Twitter is abuzz with the anguished cries of Netflix customers, many of whom will soon be paying $16 per month instead of $10 per month for movie rentals. Many others have angrily threatened to cancel their subscriptions. Instead of focusing on that, though, let’s look at how Netflix could raise prices by 60% (for some users– others may see smaller increases, no change, or even a small decrease).

First of all, Netflix is a data-driven company.  They have lots of data and they are constantly trying to use it more effectively.  They sponsored a $1M contest to see if independent teams could improve on Netflix’s algorithms to suggest movies you might like based on what you have already seen.  They know how much money they make on what kinds of subscriptions.  (They even got in trouble a few years ago for “throttling” or slowing down the shipment of “unlimited” DVDs to people who watched a lot.)  So they knew, before they changed prices, what kinds of changes in demand and volume and price would be profitable for them.

Speaking of profit, the goal for Netflix is making money, not shipping DVDs or streaming videos.  Since they pounded Blockbuster, they have emerged as the leading source for movies and TV show reruns.  And you can make a good case that they have been underpricing for some time.  Streaming is the future, so Netflix is not interested in subsidizing the DVD business for $2/month on top of the streaming fee.  If you want DVD’s, you need to pay $8/month at a minimum.  This will allow them to actually make money on the DVD side of the business.  Some people will probably quit and rent from kiosks like RedBox instead, but these are customers at the margins.  Netflix probably has good data to estimate what portion of their subscribers are likely to leave for kiosk services.

What about other alternatives?  Does anyone really want to drive to Blockbuster anymore?  Amazon Prime members get free streaming videos, although their selection is probably even worse than Netflix’s on-demand line up.  Cable companies and Apple offer on demand rentals, usually with a much better selection of new releases, but these videos cost about $5 a pop, on top of your cable subscription, so it’s not exactly a cheap option.

In other words, the value from Netflix for cost and convenience is pretty hard to beat, even at the higher prices.

Netflix has a couple of weak spots, though, related to content.  When they started, they were small, and useful threat for the studios against the dominance of Blockbuster.  (Blockbuster got greedy, which is why we have new release movies for sales for less than $20, but that’s another story.)  Netflix also managed to acquire streaming rights from Starz, which were cheap at the time.  When that agreement expires, Netflix expects to fork over much more money to the studios.  They also need to expand the on demand library, which might enable them to get out of the DVD business altogether.  The amount of content available and the price Netflix will have to pay for it are still up in the air, but Netflix is getting ready for a larger showdown with the studios.

Unless you’re a Netflix customer, none of this may matter to you. But what lessons can you apply to your business?

First, do you know how profitable your customers are?  Most businesses make over 100% of their profits from about 20% of their customers.  They break even on 70% or so, and actually lose money on some customers.  Your pricing plan should encourage those money losing customers to either make you money or take their business elsewhere.

Can you model the impact of price, cost and volume changes?  If you know your customer profitability looking backwards, that’s helpful.  But what you really want to do is figure out what it will look like in the future, based on certain assumptions, like changes in price, volume, and costs.  Businesses have an almost inherent fear of “losing customers”, even though losing customers can increase profits, especially if price increases are involved.  Unless you have a model to help you understand the bottom line impact of price, volume, and cost changes, it’s hard to make good decisions, and you’re likely to underprice out of fear.

How dependent are you on key suppliers?  Netflix is a distributor.  They deal with much larger studios (and cable providers, whose pipes are necessary to bring online content).  The studios are afraid of Netflix turning into an online Blockbuster, which could then control the industry.  They are well connected politically, and despite being strategic idiots, they have good lawyers who know how to extract the most value from a given transaction.  If you are beholden to key suppliers, your cost structure and pricing structure are also beholden to those suppliers.

By the way, I don’t think we’ve helped anyone push through a 60% price increase this year, but we’ve a couple of companies increase prices more than 30%, with minimal impact on sales and a huge impact on profit.

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