Is Netflix a variable cost or a fixed cost business, and how does that
impact the future of the streaming industry? This is going to be a really fun one because Netflix
is not just Netflix. It's something more. It's a shared cultural experience as Tiger King showed us
in the coronavirus epidemic, with more than 30 million people tuning in in the first 10 days of
Tiger King. What a fantastic collective experience and a total demonstration of how the revolution of
streaming has brought content to a different place than it was even five years ago. Netflix is for me
one of the ones that got away, a business that I just never really
thought would sustain itself over so many pivots, and has impressively reinvented itself
multiple times. Right now, I would say that Netflix is on its 3.0 revolution. The first
was let's send movies to people independently in their homes through the mail, and that was
cool for a while. And it was revolutionary, and it did change the way that we watched things.
But then Netflix said hey, it's just not enough to send it to them in the mail,
we should create a platform where they can watch it from their own TVs or their own phones.
Hence 2.0, smartphone revolution. 3.0 is self-produced revolution, and Netflix is there
right now. So in 3.0, has Netflix's business model changed? Was it originally a variable
cost business, and is it now a fixed cost business, or vice versa? And ultimately,
how is Netflix doing now? But then, probably most importantly, based on its business model,
what is necessary to drive the success of Netflix going forward. Let's dive in and figure it out.
Netflix is more than just a business. It's an entrepreneurial dream. It's a business that
started in 1997 by two entrepreneurs that thought, Hey let's do something different inside the movie
distribution industry. And different they did do. But it's become more than that. It's become an
icon of transformation, an icon of disruption, and an opportunity to think about how, if you
understand the business model of an industry, you might be able to pivot and innovate based on that.
Netflix, after its founding in 1997, went through these three major changes to a place
where in April 2020, they had over 182 million paid subscriptions around the world. So not just
those that are in their free month trial with Netflix, but those that are paying on an annual
basis. And I don't know about you, but I use Netflix. However, not as much as I used to, and
I’m still paying for it. So that started making me question what kind of business is Netflix in.
Am I a good customer? Does that pose a threat to their business over time? Well, let's take a look
and see. Netflix was really the first of the cord cutting pioneers, and for Netflix you might still
have had cable, but also a Netflix subscription. Now your menu is becoming cable or a multitude
of a couple of the streaming subscriptions. And at some point, we might get saturated with that.
But Netflix is doing okay. When we take a look over at their financials, we can confirm whether
they're a variable cost or a fixed cost business. Which do you think? Think about it for a second.
When we ask in our classes, we get a pretty wide range of responses. A lot of classes will say that
it's a pretty even split, 50/50 variable costs or fixed costs. Some are like it's for sure a
variable cost business because each person has an incremental subscription onto the platform.
And other people are like absolutely not, this is a fixed cost business where they
pay for or license things and then they distribute them in a different way. And Netflix,
as the original business, as the DVD business, was much more of a variable cost business. But in 3.0,
Netflix acquires the rights to distribute something once, and then distributes it over,
and over, and over again. So Netflix is by all means a fixed cost business. Does it have
variable costs? For sure. It needs to acquire customers, and it processes your credit card
every month. But for the most part, Netflix is a great example of a software as a product business,
where the software is not a service that you're using to do other things, but the end point is
the utilization of the software. And that software as a product business is a fixed cost business.
We can go over to the financials and take a look at them. In 2019,
the revenues for Netflix, $20 billion. The cost of revenues, $12.4 billion. However,
when we look into what that cost of revenues is, that's licensing and production of shows.
So when you license a show like The Office on to Netflix, well, in that case, you license it not
based on how many users are coming out the other side. In fact, one of the most genius things that
Netflix ever did was not report users back to those that they licensed because they
lost the data that they were getting from their users. And Netflix now is able to have that data
to identify potential winning combinations for new shows. Enter a show like Tiger King. Who
would have thought, except for Netflix, that Tiger King would be such the phenomenon that it is. But
Tiger Sing was an example of, in this 3.0 model, where Netflix is producing and not just licensing
its own shows, a way that they can take their algorithms, understand what it is that people
are most interested in watching, create content that fulfills that, produce it, release it.
But at the front, spend a fixed amount to do it, on the back end add subscribers and add value to
the subscribers that they currently have by releasing the content. So that $12.4 billion,
the cost of revenues, although that's usually considered a variable cost, in this business it's
absolutely not. If I don't go on to Netflix for a month, they still are collecting my money. If
I go on 50 times a month, they don't need to pay more for that. So the cost of revenues at $12.4
billion is basically all fixed cost. In addition, marketing, $2.7 billion, that's a fixed cost.
Technology and development, $1.5 billion, that's a fixed cost. And then general administrative,
$900 million, that is also a fixed cost. So you've got really good operating income
on this revenue amount, and then your net income is also pretty attractive. So still though, under
10% of your total amount, and you'll see that really frequently in high fixed cost businesses.
What are the challenges that Netflix could face going forward in its operating model? Well,
number one, they're operating at these kind of low margins. I mean $1.9 billion of net income is not
a ton when you need to go produce the next Tiger King 10 times. There are a lot of other shows that
Netflix has produced that haven't done anything near what Tiger King has been. And the cost of
producing high quality content is not inexpensive, so they have to spend that money on something
and it's going to be new content. So it's not just gravy that they're able to capitalize on.
It's not like a Zoom, or something else that's a software as a service. So software is a product,
you have to keep investing in your product. And for something like Netflix, you're seeing an
increase in - we're not sure if it's coopetation or competition from a place like Disney.
Coopetition is when I use both. I’m happy, they both look the same, but I utilize both.
Competition is when I only choose one, and it's still to be seen whether people see Disney Plus,
for example, as true competition for Netflix or whether it's just coopetition, where I’ll take
both. Cut my cord and take both into the fray. So at the end of the day, this business needs to,
in order to be successful, to continue to drive usage and subscribers. That 100
million plus subscriber number needs to continue to grow, or they're going to need to acquire
content, or build it for less. If Netflix is able to do one or both of those, then they'll utilize
the capacity that they already have, maximize revenue, and succeed as a fixed cost business.
If you're thinking about starting a business that's software as a product,
make sure you understand what makes it successful. And if you're evaluating business that sells
software as a product, it's also important to know that when you have a fixed capacity and
you have to invest in your product, you need to be able to add enough incremental users to
make that revenue boost worth it. Thanks so much for joining us. If you enjoyed this case study,
please join us on Strategy Simplified, our podcast, or on our YouTube channel.