NETFLIX

SCM Case
Assignment
Project Group 2
Abanish S Vijay (1911364)

Prasoon Sudhakaran (1911437)

Naveen K (1911259)

Manoj Kumar M (1911044)

Naveen E Joshua (1911049)

Rahul Karuppiah (1911344)

Revenue Model

Starting in 1997, Netflix began with a DVD rental model via mail. Customers had to pay $4 per movie in
addition to $2 for handling and shipping charges. What frustrated consumers the most was the charging
of late fees on par with local DVD shops. Netflix addressed with by removing late fees and introducing a
subscription model in 1999. This was further shifted to a prepaid subscription model with unlimited
rentals. Subscribers were allowed to rent at a time upto three movies and exchange them at their
convenient time. What really attracted customers were the ‘unlimited’ offering and this created great
word of mouth publicity. The primary expenses for Netflix were the costs of purchasing movies for their
collection (content acquisition) and the cost of acquiring customers(which amounted to a per-customer
rate of $100-$200).

In comparison, a brick-and-mortar model was used by Blockbuster to rent movies to customers. In 2004,
Blockbuster introduced Blockbuster Online to counter Netflix, which had shifted to an online business
model. Blockbuster Total Access was introduced in 2006 by integrating the online store with the brick-and
mortar stores. This provided customers with greater freedom to exchange the DVD either via the store or
by post. However, Blockbuster was still collecting huge late fees, which amounted to approximately 10%
of their annual revenues in 2004. They removed late fees in 2005, much later compared to Netflix. By
then, there was significant customer backlash against Blockbuster, which further reduced their revenues.
Removal of late fees also reduced their total revenues by $600 million but did not add significantly to their
customer acquisition. They were also asset-heavy with high overhead expenses adding significantly to the
overall costs. They had 5194 physical stores with 1 manager and 10 staff per store.
Profitability

a) Utilization rate

DVD turnaround was shorted as the delivery and the return time was reduced by Netflix as they had a
partnership with USPS and opened more distribution centers. Netflix measured the time and motion of
the entire process and improved the same. The employees were able to open and restuff around 800
DVDs in one hour. It promoted and showed the movies that were already in stock and acquired, and
removed the ones which were not immediately available which included mostly the new releases thus
increasing the utilization rate.

Compared to Netflix, Blockbuster had a higher number of stores and employees (5194 stores
and 10+1 employees per store). Blockbuster incurred higher costs because of this higher number of
stores and employees. Blockbuster had approximately 2500 titles per store and dedicated significant
space to successful movies and 100 releases per store. The demand for these titles fell rapidly post the
first three weeks. Blockbuster also charged extended viewing fees or late fees to get the maximum
utilization of a DVD. Through this model, they were successful in reducing stockouts and increasing
opportunities for renting. Blockbuster also reduced the unpopular movie collection which had less
demand.

b) Churn rate

Netflix wanted to reduce the churn rate and they eased the process of unsubscribing in order to achieve
this aim. Unsubscribing now required only a small feedback from the customer. Switching costs were
also increased by providing customers by providing customized content to customers. This content was
provided by considering their user ratings per movie which in turn affected the average queue length.
The user information and preferences were kept ready in case the customer decided to come back at a
future date. The churn rate dropped from 6.3% in 2002 to 3.6% in 2006.

Blockbuster were adopting a strategy to improve the instore experience of the consumers. Inorder to
achieve this, they rapidly expanded their number of stores to 5194 US locations and with this they were
targeting to serve around 70% of the US population within a 10 min drive. Also, on an average they had
around 10 staff per store who would be giving recommendations to the customers and would help them
in selecting the movies. Another initiative was the adoption of Coupons. Online customers were given in
store coupons and the online rental requests were also stocked in the store inventories. With all these
moves they were able to increase the switching cost for the consumers.
Content

Netflix was mainly focusing on popular movies. The website used to feature 5 different movies every
week then they used to do this every day. After the development of Proprietary Recommendation
System (PRS) by Netflix, the recommendations were personalized, his/her previously rented movies and
the ones that are currently in the cart were used for achieving personalization. In order to reduce
customer frustrations only in stock movies were displayed. With the PRS, Netflix was able to promote
content which lacked in marketing and were able to show content which was less popular. Netflix
started to build on their collection by buying around 2500 titles from big studios like Walt DIsney and
Sony in 2008. In order to differentiate themselves they stated to develop Original Content in 2010.
While Blockbuster was more focused on latest releases and they were promoting this more actively
through their stores. It did not focus much on lesser known and independent films due to the
inconsistency in demand.

Vertical Integration

To tackle increasing licensing costs and to sustain differentiation, Netflix explored the idea of developing
original content, a procedure popular among cable channels to differentiate themselves. House of Cards,
Arrested Development reinforced the idea of Netflix being an entertainment service brand, this idea was
not explored by Blockbuster.
Distribution Channels

Netflix prioritized on improving customer satisfaction by delivering DVDs within a day to all its subscribers.
Netflix aggressively built distribution centres (58 DCs by early 2009) across country and improved
relationship with USPS to enhance DVDs turnaround time. Blockbuster relied only on its 5194 stores to
serve its customers.

Technology and Innovations

Netflix let its user sort their movie selection by titles, director, actor, and genre to build a movie queue to
be delivered from Netflix, using Netflix’s search engine. Netflix developed a proprietary recommendation
system, which took customer ratings for the movies identified from their favourite genres. Similar ratings
form over millions of subscribers helped them recommend movies to subscribers. The recommendation
refined with every additional movie customer consumed. This helped in managing Netflix’s inventory
management and library utilization as the recommendation system screened out the movies which were
out of stock, intended to avoid frustrating customers. Netflix shifted to VOD platform early in 2001. Netflix
invested in technology developed by Roku which bridged the gap between TV sets and internet. Netflix
was also negotiated to make its services available in Microsoft Xbox. Netflix also focused on improving its
streaming infrastructure by migrating its transcoding and streaming applications to Amazon Web Services.
Blockbuster were not quick in adapting technologies as its online service was launched in 2004, which was
very late to make any significant difference.

Contracts
Half of the movies acquired by Blockbuster were based on a purchase model (it had to make a fixed
payment to studios of approx. $15-18 per unit, rented $4 per unit 9-10 times and at last resell for $8) and
the rest of the movies based on the revenue share model (it paid $5 per unit to studios, rented 9 times,
was sold again at $8, and with the studies it shared revenue). 81.80% of the contracts were of revenue
sharing type with the studios in 2006. There were 5194 stores in total in the U.S. out of which 4255 were
owned by the company and the rest were franchised.

Netflix followed purchase and the revenue share model in the beginning, similar to Blockbuster. However,
as Netflix moved to be an online streaming platform and also started to acquire rights of low budget
unpopular movies, it began to pay for every work of artists that was used a royalty amount.
Q2. Did Reed Hastings make the right decision in trying to separate the DVD-by-mail business from the
streaming business?

Netflix made the bold decision by separating both the DVD by mail service and the streaming services.
Although it was a strategically sound move, it was a fast and abrupt implementation and resulted in
being far away from customer centric.

One of the major reasons as to why separating the business was smart and strategic in nature is due to
fact both business was differently structured in terms of their cost and process requirements. Following
are some of the reasons that validated the decision to separate both the businesses:

1. Infrastructure requirements: DVD by mail required a large number of distribution centers , sorting
centers and workforce across US. The streaming business however did not utilize them and required
large number of servers and future investments in upgrading them to support the increased growth
in online viewers.
2. Content acquisition: Content acquisition was cheaper and easier for DVDs as they could be procured
from any source. In contrast, content acquisition was a relatively complicated and costlier process
for the streaming business.
3. Competition: Firms such as Blockbuster and Redbox were the key competitors for the DVD by mail
service, where as Amazon, Hulu, iTunes posed as competition for the streaming business.
Considering the large differences in the market and competitors, separating the businesses would
enable management to have different objectives and also make better decisions over the course of
time.
4. Pricing: There was strong shift in the market, where consumers were migrating from DVDs to online
streaming, thus increasing the running costs for the DVD business while its fixed costs remained
intact. This would have resulted in a need for the online streaming business to be priced higher
accordingly to cushion the increasing costs of DVD business.

These were some of the key factors that enforced the decision to separate both the businesses and
create increased focus and also enable the company’s success in the two competitive markets. Although
pricing segregation was a necessary change, the assumption that consumers would immediately shift
towards online streaming was flawed. It was a gradual process as consumers took time to adopt to new
technology. The pricing change could have also been done gradually in response to the shift of DVD
consumers. Netflix administration had incorrectly assumed that DVD consumers would quickly switch to
streaming services. The consumers should’ve been given more time to embrace the new technology
change before bringing the new business under Netflix brand name.

Netflix also made a brand management error by deciding to rebrand its DVD-by-mail business as
“Qwikster” and keeping the brand name of Netflix for its new online streaming service. Reed Hastings
made an incorrect decision to differentiate the two business models. The decision was made on the
assumption that Netflix brand would dominate the streaming service industry over other competing
brands such as Amazon or Apple. As this decision was recalled, the damage done to the brand was partially
mitigated, however some permanent damage remained. The DVD by mail service from Netflix was placed
as a consumer focused, innovative service with online assisted selection. Consumers had strong loyalty to
the original Netflix brand name and rebranding this original service to Qwikster was a wrong decision.
Netflix should’ve branded both of its services under the same brand name. It could also have kept the old
brand name for the original service and kept the new name for the new service offered.

Netflix also made a mistake in communicating the rebranding exercise to its consumers. The
public apology from Reed Hastings was not convincing to the customer base as he didn’t apologize for
increasing the DVD and online streaming service price by 60%. Customers were not given the chance to
bring their recommendations, queues and billing together after the brand split. This lead to duplication of
efforts and a lot of confusion to the consumers.

SUMMARY

From the previously mentioned facts, we can conclude that Reed Hastings made the correct decision in
splitting the Netflix DVD-by-mail business and the online streaming business. The manner and the timing
in which the decisions were implemented could have been better. Netflix should have slowly phased out
their DVD by mail business as online streaming services naturally gained popularity. The sudden abrupt
change should have been avoided and this could have reduced the customer confusion and
dissatisfaction.