The Trap of Marginal Thinking: Lesson from Blockbuster vs Netflix
In the United States, in the late 1990s, Blockbuster dominated the movie rental industry. It had stores all over the country, a significant size advantage, and what appeared to be a stranglehold on the market.
Blockbuster had made huge investments in its inventory for all its stores. But, obviously, it didn’t make money from movies sitting on the shelves; it was only when a customer rented a movie, and a clerk scanned the movie out of the store, that Blockbuster made anything. It therefore needed to get the customer to watch the movie quickly, and then return it quickly, so that the clerk could rent the same DVD to different customers again and again.
To prod customers to return the DVDs quickly, the company levied big fines for every day that the customer forgot to return the DVD on time — if Blockbuster didn’t, it wouldn’t make money, because the DVD would be sitting in a customer’s home rather than be rented to someone else. It didn’t take long before Blockbuster realized that people didn’t like returning movies, so it increased late fees so much that analysts estimated that 70 percent of Blockbuster’s profits were from these fees.
It didn’t take long before Blockbuster realized that people didn’t like returning movies, so it increased late fees so much that analysts estimated that 70 percent of Blockbuster’s profits were from these fees.
Set against this backdrop, a little upstart called Netflix emerged in the 1990s with a novel idea: rather than make people go to the video store, why don’t we mail DVDs to them?
Netflix’s business model made profit in just the opposite way to Blockbuster’s. Netflix customers paid a monthly fee — and the company made money when customers didn’t watch the DVDs that they had ordered. As long as the DVDs sat unwatched at customers’ homes, Netflix did not have to pay return postage — or send out the next batch of movies that the customer had already paid the monthly fee to get.
Netflix customers paid a monthly fee — and the company made money when customers didn’t watch the DVDs that they had ordered.
It was a bold move: Netflix was the quintessential David going up against the Goliath of the movie rental industry. Blockbuster had billions of dollars in assets, tens of thousands of employees, and 100 percent brand recognition. If Blockbuster decided it wanted to go after this nascent market, it would have the resources to make life very difficult for the little start-up.
But it didn’t.
By 2002, the upstart was showing signs of potential. It had $ 150 million in revenues and a 36 percent profit margin. Blockbuster investors were starting to get nervous — there was clearly something to what Netflix was doing. Many pressured the incumbent to look more closely at the market. So Blockbuster did.
When it compared Netflix’s numbers to its own, Blockbuster’s management concluded, “Why would we bother?” The market Netflix was pursuing was smaller; it might get bigger, but it was unclear how big it had the potential to be.
More troubling for Blockbuster’s management, though, was that Netflix’s profit margins were substantially smaller than what Blockbuster was used to. And if Blockbuster did decide to attack Netflix, and if it were successful, those efforts would most likely cannibalize sales from Blockbuster’s very profitable stores. “Obviously, we pay attention to any way people are getting home entertainment. We always look at all those things,” is how a Blockbuster’s spokesperson responded to these concerns in a 2002 press release. “We have not seen a business model that is financially viable in the long term in this arena. Online rental services are ‘serving a niche market.’”
Netflix, on the other hand, thought this market was fantastic. It didn’t need to compare it to an existing and profitable business: its baseline was no profit and no business at all. Compared to that, Netflix was very happy with their relatively low margins and their “niche market.”
So, who was right?
By 2011, Netflix had almost 24 million customers. And Blockbuster? It had declared bankruptcy the year before.
Blockbuster followed a principle that is taught in every fundamental course in finance and economics: that in evaluating alternative investments, we should ignore sunk and fixed costs (costs that have already been incurred), and instead base decisions on the marginal costs and marginal revenues (the new costs and revenues) that each alternative entails.
But it’s a dangerous way of thinking. Almost always, such analysis shows that the marginal costs are lower, and marginal profits are higher, than the full cost. This doctrine biases companies to leverage what they have put in place to succeed in the past, instead of guiding them to create the capabilities they’ll need in the future. If we knew the future would be exactly the same as the past, that approach would be fine. But if the future’s different — and it almost always is — then it’s the wrong thing to do.
Blockbuster looked at the DVD postal business using a marginal lens: it could only see it from the vantage point of its own existing business. When viewed like this, the market Netflix was going after did not look at all attractive. Worse, if Blockbuster did go after Netflix successfully, this new business was likely to kill Blockbuster’s existing business. No CEO wants to tell shareholders that he wants to invest to create a new business that’s going to be responsible for killing the existing business, especially if it’s much less profitable. Who would go for that?
Netflix, on the other hand, had none of those concerns. There was nothing weighing it down — no marginal thinking. It assessed the opportunity using a completely clean sheet of paper. It didn’t have to worry about maintaining existing stores or propping up existing margins; it didn’t have any. All Netflix saw was a huge opportunity … the exact same opportunity that Blockbuster should have seen, but couldn’t.
Marginal thinking made Blockbuster believe that the alternative to not pursuing the postal DVD market was to happily continue doing what it was doing before, at 66 percent margins and billions of dollars in revenue. But the real alternative to not going after Netflix was, in fact, bankruptcy.
The right way to look at this new market was not to think, “How can we protect our existing business?” Instead, Blockbuster should have been thinking: “If we didn’t have an existing business, how could we best build a new one? What would be the best way for us to serve our customers?” Blockbuster couldn’t bring itself to do it, so Netflix did instead. And when Blockbuster declared bankruptcy in 2010, the existing business that it had been so eager to preserve by using a marginal strategy was lost anyway. This is almost always how it plays out. Because failure is often at the end of a path of marginal thinking, we end up paying for the full cost of our decisions, not the marginal costs, whether we like it or not.
From How Will You Measure Your Life? Book by Clayton M. Christensen, James Allworth, and Karen Dillon