Dina Rizkia Rachmah (29120431)

MM5002 - ACCOUNTING - MID TEST

LECTURER: ERMAN SUMIRAT

e h a vio r s
C o st- B
d C
an is on V P
A na ly s
tf lix I nc .
Ne
MASTERS OF BUSINESS ADMINISTRATION
SCHOOL OF BUSINESS AND MANAGEMENT
INSTITUTE OF TECHNOLOGY BANDUNG
 MM5002 ACCOUNTING – MID TEST


The Beginning
Now being one of the most popular entertainment platforms, Netflix used to be just a DVD
rental and sales company. It began in Scotts Valley, California in 1997 when a couple of men,
Reed Hastings and Marc Randolph, who had an idea of renting DVDs by mail. Hastings, a
computer scientist and mathematician, owned a company called Pure Atria where Randolph
was working at as a marketing director. Hastings invested $2.5 million from the money he
attained from selling Pure Atria to Rational Software Corporation for $700 million. It was in
fact a very simple concept where they both tried to have the experience by emailing themselves
a DVD. It reached their level of satisfaction, hence the idea for Netflix was born. Soon after,
Hastings and Randolph launched “Netflix.com” as the first DVD rental and sales site with
only 30 employees and 925 titles available (Exhibit 1). The subscription feature that offers
members unlimited DVD rentals without due dates, late fees, or monthly rental limits was
introduced in 1999 (Exhibit 2). The business kept on developing, one way was by using the
members’ ratings on past titles to provide future movie suggestions for them, thus the release
of the personalized movie recommendation system in early 2000 (Exhibit 3).

Ups and Downs

Netflix did not only go through their good days but there were some rough patches as well,
had some losses that totaled up to $57 million and was offered an acquisition deal by
Blockbuster for $50 million. However, Netflix could not accept the offer. Due to the fall,
Netflix decided to make some changes with their prices to become more affordable. Ever since
then, by early 2002 there was a huge increase in their subscription business that opens up a
huge opportunity. Netflix makes its initial public offering (IPO) on May 29, 2002, selling 5.5
million shares at a price of $1 per share under NASDAQ ticker NFLX.

Netflix’s first profit of US$6.5 million on revenues of US$272 million was posted in 2003, and
is issued a patent by the U.S. Patent & Trademark Office to cover its subscription rental
services for the over 1 million memberships. After all the hike in the business, Netflix was
sued for false advertising in relation to claims of “unlimited rentals” with “one-day delivery”
a year after. However, despite all that, Netflix’s membership was rapidly growing and reaches
up to 5 million by 2006. Then in 2007, streaming feature was introduced for the members to
be able to watch series and films instantaneously.

The growth of the company was massive, to the point where Netflix partners up with
consumer electronics brands such as Xbox 360, Blu-ray players and TV set-top boxes in order
for Netflix to be allowed to be streamed everywhere conveniently. For about almost 3 years
and 40,000 submissions, the team Bellkor’s Pragmatic Chaos was awarded $1 million Netflix
Prize to improve the accuracy of the future suggestions feature by 10%. As Netflix became
available on smart TVs, the membership exceeds 10 million, hence the publication of the
Netflix Culture Deck.

1
 MM5002 ACCOUNTING – MID TEST


Going Worldwide
The expansion of Netflix kept on growing, it arrived in Canada in 2010 and Latin America
and the Caribbean in 2011, become available on mobile devices, and the debut of kids
experience as well. 2012 was the peak year for Netflix in which its membership reaches 25
million and was launched in United Kingdom, Ireland, and the Nordic Countries. This is the
period for Netflix to increase its partnerships for globalization. By 2014, Netflix membership
exceeded 50 million and became accessible in Austria, Belgium, France, Germany,
Luxembourg, and Switzerland. Netflix also began streaming in 4K Ultra HD.

How The Business Operates

First things first when analyzing one’s business model is to know what the key activities and
key resources or assets are, then only they would be categorizes into fixed and variable costs,
and direct and indirect costs. In this case, Netflix is a broadcasting and production company.
Although it is states at a production company, Netflix’s way of earning its revenue and profit
are different from any other production companies. Two accounting standards is used for
their streaming content costs; ASC 920: Entertainment – Broadcasting that is used for the
streaming service with content that they license (rather than own), and ASC 926:
Entertainment – Films that is used for the original content that was self-produced and where
they own the intellectual property. There are several benefits using this type of business
concept, definitely decreases operating costs (no studio middle-man), ownership of the
intellectual property allowing them to monetize in different ways such as licensing and
merchandising, and greater rights flexibility that includes global rights and exclusivity. With
this system implemented in the business model, Netflix does not have that many fixed costs.
With this kind of business system, the fixed and variable costs can be elaborated as follows:

Table 1. Cost Structure of Netflix Inc. (Source: Overview of Content Accounting, Netflix
Inc. 2020)

Variable Costs Fixed Costs

Content amortization Technology and Development
Payment processing fees General and Administration
Cost of revenues Customer service
Streaming delivery
Operation costs
Marketing

2
 MM5002 ACCOUNTING – MID TEST


Table 2. Variable and fixed costs of Netflix (Source: Netflix Financial Statement 2019 &
2020)
2019 2020
Cost of revenues $ 12,440,213,000 $ 15,276,319,000
Marketing $ 2,652,462,000 $ 2,228,362,000
Technology and development $ 1,545,149,000 $ 1,829,600,000
General and administration $ 914,269,000 $ 1,076,486,000

Based on Table 1, both variable and fixed costs simply consists of only 2 costs. However, cost
of revenues that is part of the variable cost, consists of several different types; content
amortization (biggest cost in the business), payment processing fees, customer service,
streaming deliver (e.g. open connect costs, payroll), and operation costs (including cloud
computing).
The Rising Star
As the expansion of Netflix becomes larger as time passes, in 2019, Netflix and CJ ENM,
Korea’s No.1 media entertainment company, and its subsidiary Studio Dragon, Korea’s
leading production studio, joined hands for a strategic partnership. They have come to a three-
year partnership deal in the beginning of 2020, where Studio Dragon and its creators will
produce original series that will be available to Netflix members around the world. As Chief
Content Officer of Netflix, Ted Sarandos made a statement, “CJ ENM and Studio Dragon
represent the gold standard in Korean entertainment and we are excited and honored to work
with them. This partnership with CJ ENM and Studio Dragon demonstrates our commitment
to Korean entertainment and allows us to bring more top-tier Korean drama to Netflix
members in Korea and all over the world.”.

This definitely proves that the Korean entertainment that includes film and drama is what
people are into at the moment – The Rising Star. In addition to that, Netflix will benefit
distribution right to other Studio Dragon titles. The deal of the partnership was that CJ ENM
will have the right to sell up to 4.99% of Studio Dragon shares to Netflix. Ever since this
partnership, as well as the starting of the global pandemic of COVID-19, Netflix’s
membership growth gets higher compared to the previous year (Exhibit 4).

3
 MM5002 ACCOUNTING – MID TEST

906800
1000000
900000
800000
700000
482450
Subscribers

600000
500000
400000 237360
300000
94980
200000
100000
0
2017 2018 2019 2020

Figure 1. Estimated Streaming Members in Indonesia 2017 – 2020 (Source: An Nissa et al.,
2020)
As shown in Figure 1 above, in 2020 the subscribers of Netflix in Indonesia alone has
increased from 482,450 (2019) to 906,800. This is a lot more compared to when it increased
from 237,360 (2018) to 482,450.

Cost-Volume-Profit of Netflix
In order to carry out the CVP analysis, the fixed and variable costs need to be elaborated to
calculate the contribution margin using the provided data (Exhibit 5). Table 2 shows the
Global Streaming Memberships data for Q4 – 2019 and Table 3 shows the calculated
operating income with the existing variable and fixed costs for the total number of
167,090,000 subscriptions worldwide.

Table 3. Netflix global streaming memberships data for 2019 and 2020 (Source: Netflix
Financial Statement 2019 & 2020)
2019 2020
Paid memberships at the end of period 167,090,000 203,663,000
Paid net membership additions 27,831,000 24,025,000
Average monthly revenue per paying membership ($) 10.25 10.25
Free trials at end of period 4,679,000 -

Table 4. Calculated data for Netflix subscriptions in 2019 and 2020

2019 2020
Variable costs $ 15,092,675,000 $ 17,504,681,000
Fixed costs $ 2,459,518,000 $ 2,906,086,000

4
 MM5002 ACCOUNTING – MID TEST


2019 2020
Total revenue $ 20,156,447,000 $ 24,996,056,000
Operating income/loss $ 2,604,254,000 $ 4,585,289,000
Contribution margin 25.1% 22.7%

With the existing data above, the CVP relationships can be expressed in 3 different ways: (1)
the equation method, (2) the contribution margin method, and (3) the graph method. Using
the contribution margin of 25.1% and an average monthly revenue per membership for all
regions $10.25, the contribution margin per subscriber in 2019 is $2.20. Whereas for
contribution margin 22.7% and an average monthly revenue per membership for all regions
$10.25 as well, the contribution margin per subscriber in 2020 is $2.32.

Has Netflix Reached Breakeven Point?

We can assume that 90% of the total marketing spending was to acquire new customers and
the 10% remaining was to retain existing customers (also known as Customer or Marketing
Retention Costs). As shown in Table 3 above, Netflix ended 2019 with Paid Members of
167,090,000 and an additional of 27,831,000. Therefore, Netflix successfully acquired
194,921,000 (167,090,000 + 27,831,000) new customers. Customer Acquisition Cost for 2019
can be estimated as 90% of the Total Streaming Marketing Budget (Table 2) divided by the
number of new customers (90% * $2,652,462,000 / 194,921,000 = $13.60). Thus, Netflix
spends about $14 to acquire a new customer in 2019.

From the Customer Acquisition Cost per person and contribution margin that have been
calculated earlier, it can be attained that the breakeven point (BEP) in terms of months would
be $13.60 divided by $2.20, which implies that Netflix will take roughly 6 – 7 months to
breakeven on its global market. There have been several considerations that were taken into
account in evaluating the breakeven point of Netflix, one being the tax interest and as the data
used is from Netflix Financial Statement 2019, this concludes that Netflix has hit breakeven
point as of now.

As for 2020, the Customer Acquisition Cost can be also estimated as 90% of the Total
Streaming Marketing Budget (Table 2) divided by the number of new customers (90% *
$2,228,362,000 / 227,688,000 = $9.79). Hence, Netflix spends about $10 in acquiring new
customers in 2020. The BEP in 2020 would then be around 4 – 5 months.

Growing with Accelerating Cash Burn

After figuring out that 90% of the marketing cost goes to acquiring new customers, Netflix is
very well known as a “cash burn” company. This is mainly due to the excessive spending of
Netflix on content, rising from about $9 billion in 2017 to $14.6 billion in 2019. On the other

5
 MM5002 ACCOUNTING – MID TEST


hand, the amortization of streaming content assets has been considered lower, growing from
$6.2 billion in 2017 to $9.2 billion in 2019.

Table 5. Net income growth of Netflix

2017 2018 2019
Net income $558,929,000 $1,211,242,000 $1,866,916,000

As shown in Table 5 above, Netflix’s performance has been improving, with its net profits
growing 3 times from around $558 million in 2017 to $1.866 billion in 2019. The large growth
in these numbers is explained by how Netflix accounts for its content investments, proven in
Figure 2 below.

90.00%

80.00% Amortization of DVD content

assets
70.00%
PERCENT OF REVENUES (%)

Amortization of streaming
60.00% content assets
50.00% General and administrative
40.00%
Technology and development
30.00%

20.00% Marketing costs

10.00%

0.00%
Q4 2016 Q4 2017 Q4 2018 Q4 2019

Figure 2. Cost Structure of Netflix Inc.

Conclusion & Suggestions

To conclude the CVP analysis on Netflix Inc., the total fixed costs and variable costs in 2019
are $2,459,518,000 and $15,092,675,000, respectively. As for total fixed costs and variable
costs in 2020 are $2,906,086,000 and $17,504,681,000, respectively. With these components,
the BEP in both 2019 and 2020 could be obtained: 7 months; 5 months. The fact that the BEP
attained in 2020 can be reached in just 5 months, it is better and quicker compared to the
calculated BEP in 2019.

As seen in the analysis that has been carried out, it is proven that the BEP attained are good
based on the data used. However, there are several factors that can be altered in order to
improve the financial statement for Netflix Inc., one being to improve the fixed costs in Netflix
Inc. As presented in the earlier discussion, the fixed cost of Netflix Inc. did increase from
$2,459,518,000 in 2019 to $2,906,086,000 in 2020, it is not that much of an increase,


6
 MM5002 ACCOUNTING – MID TEST


nonetheless it is always better to keep the fixed costs come down to a lower value if possible.
Worse comes to worst, the fixed costs should be kept steady. How do we get the fixed costs
to a lower value? Payroll or employees’ salaries is a significant portion in a fixed cost, ways
to reduce this may be by hiring entry level employees, or more interns could be hired than
permanent employees. In Netflix’s case, their variable costs are way higher than their fixed
costs, and most of the variable cost goes to marketing. As marketing cost is important in
customer acquisition for Netflix, Netflix could definitely reduce their content amortization
cost by having their own filming studio (which will then increase the operations cost), or
reduce their operations cost by licensing with more film owners (which will then increase the
content amortization cost). Definitely in a business, one way or another, the company will
undergo an increase and a decrease when altering a cost. However, a healthy and successful
business or company ensures that their liabilities do not take up most of their assets.

7
 MM5002 ACCOUNTING – MID TEST


Exhibit 1 First launching of Netflix as “Netflix.com”

Exhibit 2 Netflix’s first subscription feature in 1999

Exhibit 3 Personalized movie recommendation system in early 2000

8
 MM5002 ACCOUNTING – MID TEST


Exhibit 4 Netflix membership growth

9
 MM5002 ACCOUNTING – MID TEST


Exhibit 5 Consolidated Income Statements of Netflix Inc.
2019 2020
Revenues: $ 20,156,447,000 $ 24,996,056,000
Cost of revenues $ 12,440,213,000 $ 15,276,319,000
Marketing $ 2,652,462,000 $ 2,228,362,000
Technology and development $ 1,545,149,000 $ 1,829,600,000
General and administrative $ 914,369,000 $ 1,076,486,000
Operating income $ 2,604,254,000 $ 4,585,289,000
Other income (expense):
Interest expense $ (626,023,000) $ (767,499,000)
Interest and other income (expense) $ 84,000,000 $ (618,441,000)
Income before income taxes $ 2,062,231,000 $ 3,199,349,000
Benefit from (provision for) income taxes $ (195,315,000) $ (437,954,000)
Net income $ 1,866,916,000 $ 2,761,395,000
Earnings per share:
Basic $ 4.26 $ 6.26
Diluted $ 4.13 $ 6.08
Weighted-average common shares outstanding:
Basic 437,799 440,922
Diluted 451,765 454,208

10
 MM5002 ACCOUNTING – MID TEST


References

Holdaway, D. (2020, Sept 1) How can a business reduce fixed costs? Divvy
https://getdivvy.com/blog/how-businesses-can-reduce-fixed-costs/

Horngren, C. T.; Datar, S. M.; Rajan, M., “Cost Accounting: A Managerial Emphasis”, 14 (2012)

Nissa, I. A.; Susilawati, W.; Suseno, N.; dan Hamdani, N. A., "Netflix Consumer Preference
Analysis", 20 (2020), 42–46.

Mittelmark, M. B., "Overview of content", Global Health Promotion 16 (2009), 14–15.

Spangler, T. (2020, Jan 16) Netflix Projected to Spend More Than $17 Billion on Content in 2020
Variety https://variety.com/2020/digital/news/netflix-2020-content-spending-17-billion-
1203469237/

Streaming, S. O. F., "Q4 2019", (2020).

Trefis Team (2020, May 1) Netflix One Question: Is It Losing Money Or Making Money? Forbes
https://www.forbes.com/sites/greatspeculations/2020/05/01/netflix-one-question-is-it-
losing-money-or-making-money/?sh=224e6eff29a6

Tseng, A. (2019, Nov 18) Why Netflix’s Operating Margins Have Big Upside The Motley Fool
https://www.fool.com/investing/2019/11/18/why-netflixs-operating-margins-have-big-
upside.aspx

Young, M. R., "Netflix the battle for your free time: Strategy guided by customer lifetime value",
24 (2019), 12.

11