What Product Managers Can Learn From Clayton Christensen: Part 1 of X — Marginal Costs
*Note: This is Part 1 of X, because the works of Clayton Christensen are full of sheer gold, and I have yet to get through all his books, and I don’t know how many posts I will write as a result.*
I’ll wait.
Go on…
It’s a quick read, and if you were a fan of “The Innovator’s Dilemma” (which I will be re-reading pretty soon here), you will enjoy it.
In today’s post, I want to focus on the section on marginal costs and revenue, and what you, as a product manager, can take from it.
On the section of marginal costs, Clayton discusses the well known story of the rise of Netflix, and the fall of Blockbuster. Taken from this article:
In the late 1990s, Blockbuster dominated the movie rental industry in the United States. 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 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. It wasn’t long before Blockbuster realized that people didn’t like returning movies quickly, so it increased late fees so much that analysts estimated that 70 percent of Blockbuster’s profits were from these fees.
In hindsight,it’s crazy to think that a vast portion of Blockbuster’s profits were made by punishing customers.
Blockbuster in the 90s, counting all that sweet late fees money
The book discusses the rise of Netflix to start filling in some niche space that was not a priority by Blockbuster, in which we reach the next excerpt:
By 2002, the upstart (Netflix) 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. “Obviously, we pay attention to any way people are getting home entertainment. We always look at all those things,” is how a Blockbuster’s responded 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. This “niche” market seemed just fine.
We all know how this turned out for both companies.
Continuing on:
Blockbuster’s mistake? To follow a principle that is taught in every fundamental course in finance and economics. That is, in evaluating alternative investments, we should ignore sunk and fixed costs, and instead base decisions on the marginal 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. As Blockbuster learned the hard way, we end up paying for the full cost of our decisions, not the marginal costs, whether we like it or not.
Who would have thought in the 90s that this would happen to Blockbuster down the road?
Let’s continue:
The answer lies in their approach to marginal versus full costs. Every time an executive in an established company needs to make an investment decision, there are two alternatives on the menu. The first is the full cost of making something completely new. The second is to leverage what already exists.
Almost always, the marginal-cost argument overwhelms the full-cost. When there is competition, and this thinking causes established companies to continue to use what they already have in place, they pay far more than the full cost — because the company loses its competitiveness. As Henry Ford once put it, “If you need a machine and don’t buy it, then you will ultimately find that you have paid for it and don’t have it.” Thinking on a marginal basis can be very, very dangerous.
Let’s say that you have a product that has done quite well for itself and has a nice chunk of market share. You’re aware that you have to make some changes for the future. You see some competitors that are making headway with a different or disruptive approach.
You have a few options. You can take the approach of creating something completely new, and deal with the upfront costs. Or, you can use your current resources. You look at the marginal costs of what you’re looking to build, and decide it may not be worth your time. Or, you might try to buy out a rising competitor to take advantage of their disruptive approach (assuming you create a smooth assimilation, which is easier said than done).
If you do take the approach of going the full costs, no doubt you will have executives and finance telling you that it’s silly, especially if you’re a well established company. If you’re a startup who has yet to find a successful model, you have the luxury of pivoting until you find an approach that works. An established company no longer has this luxury, and makes it a harder case to deal with the upfront costs, and instead look to the marginal costs. If it worked for them in the past, why should we take a risk now?
Startups have the advantage in being able to take bold risks that established companies. At the time, Netflix had no marginal costs or revenue to compare itself to, so it boldly went forward with its approach which paid off in the long run.
It may end up being business as usual for awhile, as it was for Blockbuster. However, overtime, they lost their share, and Netflix took over. Blockbuster focused on the marginal costs and revenue and delayed, instead of dealing with the upfront costs of pursuing the direction that Netflix did, or even purchasing them outright.
And then Netflix said that we’ll go out of business if we don’t look at this crazy internet thing! Ha!
So, as a product manger, depending on where you are, the size of the company, how well established you are, you may have some decision making power in this, or it may lie to those above you. That said, in these decisions, you need to make a strong case in regards to marginal costs and revenue. We have seen time and time again what happens when a company comes in with a disruptive approach to an industry and are ignored or mocked by established companies.
On the other hand, if you are at a startup that is taking the disruptive approach, you have a unique competitive advantage in which marginal costs and revenue are not a concern for you. You’re still trying to figure out a model that works. Your established competitors are going to take time to change their approach, and depending on how fast you can disrupt, you may have driven them out before you know it.
While not the sexiest topic in the world, you should have an understanding of how marginal costs and revenue work as a product manager. Keeping them in mind can help you take a different perspective in how you deal with things moving forward. Clayton Christensen is full of great pockets of knowledge such as this.
This guy gets it.
Originally published at www.pmpaul.com on September 27, 2016.
