Last time I have covered economies of scale using Netflix as an excellent example of this important concept.
This time we will be looking at important concepts related to economies of scale:
- Diseconomies of Scale
- Economies of Scope
- Economies of Density and Economies of Agglomeration
I will continue using Netflix since we want to learn from real-world examples.
Join me for a tour through these concepts and more interesting facts about Netflix!
Diseconomies of Scale
Diseconomies of scale set in as a firm grows and lead to an increase of unit cost of outputs.
Diseconomies of scale can have many causes – so let’s look at a few types and examples that Netflix has come across and are actively trying to manage.
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(1) Diminishing returns (e.g. marketing costs)
When asked about a slowdown of growth in the US market Netflix responds to their investors:
The US remains our largest and most highly penetrated market. Therefore, there may be quarters where net adds are down year over year, which is the natural result of greater penetration. We have built in flexibility to our business model in terms of how quickly we grow content and marketing spend, so we intend to keep US contribution margins growing even with lower membership growth. There is no change to our view on the long term attractiveness and US market size of Internet television, and no change to our view of the ultimate size of our US membership, which we believe can ultimately reach 60-90 million homes.
This in itself can lead to a number of effects. E.g. marketing spend will be less effective in getting new subscribers and possibly only help to neutralise churn. There will still be a considerable need for marketing spend for the purpose of stimulating consumption to prevent people from cancelling their subscription over time. There may be a need to go to more expensive marketing to reach further growth increasing the cost per customer acquisition.
These effects are also called diminishing returns which is closely linked to diseconomies of scale.
(2) Inelasticity of supply
When inputs are in scarce supply (or aggregate demand increasingly exceeds supply) then prices will go up. Content cost is one such example. They increase as competition among streaming providers leads to bidding up prices on the same pieces of content.
Further, as your company grows and becomes more profitable, suppliers try to participate in this growth. There will be a tug-of-war around input costs. As Netflix has grown so have their ambitions of providing exclusive content. But exclusive rights come at a price and make content more scarce as other streaming providers bid to license the same content exclusively (or non-exclusively) in competing offers.
Our licensing is generally time-based, so that we might pay for a multi-year exclusive subscription video-on-demand (SVOD) license for a given title. In each market, we license content from multiple suppliers, mirroring the fragmentation of the content industry. Typically our bids are for exclusive access to the SVOD rights, and we are up against various cable and broadcast networks, as well as online video competitors. As a rule, content owners always want another bidder, and never want one bidder to become too strong.
As we said last time, Netflix may opt to create more of their own shows in this case. Though, if others do the same to an increasing degree then the problem may just move to the lack of supply of talented filmmakers, actors, screenwriters or other parts of this process. Over time, this would adjust as well but it may also give these players greater negotiating power for their salaries/wages. This can lead to an adjustment process that goes for a decade or even more until it reaches a new equilibrium.
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(3) Company culture
One of the most obvious and known causes for diseconomies of scale are related to cultural phenomena associated with large/growing companies (the analogy of metastasising growth comes in mind). Netflix is aware of these phenomena and calls them out on their culture page.
The principal-agent problem sets in and departments compete for resources trying to achieve outcomes that benefit their department but not necessarily the company:
“We trust our teams to do what they think is best for Netflix — giving them lots of freedom, power, and information in support of their decisions. In turn, this generates a sense of responsibility and self-discipline that drives us to do great work that benefits the company.“
Nice words in a culture statement would not be enough. But Netflix is known to act rapidly on those who are not a cultural fit.
Management, communication, over-specialisation:
This kind of organization is very specialized and well adapted to its business model. Eventually, however, over 10 to 100 years, the business model inevitably has to change, and most of these companies are unable to adapt. To avoid the rigidity of over-specialization, and avoid the chaos of growth, while retaining freedom, we work to have as simple a business as we can given our growth ambitions, and to keep employee excellence rising.”
Decision making, biases and fallacies:
Hiring more people than needed in anticipation growth rates will never taper off; accepting disproportionate salary increases; pouring resources into elusive future growth opportunities add costs that are difficult to remove (until financial result go south); investing into ever-diminishing returns; looking at the wrong metrics can all be related to/caused by convoluted decision processes.
The word “decision” is mentioned 33 times in their culture statement. Here is one important excerpt:
For every significant decision there is a responsible captain of the ship who makes a judgment call after sharing and digesting others’ views. We avoid committees making decisions because that would slow us down, and diffuse responsibility and accountability. We farm for dissent; dissent is not natural or easy, which is why we make a concerted effort to stimulate it. Many times, groups will meet about topics and debate them, but then afterwards someone needs to make a decision and be that “captain”. Small decisions may be shared just by email, larger ones will merit a memo with discussion of the various positions, and why the captain made such a decision. The bigger a decision, the more extensive the dissent/assent gathering should be, usually in an open shared document. We are clear, however, that decisions are not made by a majority or committee vote. We don’t wait for consensus, nor do we drive to rapid, uninformed decision making. When the captain of any particular decision is reasonably confident of the right bet for us to take, they decide and we take that bet. Afterwards, as the impact becomes clearer, we reflect on the decision, and see if we could do even better in the future.
As companies grow, they often become highly centralized and inflexible. Symptoms include:
- Senior management is involved in many small decisions
- There are numerous cross-departmental buy-in meetings to socialize tactics
- Pleasing other internal groups takes precedence over pleasing customers
- The organization is highly coordinated and less prone to error, but slow and frustrating
We avoid this by being highly aligned and loosely coupled.
Making culture work is not easy and even despite their focus on this you will still find reports of company politics within the firm from their employees and ex-employees. Netflix’s culture is one of the most revered ones but it does not remain uncriticised by any stretch of imagination.
These types of problems and frictions can materialise even in the smallest companies and lead you off track.
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Economies of Scope
Economies of scope are efficiencies formed by variety, not volume. The expansion of product portfolios is anticipated to come at lower unit cost due to economies of scope. But my view is that this needs to be assessed case-by-case, and where reasonably possible experimented with, before making a decision.
Areas of diversification
Netflix has a number of areas of potential diversification:
- Content types, genres and portfolio
- Content sourcing (non-exclusive, exclusive, self-created)
- Pricing plans
- Other access parameters, e.g. resolution, concurrent streams
But they pursue the opportunities in a very focused manner.
(1) Types & genres
Netflix has large diversification of content though in a limited amount of genres that they focus on. Potential areas of diversification are:
- Different types: TV series vs movies
- Different genres within those types (drama, comedy, etc)
Within the genres, Netflix still keeps a lid on which genres / types of content they embark on:
We are not a generic “video” company that streams all types of video such as news, user-generated, sports, porn, music video, gaming, and reality. We are a movie and TV series entertainment network.
One could imagine them embarking on closely related entertainment genres such as:
- Games shows (“Who wants to be a millionaire?”)
- Food shows
- Travel shows, etc
But they are not doing this – at least not at this stage.
(2) Content creation vs acquisition
Another dimension of potential diversification is in the way of creation/acquisition of the content:
- Non-exclusive content that is also available through other media distribution channels
- Exclusive content created by a third party
- Netflix originals, created by Netflix and exclusively used by them (it is imaginable that they license it out a few years down the track)
It is easy to see the economies of scale when you think of the creation of own content:
- As they have an increasing audience the cost of producing their own originals gets spread across a large subscriber base (I have covered this aspect last time).
- You are getting better and more efficient in the act of creating itself as you do more of it
Over the long run, we believe self-producing is less expensive (including cost of capital) than licensing a series or film, as we work directly with the creative community and eliminate additional overhead and fees. In addition, we own the underlying intellectual property, providing us with global rights and more business and creative control.
But there are also economies of scope to be benefited from. These come in play where activities remain the same (and with that the fixed cost component) irrespective of how (and by whom) the content is created, e.g.:
- Distribution, i.e. the streaming infrastructure is the same for 3rd party content and self-created content
- Technology & development efforts
- Marketing remains largely the same (though there could be more marketing on self-created content but the type of marketing is largely the same)
- Most of the general & admin activities remain the same (though as I said last time, there are organisations within Netflix that do specialise on self-created content)
Where Netflix creates its own content, they do so across different genres (drama, comedy, etc). A lot of the underlying cost drivers are the same. Some actors may be specialised on one genre (though this may be more perception/expectation than reality) and similarly, directors but most actors/directors can do more than one genre. Same holds true for most of the other ingredients (people, tools, processes, etc).
(3) Revenue streams
One can imagine that they diversify on their revenue streams by e.g. offering a low-cost subscription that comes with advertising interruptions. But Netflix wants to remain with their original subscription model:
We don’t offer pay-per-view or free ad-supported content. Those are fine business models that other firms do well. We are about flat-fee unlimited viewing commercial-free.
Or they could introduce a premium content layer for access to their blockbuster content (but they don’t):
We have tiers based on simultaneous streams (1 stream, 2 streams and 4 streams) and picture quality but we don’t think tiers of content would be wise at this time.
Potential benefits of economies of scope
When done right, economies of scope can come with a number of benefits (not all apply in all cases):
- Flexibility to adapt to changing tastes, e.g. one competitor has had a breakthrough success with a new type of TV series (Game of Thrones, anyone?) you can jump on that bandwagon too … (yep, sometimes copying is almost inevitable though not our preferred approach as innovators)
- Utilisation of your assets and staff
- Customer satisfaction due to the amount of choice
- Staff satisfaction and development
- Brand reputation – your brand does not stand for one and one thing alone
False promise of economies of scope
Economies of scope can be a real balancing act!
Firstly, it is not as applicable to all industries equally. Secondly, you have to choose across which dimension to diversify.
- You can add a lot of complexity to your business for little additional value to your customer
- You may be just increasing your cost base without notable revenue increases (or cannibalise you other offerings). Test what you are getting in return, e.g.:
- additional customers,
- increased pricing,
- higher customer lifetime values (e.g. through reduced churn),
- more consumption per customer (i.e. satisfaction and thus lower risk of churn and more likely to promote your offering)
- The false promise of economies of scale may be the fastest way into diseconomies of scale by e.g.:
- adding hidden costs or
- adding complexity and different parts of the organisation competing for internal resources
Personally, I like Netflix’ focus and encourage being clear about it for innovators in the early days. In most cases, diversification can come (way) down the track once you have grown. Companies like Uber, Airbnb have also only diversified after they have had many million repeat users.
Economies of Density and Economies of Agglomeration
I handle these concepts as largely overlapping and am going to focus largely to this from a location perspective.
Both Economies of Density and Economies of Agglomeration are around efficiency can lead to:
- cost savings due to physical proximity (e.g. short supply chains)
- productivity gains due to e.g. network effects – exchange of ideas, experimentation, human capital, etc
Known examples are:
- Malls, markets (bazaars) are some of the best-known examples and event within malls specialised shops are often in close proximity to each other (benefiting from the customers being in a certain state of mind…)
- Industry clusters: Silicon Valley as the most famous example, with many companies, suppliers in proximity to each other
Netflix didn’t choose their various locations by chance. Their headquarter is located in the Bay Area in Los Gatos, California in close proximity to many other tech companies. This helps with sourcing talented staff as well as with the cooperation on technology with other players.
- Firstly, they are not all in one location, which from an economies of scale perspective (metric: lease cost per employee), would be the most efficient
- They have their headquarter in Los Gatos, California which is “is part of Silicon Valley, with several high technology companies maintaining a presence there”
- Los Gatos is also the key location for their technology & development efforts, which was in excess of >$1.2b costs in 2018
- Their content acquisition and other general & admin offices were located in Beverly Hills, Los Angeles (close to the movie studios)
- Their studios in Hollywood’s Sunset Bronson Studios have been selected with economies of agglomeration in mind “Icon is a state-of-the-art facility that places Netflix squarely in the middle of Hollywood’s creative culture to support our next stage of growth and content creation”
These effects can play a big role for young or mature company
Related articles (Netlifx archives)
We are explaining important financial concepts using Netflix as our deep, real-world example:
We are explaining important unit economic concepts using Netflix as our deep, real-world example: