he concept of economies of scale can be one of the most valuable ingredients to bringing down your cost structure as you scale up your innovation idea.
Economies of scale are an accepted concept that makes common sense – so, why bother writing anything about it?
Because the journey of scaling up (and benefiting from economies of scale) will, in reality, be very different from what you learn in the economics textbook. Today, I am going to use Netflix as an in-depth, real-life example to demonstrate the challenges on their innovation journey as they have grown over the years.
You will also learn how Netflix transformed from a DVD-mailing company to an envied tech powerhouse.
Let’s get started!
Economies of Scale (EoS)
Let’s have a brief look at how real-life economies of scale (EoS) can differ from the textbook.
Economies of Scale can be described as:
- “the cost advantages that enterprises obtain due to their scale of operation (typically measured by amount of output produced), with cost per unit of output decreasing with increasing scale.”
For starters, we should point out that this includes:
- The ability to invest in a better customer value proposition (or other assets / activities) by being able to spread (fixed / indirect / one-off) costs across a larger (existing or future) customer base
Economies of scale unfold differently in a real-world setting than in an economic setting where you are backwards looking and over a long period of time and accounting differently. Especially in the case of smaller firms or start-ups, things will look more like scenarios B and C above. This can take you by surprise if you trust the textbook curve too much.
Investment decisions
Unit cost reductions can come from ongoing optimisation efforts related to scaling up. In other cases, they may also require capex (or one-off opex) to be invested to achieve these lower unit cost levels. When Netflix went to streaming they reduced their fulfilment cost but had to first invest into technology and development for a number of years.
Competitive advantage
One of the big rewards of materialising economies of scale are improving competitive advantages:
- Lower unit cost can allow you to reduce the price for your goods that smaller competitors may not be able to achieve profitably
- The first company that achieves lower unit costs can out-compete other and gain market share which may further deteriorate the case for competition to invest in the same technology
- Further, it can give you a lead that you can use to front run others in additional investment decisions. Look at scenario (B) where you get over the first hump at point 2 and then over the next hump at point
- Economies of scale have been a major source of competitive advantage for the large players in their respective industries for a long time
Types of economies of scale
Economies of scale and respective unit cost reductions can occur anywhere throughout your value creation process:
- Technical
- Supply chain
- Distribution and logistics
- Manufacturing and production
- Research & development
- Specialisation
- Marketing
- Financial
- Network effects
- And more
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Example Netflix
Let’s now look at Netflix 20-year journey from an economies of scale perspective (we will be looking at Netflix through a number of other lenses throughout my next new articles).
Here are some of the key milestones and decisions that you should be aware of:
- Netflix is founded in 1997, has their IPO in 2002 and publishes data reaching back to 1998. This shows us significant unit cost reductions as they scale up in the early years across all major cost items between 1998-2002
- From the early/mid-2000s, Netflix starts investing in the Netflix Box (that was later called Roku player and split out as a separate company Roku Inc)
- From 2005, these efforts ultimately morphed into streaming which went live another 2 years later from 2007
- From 2010, Netflix starts going international, first in Canada and Latin America then successively worldwide
- From 2013, Netflix starts creating Netflix Originals
- The international expansion concludes in 2016. From here, Netflix is in a “steady-state” where it is easier to track the unit cost effects of their decisions
Scalable business model
Netflix very frequently points out the scalability of their business model (in basically every annual report). Here is one such example:
Annual report, 2007: Scalable Business Model. We believe that we have a scalable, low-cost business model designed to maximize our revenues and minimize our costs. As we continue to expand our subscriber base, we are able to leverage operational changes in a cost effective manner which further reduces our operating costs on a per subscriber basis. Such cost reductions include increased automation and vendor negotiating leverage.
Instead of using operating cost on a per subscriber basis I have decided to use the individual cost components as a percentage of revenues. I consider this better as it also accounts for the churn of subscribers during each annual period (whereas unit cost per subscribers at year-end omits this, it also weeds out the free-trial subscribers that may never lead to any revenues).
(1) Fulfilment economies of scale
2002: The starting point
You may have forgotten it but in the early days (founded in 1997) Netflix was a mailing company that would mail millions of DVDs per day to their customers delivered by US Postal Service.
In these days, fulfilment costs are one of the highest individual operating expenses. It is defined as:
Annual report 2002, pg F-10 Fulfillment costs represent those costs incurred in operating and staffing the Company’s fulfillment and customer service centers, including costs attributable to receiving, inspecting and warehousing the Company’s DVD library. Fulfillment costs also include credit card fees.
Just to give you an idea of how things worked when Netflix was a DVD rental-by-mail company:
“We currently stock more than 14,500 titles on more than 5.1 million DVDs. During December 2002, we shipped to and received from subscribers more than 9.7 million DVDs.
We currently are operating 18 shipping centers serving the metropolitan areas of Atlanta, Boston, Dallas, Denver, Detroit, Houston, Los Angeles, Miami, Minneapolis, New York, Newark, Philadelphia, Phoenix, Portland, San Francisco, Stamford, Seattle and Washington, DC.
We plan to open additional shipping centers in 2003. We estimate the set-up cost of a shipping center to be approximately $60,000.
We believe our shipping centers allow us to improve the subscription experience for non-San Francisco Bay area subscribers by shortening the transit time for our DVDs in the U.S. Postal Service.”
By 2004, Netflix has 30 shipping centres in 2004 and it is the last time they call out the number of fulfilment centres.
I have pulled out the fulfilment cost as a percentage of revenues over the first 10 years. The effects of economies of scale can be well seen. Further, with declining fulfilment costs per revenue, more funds are left for investment, marketing and other activities that can increase future revenues.
Netflix explains in their words the initial reduction of fulfilment costs (page 17, annual report 2002): “As a percentage of revenues, fulfillment expense decreased from 17.7% in 2001 to 12.7% in 2002 due primarily to a combination of an increasing revenue base and substantial improvements in our fulfillment productivity due to our continuous efforts to refine and streamline our fulfillment operations.“
(2) Technological economies of scale
Now let’s look at technology. It is a very important source of economies of scale. But investments in technology are also always a journey …
The innovation journey to streaming
There are two primary drivers for streaming:
- A better customer value proposition underpinned by the convenience of streaming
- Rapid and vast scalability, thus the opportunity for rapid revenue growth and unit cost reduction due to economies of scale
2005: the “Netflix Box” (later, Roku player)
Netflix’ journey to streaming took several years and was not a linear one. Here is what one of the leads of their initial efforts reports :
It wasn’t the first time that Netflix had evaluated an internet-only option, but only in the mid-2000s did data speeds and bandwidth costs finally reach the point where asking users to download an entire movie online no longer seemed like a crazy idea. The initial thinking was that we would create and supply customers with a “Netflix box” that they could use to download movies overnight to watch the next day. It was incredibly difficult to acquire the download rights to movies, just as it was difficult to create the new box and service, but by 2005, we were finally ready to launch.
After working for a few years on the Netflix Box (which eventually became the Roku player), Netflix pivoted to streaming as we know it today:
That pivot took two long years, during which we had to renegotiate all our rights and build an entirely new architecture to host and serve content. We had to transform our “Netflix box” from a hard drive that would download video to one that would stream it.
Netflix includes all important elements in their technology and development costs that we would like to see there:
Technology and development expenses consist of payroll and related expenses we incur related to testing, maintaining and modifying our Web site, our recommendation service, developing solutions for downloading movies to subscribers, telecommunications systems and infrastructure and other internal-use software systems. Technology and development expenses also include depreciation of the computer hardware and capitalized software we use to run our Web site and store our data.” Annual report, 2005. It is also the first mention of downloading movies to subscribers
2007: Streaming, finally
- From 2007, streaming goes live. They give free access to their DVD subscribers and thus have a large customer base from the scratch
- Until mid-2011, customers can use both offerings in parallel for one price
- Initially, Netflix had their own hardware infrastructure then switched onto Amazon Web Services (I have described the cost implications here)
- Netflix conquered the domestic US market first, then started expanding internationally
2010-2016: International expansion
The international expansion:
- 2010 & 2011: The American continent
- 2012-2014: UK, Scandinavia, Central Europe
- 2015: Oceania, Japan, Western Europe
- 2016: Rest of World (with exception of US-sanctioned countries and China)
Observations
- The curve follows scenario B with an early low (point 1) in 2004-2006 consuming ~5% of revenues
- From there, it starts increasing as Netflix starts investing in developing streaming and its expansion internationally
- It peaks at 9.15% of revenues and starts tapering back with 7.75% in 2018
- The streaming efforts start in the mid-2000s and go up to the conclusion of the international expansion in the mid-2010s – a journey of a good 10 years
Structural change
If you overlay the fulfilment cost curve with the tech & development curve you see how the structural cost basis changes over time:
- A shift from fulfilment expenses to technology and development
- In the early years, tech/devel and fulfilment costs were in a similar ballpark
- But in the mid-2000s (2004-07), fulfilment expenses strongly exceeded tech/devel (by a factor of 2:1 in some of those years – not a tech company at all at that time)
- The investments into streaming provided a better value proposition but also lead to a significant reduction of the operational costs for fulfilment
- The tech & development costs invested in streaming are temporary and start to wind down as shown above
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(3) Supply chain and commercial economies of scale
The acquisition of content is the biggest cost to Netflix in most years. Once streaming commences, these costs go up dramatically. And I am not sure if this was expected to the extent it happened. This makes it an interesting point for us as innovators.
DVD library
Let’s look at the sourcing of the DVD library and the cost of content acquisition (in their own words).
Direct purchase:
Annual report, 2002, pg F-7 “Historically, the Company purchased DVDs from studios and distributors.
Annual report, 2010, pg 9: “Direct purchase of DVDs requires us to be able to accurately forecast demand in order to ensure that we have enough copies of a title to satisfy but not exceed demand so that our subscriber satisfaction is not negatively impacted. However, if we purchase excess copies of title or experience an increase in usage of a title without a corresponding increase in subscriber retention and growth, our content and fulfillment costs will increase disproportionately to revenues thus adversely affecting our operating results.”
Revenue sharing:
Annual report, 2002, “In 2000 and 2001, the Company entered into a series of revenue sharing agreements with several studios which changed the business model for acquiring DVDs and satisfying subscriber demand.
These revenue sharing agreements enable the Company to obtain DVDs at a lower up front cost than under traditional buying arrangements.
The Company shares a percentage of the actual net revenues generated by the use of each particular title with the studios over a fixed period of time, which is typically 12 months for each DVD title […]
The implementation of these revenue sharing agreements improved the Company’s ability to obtain larger quantities of newly released titles and satisfy subscriber demand for such titles over a shorter period of time.”
Annual report 2007, pg 15: “We have seen the purchase mix shift toward direct purchasing arrangements as revenue sharing agreements expire.”
Netflix calls the revenue sharing model an important part of their business model prior to streaming. Once streaming goes live things change rather quickly.
Streaming content library: Unintended side effects?
Streaming goes live in 2007 with only a very small selection of titles (1,000 streaming titles compared to 100,000 DVD titles). As streaming becomes more popular, more titles get added and costs increase rapidly. By looking at their overall profit margins, I assume that the cost increase was not expected to this extent. In 2012 the operating profit falls to 1.48% from low double digits in the preceding 3 years and from high single digits in the 3 years prior to that.
When net income plunged some 92% Netflix stated in their annual report 2012, pg 20:
“Consolidated revenues for 2012 increased as compared to prior years due to growth in streaming subscriptions. Operating income and Net income in 2012 both declined as compared to prior year reflective of increases in both cost of revenues due to streaming content investments and marketing to support our launch into new International markets.”
In the first years after streaming started, Netflix had to negotiate carefully (and with a big check book) to get rights to stream some of the more popular shows (you can get an insight about that situation at the time in this article from 2010).
Looking at the above chart, we see a curve emerging as shown in scenario C in our economies of scale journeys. We see a tapering the latest data and it will be interesting to follow the next few years. The ability to reduce content costs will depend on a number of factors (not just economies of scale) but also the industry structure. Content providers (studios, etc) will try to get as much as possible and this will put a floor to Netflix’ scaling effort (and therefore I don’t expect a massive tapering as in point 3 of scenario C).
Here are some insightful explanations compiled from the annual reports 2011-2013 as the new cost structure emerged:
Annual report 2011, pg 28 (repeated in 2012):
Content acquisition and licensing expenses increased by $674.4 million. This increase was primarily attributable to continued investments in streaming content resulting in an increase in the average number of streaming content titles available for viewing to our domestic subscribers as compared to the prior year. The increase is also partially attributed to an increase in streaming content titles available in Canada as well as to our Latin America and Caribbean expansion in the second half of 2011
Annual report 2012, pg. 5:
“Given the multiple-year duration and largely fixed cost nature of content licenses, if subscriber acquisition and retention do not meet our expectations, our margins may be adversely impacted. Payment terms for streaming licenses, especially programming that initially airs in the applicable territory on our service (“original programming”) or that is considered output content, will typically require more up-front cash payments than other licensing agreements. To the extent subscriber and/or revenue growth do not meet our expectations, our liquidity and results of operations could be adversely affected as a result of content licensing commitments and accelerated payment requirements of certain licenses.”
Annual report 2013, pg 4:
We must continue to build and maintain strong brand identity. We believe that strong brand identity will be important in attracting and retaining members who have a number of choices from which to obtain entertainment video. To build a strong brand we believe we must continue to offer content and service features that our members value and enjoy. We also believe that these must be coupled with effective consumer communications, such as marketing, customer service and public relations. If our efforts to promote and maintain our brand are not successful, our ability to attract and retain members may be adversely affected. Such a result, coupled with the increasingly long-term and fixed cost nature of our content acquisition licenses, may adversely affect our operating results. With respect to our expansion into international markets, we will also need to establish our brand and to the extent we are not successful, our business in new markets may be adversely impacted.
This gives us a pretty good picture of the content cost, customer experience, the Netflix brand and their margins.
Netflix Originals
Economies of scale and scaling up also have non-linear effects. Once you grow beyond a certain size new opportunities arise.
For Netflix, this was the opportunity to create their own original content. In their own words:
“Since 2013, we’ve been at a scale where we can economically create original content for Netflix and our offering has grown as we gain further scale and confidence. With each original, we learn more about what our members want, about how to produce and promote effectively, and about the positive impact of originals on our brand.“
Own content reduces their dependency to studios somewhat and this could lead to a shift of powers within the wider industry (esp if others, like Amazon, continue creating their own originals as well). Original content helps to build their brand and avoids them being a pure content distribution company. It increases also the barriers of entry for new entrants.
Contribution margins
This brings us to the obvious risk of studios continuously ramping up licensing costs. Netflix has made clear statements on this early on. An excerpt from Netflix’s annual report from 2010, pg 7 basically make clear that they believe to have sufficient choice so that incremental content addition will always make sure that margin targets are not compromised (provided forecasted subscriber growth rates are being met):
“As we grow, we are able to spend an increasingly larger amount for the licensing of streaming content. We believe that the streaming content we make available to our subscribers is sufficiently diversified, such that we will not be forced to pay licensing fees for content in excess of our desired operational margins. We believe that any failure to secure content will manifest in lower subscriber acquisition and retention and not in materially reduced margins. Nonetheless, given the multiple-year duration and largely fixed nature of content licenses, if we do not experience subscriber acquisition and retention as forecasted, our margins may be impacted by these fixed content licensing costs.”
This philosophy has remained the same from those early days of streaming. I will cover the concept of contribution margins in a separate article in the near future using Netflix’ example as this is a very important concept.
With this, you have gained excellent understanding of Netflix’ content cost. It is one of the most fundamental parts of its business.
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(4) Marketing Economies of Scale
Sometimes overlooked is the fact that you can also achieve economies of scale in the area of marketing. It is another crucial ingredient to Netflix’ success. The growth rates that Netflix has achieved would not be possible without extensive marketing. And that is important because – as we are clear by now – growth is what is fuelling economies of scale.
Let’s start with an example from their 2010 annual report, pg 29:
By continuously improving the customer experience, we believe we drive additional subscriber growth in the following ways: […] Additional subscriber growth leads to greater word-of-mouth promotion of our service, which in turn leads to more subscriber growth at an increasingly cost-effective marketing spend.“
| As of / Year Ended December 31, | ||||||||||||||||||||
| 2010 | 2009 | 2008 | 2007 | 2006 | ||||||||||||||||
| (in thousands, except subscriber acquisition cost) | ||||||||||||||||||||
| Other Data: | ||||||||||||||||||||
| Total subscribers at end of period | 20,010 | 12,268 | 9,390 | 7,479 | 6,316 | |||||||||||||||
| Gross subscriber additions during period | 16,301 | 9,332 | 6,859 | 5,340 | 5,250 | |||||||||||||||
| Net subscriber additions during period | 7,742 | 2,878 | 1,911 | 1,163 | 2,137 | |||||||||||||||
| Subscriber acquisition cost (4) | $ | 18.03 | $ | 25.48 | $ | 29.12 | $ | 40.86 | $ | 42.94 | ||||||||||
You can see a significant reduction in customer acquisition costs from:
- $42.94 per subscriber in 2006 to
- $18.03 per subscriber in 2010
But I’d like to call out some additional observations:
- This metric is calculated as gross subscriber addition during the period
- It is their metric to assess the effectiveness of their marketing efforts (this makes sense)
- If you compare this to the net subscriber addition, things look different – I have mapped this out below
- Net subscriber is a metric for the end-to-end funnel and not only marketing but also retention which in itself has a number of facets
- If we look over the long term, we can see that the net subscriber addition per marketing spend also improves
- Compare below the first eight years with the last eight years and you will note a significant improvement
- As an innovator, you can see that economies of scale, once again, don’t follow the textbook with a nicely sloping down curve
I will cover the topic of customer acquisition and retention (and the outliers below) in more depth in an article in the near future using Netflix as an example.
(5) Specialisation Economies of Scale
One of Adam Smith’ key insights was an increase in productivity due to specialisation and the division of labour. There are economies of scale to be gained through specialisation of individuals and organisations within the firm. Decisions to in or outsource are crucial in this discussion.
Let’s look at a few concrete Netflix examples:
(1) ROKU player: where Netflix has consciously decided not to specialise on
Specialisation often is seen in in- and out-sourcing decisions. Take the example of what has become the Roku player. From the early 2000s, Netflix started working on a “Netflix box” that would download movies over the internet overnight for people to watch. In 2005, Netflix decided to go the path of streaming rather than the Netflix box. In 2008 after streaming went live, Netflix outsourced the Roku player (as it was called then) by spinning out Roku Inc (and remaining a large shareholder of it). Roku now creates streaming set-top-boxes for Netflix and other streaming content.
It shows that Netflix did not want to divert attention and keep focused/specialised on what they are known for: content.
(2) Netflix Originals
Netflix decided to create their own original shows from 2013 onwards. This is one has lead to an increase in general and admin cost as stated, e.g., in the 2017 annual report, pg 24:
General and administrative expenses increased primarily due to a $184.7 million increase in personnel-related costs, including stock-based compensation expense, resulting from a 56% increase in average headcount primarily to support our international expansion and increased production of original content, and an increase in compensation for existing employees.
On pg 4 of the same report, you can see that this is seen as a differentiating customer value proposition that plays a role in attracting and retaining subscribers.
We believe that original programming can help differentiate our service from other offerings, enhance our brand and otherwise attract and retain members.
It also helps in negotiating better terms with studios on obtaining exclusive rights from them due to the fact that they have the alternative option to invest more in creating originals themselves if the studios offer overly unfavourable terms (a simple insight from Porter’s Five Forces). In 2010, Netflix was just another bidder among many to compete for content rights. With scale they have gained clout.
(3) Marketing capability
Marketing plays a key role in Netflix’ growth which is why they have built internal capability over the years. In the latest annual report (2018), Netflix reclassified costs that were previously captured as general and admin into marketing. This has provided some insight into these specialised costs (though only for the years 2016, 2017). You see these split out below.
- It equated to 45.7% of general and admin in 2016 and
- 25.4% in 2017
Netflix says about their focus:
“Netflix is a global internet entertainment services network offering movies and TV series commercial-free, with unlimited viewing on any internet-connected screen for an affordable, no-commitment monthly fee. Netflix is a focused passion brand, not a do-everything brand: Starbucks, not 7-Eleven; Southwest, not United; HBO, not Dish.
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.
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.
We are a relief from the complexity and frustration that embody most MVPD relationships with their customers. We strive to be extremely straightforward[…]“
What are the areas that your innovation needs to focus on and scale up? What are the economies of scale that you can leverage as you scale those?
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(6) External economies of scale: Network effects
Let’s now look at one example for external economies of scale. I am choosing network effects as one example but there are more. I will cover things like agglomeration next time.
One of the most important external EoS in Netflix’ history was the rapid spreading of DVD players from 2002 onwards. This lead to a reduction of prices of players and DVDs which both greatly contributed to a larger customer base as well as a lower cost base (e.g. lower DVD prices) to benefit Netflix.
Wikipedia reports“But then the sales of DVD players finally took off as they became more affordable, selling for about $200 around Thanksgiving time, becoming one of that year’s most popular Christmas gifts. By early 2002, Netflix saw a huge increase in their subscription business.”
Another, much larger network effect was that of the expansion of the internet and in particular, steadily increasing bandwidth and penetration across large parts of the population. This was the enabler of the success of streaming!
And finally, let’s recognise that these external effects still exists – see Netflix’ latest annual report, pg 2:
Our membership growth exhibits a seasonal pattern that reflects variations when consumers buy internet-connected screens and when they tend to increase their viewing. Historically, the first and fourth quarters (October through March) represent our greatest membership growth across our Domestic and International streaming segments.
As you can see economies of scale don’t only come from internal sources.
Economies of Scale: crucial conclusions
We all know intuitively that economies of scale are an important concept that can help innovators bring down their unit cost structure as they scale up. But you have also seen that it’s just a bit more tricky than the nicely sloping down textbook curve.
Some final conclusions
- The early days of scaling up can be particularly painful as they can be very loss-making
- As you grow your business (i.e. revenues), EoS can help you reduce the cost side as a percentage of revenues and therefore give you more funds to invest in further growth drivers and/or reduce pricing – a competitive advantage to new entrants
- Economies of scale can often be accelerated through the right investment decisions. However, in these cases unit cost can often go backwards initially. This is important to take into account
- Timelines for economies of scale can play out over a much longer time than expected
- Along the way, other – unexpected – things can happen (think of the streaming content costs)
- As things don’t play out as described in the textbook it is important to not get discouraged!
And I hope you have enjoyed Netflix’ innovation journey described from an economies of scale perspective and learned a lot!
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