How the tiny Netflix beat the mighty Blockbuster?

In the late 1990s, Blockbuster dominated the movie rental industry in the U.S. It had stores all over the country, a huge size advantage. It had made large investments in its inventory. But, obviously, it didn't make money from movies sitting on their shelves; it was only when a customer rented a movie that Blockbuster made anything. It also needed the customer to watch the movie quickly and return it back so that the same DVD could be rented to different customers again and again. It didn't take long before Blockbuster realized that customers didn't like returning movies. So, to make the customers return the DVDs they levied late fees so high that analysts estimated that 70 percent of Blockbuster's profits were from late fees.

Set against this backdrop, a little upstart named Netflix emerged in the 1990s with a novel idea. Why make customers go to the stores to rent DVDs? Netflix decided to mail movies to the customers and charge them a monthly subscription fees. So, unlike Blockbuster, Netflix made money when customers didn't watch the DVDs that they had ordered. As long as DVDs sat unwatched at customer's 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.

By 2002, Netflix was showing signs of potential. It had $150 million in revenue and 36 percent profit margin.

Blockbuster's investors started to get nervous about it. They forced Blockbuster to look into the market more closely. So Blockbuster did.

What Blockbuster found was that Netflix's profit margin was much lesser than their own. They also concluded that they have not seen any business model to be successful in movie rental arena in the long run. Online rental services was serving a 'very niche market.' On top of it, the management felt that even if they go after Netflix and launch into online rental services, they will cannibalize their own business.

Who would like to launch a business which can cannibalize their existing business? Thus, the idea of pursuing Netflix was dropped.

Netflix, on the other hand, thought that this market was fantastic. It did not need to compare it to any existing and profitable business: it's baseline was no profit and no business at all. So, Netflix was quite happy with its relatively low profit margins and their niche market.

So, who was right? Blockbuster or Netflix?

By 2011, Netflix had 24 million customers. And Blockbuster? Well, they filed for bankruptcy just the year before.

Blockbuster had followed a principle that is taught in every fundamental course in finance and economics: that in evaluating alternative investments, we should ignore fixed and sunk costs, and instead base decisions on the marginal costs and marginal revenues that each alternative entails.

But it is a dangerous way of thinking. Almost always, such analysis shows that marginal costs are lower, and marginal profits are higher, than the full cost. This doctrine biases companies to leverage what they have created to succeed in the past, instead of guiding them to create the capabilities they will need in the future. If we knew the future would be exactly as the past, that approach would be fine. But if the future is different - and it almost always is - then it is the wrong thing to do.

Blockbuster looked at the DVD rental business using a marginal lens. It saw it only from the advantage point of its own existing business by comparing its marginal profits and revenues to that of Netflix. Thus, Netflix seemed totally unattractive.

But, Netflix had none of these concerns. There was nothing weighing it down - no marginal thinking. It assessed the opportunity using a completely clean sheet of paper. It had no comparisons to make to the previous revenues or profits. All Netflix saw was a huge opportunity....the 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 profit margins and billions of dollars in revenue. But the real alternative to not going after Netflix turned out to be bankruptcy.

For Blockbuster, the right way to look at this new market was not to think, "How can we protect our existing business?" It should have been, how could we best build a new one? What would be the best way to serve our customers? But Blockbuster didn't do so and it completely lost itself.

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.

Source: "How Will You Measure Your Life?" by Clayton Christensen, James Allworth & Karen Dillon