SUBMITTED BY GROUP 4

Sai Sravani 1911079

NETFLIX IN 2011
SCM1 - Case Assignment submission
Q1. How would you characterize the differences between the Blockbuster and Netflix
VHS/DVD business models?
Blockbuster Business model:
Blockbuster entered the market in 1985 as a movie rental company that saw the opportunity of
rapidly scaling the video rental retail business. From a single store, it bulldozed its way to
become market leader by 2006. Its business model revolved around the consumer behavioural
insight that movie rentals were usually impulsive decisions, implying that the top priority for
a customer is to how quickly can he obtain the movie of his choice. Usually their preference
was for the newest releases given the promotions & anticipation attached to them.
Consequently, Blockbuster’s growth strategy focused on opening retail stores across US to
expand its geography coverage. Through expanding its presence, it achieved a duel target of
increasing penetration in new locations and share in existing markets. By 2006, it established
around 4255 company owned stores & 939 franchised stores. All the store locations were
chosen based on customer concentration & proximity to competitors to ensure high visibility.

Each retail outlet assortment contained 2500 titles on an average. Substantial shelf space was
allotted to hit movies & new releases as they contributed to 70% of the demand. Each location
held about 100 copies of new releases fulfilling 75-80% of the company level forecasted
demand. This demand for new releases lasted for the first three weeks & later dropped sharply.
Hence, Blockbuster’s business model was dependant on maximizing the no. of days a copy
was on rent during this window post which copies are re-sold at markdown prices. These retail
stores employed part time workers who took care of sales & provided recommendation
assistance to customers.

Approximately half of Blockbuster’s rental revenue was from purchase model, in which it paid
the studio about $15 – 18 & rented the copy 9 – 10 times at $4, then resell the DVD at mark
down price. The other half of revenue is through revenue sharing model, in which the company
paid an upfront fee of $5 per copy & shared 30% of sales & markdown revenue with studio.
Copies not returned to the store by the end of the specified renting period (often in the range
of two days to a week) were subject to late fees. These late fees represented a substantial chunk
of overall revenue.
Netflix business model:
Netflix was founded in 1997 with a vision to be the ultimate online destination for movie
enthusiasts targeting the consumer need for convenience and selection rather than mere impulse

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purchase. Netflix website provided a search engine for the customers to select from its
compendium of movies by title, director, genre, and actor. Customers can place a movie rental
order and would receive the DVD by mail. The pricing model was like that of traditional video
rentals. Search engine allowed customers to build a queue of movies they would want to rent.
Subscribers received a DVD of movie next in the queue as soon as they returned the prior. This
queue helped in accurate forecast of immediate demand, optimum inventory planning & higher
customer satisfaction.

Netflix gained market by offering beyond DVD rentals. It provided a proprietary recommendation
system built on the customer generated ratings. Upon knowing customer preferences and favourites
through a survey, the back-end program combined the customer profile & customer movie ratings
to recommend films to the customers. The recommendation included a list of movie titles, customer
ratings, movie synopsis, match of film to customer preference and why is that film being
recommended. The program also filters the movies currently out of stock & already rented by that
customer. Because Netflix held a large inventory of movies and millions of customer generated
movie ratings, this software ensured it picked the best movie for a customer accurately reflecting
their tastes & preferences. On the company front it helped avoid customer dissatisfaction due to
stockout & maximized utilization of inventory, serving the same number of customers but with
fewer copies of new releases. Unlike competitors whose 70% revenue was from new releases & hit
movies, Netflix derived only 30% of its revenue from them. Netflix’s model focused on utilization
of less popular films in the collection and significantly gain revenue on them, thus, growing into a
major distribution channel for independent & small studios.

Though it initially operated on the traditional pricing model, Netflix soon shifted to a prepaid
subscription model and then introduced unlimited DVD rentals per month. With this shift, it
changed the disadvantage of its longer delivery time into having a movie with the customer all the
time. Having movies in customers’ homes all the time added value to Netflix and increased
customer retention. This model proved to have more compelling value proposition: ‘unlimited’ and
resonated with a new customer segment for whom movie rental is a part of daily entertainment.

Netflix managed its inventory costs through studio contracts with small fixed upfront fee and
variable fee per title based on total no. of rentals. In 2001, it further tied up with USPS to intercept
returns and rapidly opened distribution centres across US for reducing turnaround time. Netflix
considered delivery time to be a key metric for growth and customer satisfaction. By continuously
improving operational efficiency in distribution centres it emerged to be a threat to Blockbuster.

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Q2. Did Reed Hastings make the right decision in trying to separate the DVD-by-mail
business from the streaming business?

But by early 2007, Video on Demand (VOD) was the next big technological advancement in
the content delivery industry. Hasting saw the potential benefits VOD can offer to the mass
market and wanted Netflix to grab this opportunity early on. Netflix then launched a streaming
feature on their website offered at a marginal cost thereby leveraging on Netflix’s strengths in
terms of its brand image, large subscriber base & renown recommendation system. The core
idea was to establish a link between DVD rental business and the streaming option to get an
extra edge over upcoming competitors.

It acquired licencing and streaming rights from large production houses. But to sustain
competition from large players, Netflix saw a need to differentiate itself through original
content. The video streaming business model was to offer original content as well as movies
on whatever device the customer wants along with access to its recommendation system to find
relevant entertainment. Netflix soon realised the immense growth opportunities in the
consumer paid commercial free subscription model for TV shows and movie streaming online.

Hastings realised that operation models of DVD by mail and video streaming are starkly
different in terms of content acquisition, inventory management (distribution centres across US
vs IT AWS cloud platform) and channel of delivery (DVD by mail vs online streaming) and
the transition from one model to another was challenging. Seeing the global market potential
in video streaming service, Hastings decided that going forward Netflix will primarily be a
global video streaming business with the DVD by mail feature being an additional service and
not the core business. Owing to this future strategy Hastings decided to split the businesses to
be able to grow independently. To further evaluate his decision, we begin by a value chain
comparison of both the businesses.

DVD by mail business value chain:

Studios: Content Movie DVD Netflix film Available to Delivered to

Video streaming business value chain:

Studios: Content AWS cloud Available to Customer

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How did DVD business operating model work?

In DVD by mail business, Netflix evolved from a purchase model to a revenue sharing model
with the major studios. This removed intermediaries from the value chain and notably reduced
costs of building inventory. It followed a prepaid subscription model with unlimited DVDs.

Further through its queue feature, and their proprietary recommendation system, Netflix
achieved accurate forecasting of immediate demand. Through its distribution centres across
US locations, strategic tie ups with USPS and acquiring distribution rights of independent films
it achieved overnight delivery for most of the 10.6 million subscribers reflecting in high
customer satisfaction and retention.

How is streaming business different from above DVD model?

Streaming business is not subject to first-sale doctrine like that of DVD model, hence
economics of scale for both the models is starkly different. Netflix owed a royalty fee to the
studio or content creator on every usage of the work. This resulted Netflix to licence large
amount of content at a huge cost even to be able to launch and attract customer attention. Then
there was marketing and customer acquisition costs which are different to that of DVD model
as the former was a well-established product and Netflix essentially made selecting and
purchasing the product convenient through its delivery and recommendation system.

In the case of video streaming, Netflix incurred huge entry barriers in terms of content
acquisition costs which were through royalty fee model, meaning large upfront as well as
continuous costs on every usage of content. There were huge technology investments to
maintain fault tolerant system of seamless streaming. Inventory management needed larger
investments for streaming as it is on IT Cloud platform whereas the former model was through
establishing 55 distribution systems. There was a substantial threat deep pocketed tech giants
like Apple and Amazon.

The asset-heavy functionality of DVD service was diametrically opposite to asset-light (cloud-
based AWS services) functioning of streaming services. The company was becoming the
largest source for driving internet traffic and wanted to place itself as a technology firm (as it
was competing with many start-ups) which was being pulled down by having the DVD service
under the same brand name

Synergies between the both models:

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Evaluating the synergies between these two services DVD and Video streaming that were at
play in 2011.

Subscriber Base

Netflix DVD by mail business had large subscriber base of 10.6 million customers. Hastings
considered these customers as a potential target when launching the streaming option on their
website. Hence, by separating the business entities there lies threat to the stand-alone
sustainability of the subscriber base in the streaming business. It results in additional marketing
and customer acquisition costs to build a strong enough subscriber base to break even given
the huge content and technology investments made.

Brand

Hasting’s strategy during the launch of streaming service on the website was to leverage the
existing strong brand value. This initially led to the growth in streaming business when
streaming was offered at an additional marginal cost. This resource is valuable, and Netflix
cannot give up on its advantage whether or not it goes ahead with split of businesses.

Pricing Strategy

Initial pricing strategy of bundling the streaming services with the DVD service was a definite
value-add to the existing subscribers allowing them to view specific content instantly. But the
pricing strategy following the split in businesses acquired considerable backlash. Netflix must
consider the customer willingness to pay for a stand-alone online video streaming services in
the still nascent market. The price should factor in customer side constraints such as technology
and company side challenges in terms of offering wide variety of content.

We would like to go for an affirmative stance on Hasting’s decision to separate the DVD-by-
mail from its video streaming business. The market backlash was due to the higher price for
availing both the DVD rental and streaming services. Initially customers could piggyback the
streaming service with a marginal price of $2 over DVD rental service price of $7.99 per month.
An extensive market research could further provide insights on demand for a stand-alone video
streaming service, willingness to pay and purchase power parity.