Contribution margins for the DVD business have been steadily increasing since the inception of streaming. But since the introduction of streaming revenues have been declining rapidly. The reason why contribution margins have been increasing is because of reduced usage of DVDs and therefore variable costs declining faster than revenues.

Why have revenues not been falling that quickly? Well, seems people have been keeping their DVD subscriptions despite using it less (or not at all), e.g. 1 DVD per week instead of 3. “Our Domestic DVD segment had a contribution margin of 52% for the year ended December 31, 2016, up from 50% for the year ended December 31, 2015 due to the decrease in DVD usage by paying members.”

Netflix-US-DVD-segment-contribution-margin — You’d be mistaken to just look at contribution margins without context. E.g., Netflix’s DVD segment clocks in increasing contribution margins year-on-year amid falling revenues. All enabled by lower usage of DVDs indicating the end for this segment is nigh [data source: Netflix annual reports]

It is not unusual for certain metrics to improve when assets approach end-of-useful-life. You can observe the same in certain industries for ROICs of major assets because many costs (esp depreciation charges, etc) may have already been fully expensed.

(2) Emerging business

We see the opposite picture for the international streaming business. Contribution margins are low (just made it into positive territory in 2018). But it is a rapidly growing business that, by current indications, should improve across all metrics, revenues, operating profits and contribution margins. But it will depend on many factors. Will Netflix be able to use their content across many of the countries (and leverage economies of scale)? How much localised content will be required? What will competition do? What subscription fees will they be able to charge? Will they have a hard time with piracy? Etc…

Netflix-international-streaming-segment-contribution-margin — Netflix’s international streaming segment started with contribution margins of -300% in 2011 (not shown here) and gradually improved to positive in 2018. We would expect that it gets better from here if it follows the domestic streaming trajectory [data source: Netflix annual reports]

Lyft contribution margin

Let’s close out with one more recent example: Lyft.

Last weekend, I was browsing through Lyft’s IPO filing which came out just a few days prior. I noticed that they called out contribution margin as a key metric as well. Here is what they contribute (sorry, pun intended) to this discussion:

Contribution and Contribution Margin are measures used by our management to understand and evaluate our operating performance and trends. We believe Contribution and Contribution Margin are key measures of our ability to achieve profitability and increase it over time. Contribution Margin has generally increased over the periods presented as revenue has increased at a faster rate than the costs included in the calculation of Contribution. […] We expect our Contribution Margin will fluctuate in the near-term as we expand our network of shared bikes and scooters; however, we expect our Contribution Margin to increase over the long-term as we scale and increase the usage of our platform and improve our ability to manage cost of revenue.

Update: CM simulation for FY19

Here now are some potential outcomes for the financial year ’19. The actuals will be available in Feb 2020. This is a crude simulation and I will review the methodology in a few weeks when I have finished our Netflix series and may update (or at least provide more details) then!

Simulation-Netflix-revenue-growth-and-operating-income-2019-detail-v1 — Simulation of Netflix revenue growth and operating income 2019 – we will compare to the actual results in Feb 2020! I will review the methodology in a few weeks (around April ’19) and many update the charts!

Simulation-Netflix-revenue-growth-and-operating-income-2019-v1 — Simulation of Netflix revenue growth and operating income 2019 (zoomed in) – we will compare to the actual results in Feb 2020! I will review the methodology in a few weeks (around April ’19) and many update the charts!

Make use of this important metric for your idea or business!

You have really learned not just about contribution margin but also a lot about other related metrics as well as important management concepts, such as fixed and variable costs. You have also seen how you can use these insights in a real-world setting (rather than theoretical discussions).

Use this valuable knowledge for your business and innovation ideas. Esp the simulation of potential outcomes for the next financial period can be a very powerful tool to manage the cost side of your business in anticipation of different sales/revenue outcomes (and close monitoring of your results as they unfold throughout the year). Building in flexibility into your cost structure will help you to do this.

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