CHAPTER TWO

Discussion Questions

1. How would you characterize the competitive strategy of a high-end department

store chain such as Nordstrom? What are the key customer needs that Nordstrom
aims to fill?

The Nordstrom website states the following: Over the years, the Nordstrom
family of employees built a thriving business on the principles of quality, value,
selection, and service. Today, Nordstrom is one of the nation’s leading fashion
retailers, offering a wide variety of high-quality apparel, shoes, and accessories
for men, women, and children at stores across the country. We remain committed
to the simple idea that our company was founded on, earning our customers’ trust
one at a time.

Nordstrom fills customer needs for high quality fashion merchandise and
outstanding levels of customer service. Price is secondary for the typical
Nordstrom shopper.

2. Where would you place the demand faced by Nordstrom on the implied demand
uncertainty spectrum? Why?

Implied demand uncertainty is demand uncertainty due to the portion of demand

that the supply chain is targeting, not the entire demand. A high-end department
store chain such as Nordstrom falls on the high end of the implied demand
uncertainty scale. There is significant variety of products that Nordstrom carries
and it is generally hard to predict demand for these fashion items. The fashion
items that Nordstrom stocks have extremely high product margin, high forecast
errors and stockout rates, and once the season is over, these items are sold at deep
discounts at their Nordstrom Rack outlet stores.

3. What level of responsiveness would be most appropriate for Nordstrom’s supply

chain? What should the supply chain be able to do particularly well?

Supply chain responsiveness takes many forms, including the ability to respond to
a wide range of quantities, meet short lead times, handle a large variety of
products, build innovative products, meet a high service level, and handle supply
uncertainty. The Nordstrom supply chain must be highly responsive in the areas
of handling highly innovative fashion products, customer response, and service
level; they are effective in supplying well-heeled customers with merchandise and
their return policy is legendary in the Pacific Northwest.

4. How can Nordstrom expand the scope of the strategic fit across its supply chain?

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 Scope of strategic fit refers to the functions within the firm and stages across the
supply chain that devise an integrated strategy with a shared objective. By
adopting an intercompany interfunctional scope strategy, Nordstrom will
maximize supply chain surplus. Nordstrom can move in this direction by working
with its suppliers as if they are actually owned by Nordstrom. Rather than viewing
the supply chain as a zero-sum game of inventory cost minimization and profit
maximization, Nordstrom must recognize that spreading the wealth and
occasionally taking on more inventory than is optimal for them will result in
improved customer service. The intercompany interfunctional scope of strategic
fit requires more effort than the other approaches presented in this section;
Nordstrom must evaluate all aspects of its supply web.

5. Reconsider the previous four questions for other companies such as Amazon, a
supermarket chain, an auto manufacturer, and a discount retailer such as Walmart.

Amazon focuses on cost and variety by providing books, music, and a host of
other household products at low prices. Customers place orders online and expect
to receive purchases in a number of days. Customer orders are processed at
central warehouses or are drop shipped from suppliers by mail or common
carrier. For the most part, the implied demand uncertainty for Amazon is lower as
they cast such a wide net. Amazon’s supply chain must be responsive in terms of
flexibility; they handle an incredibly diverse range of products. Amazon’s supply
chain should be able to provide low prices, wide variety, and reasonable delivery
schedules for its customers. In every link of the supply chain, Amazon must
function on the cost-responsiveness efficient frontier in order to support its
competitive strategy.

A supermarket chain focuses on cost and quality, with some specialty chains
adding flexibility by carrying a broader range of products that may be targeted
toward customers interested in organic products or ethnic cuisine. Implied
demand uncertainty for a supermarket chain tends to be low; shoppers are
typically repeat customers and have a constant demand level. The supermarket
supply chain must be responsive by receiving produce quickly to ensure freshness
and have a high service level. Supermarket supply chains tend to be well-
established and can improve strategic fit by emphasizing speed to maintain
freshness, hence perceived quality.

Auto manufacturers have extremely complicated supply chains that are

increasingly focused on flexibility and lean operations. Implied demand
uncertainty for auto manufacturers varies considerably by target market and
manufacturer. Automotive supply chains among the big three in the United States
have made great progress in the last decade and recognize that they must be
responsive from a time and flexibility standpoint.

Walmart’s supply chain is obsessed with cost and is facilitated by a low implied
demand uncertainty, its impressive logistics system and its management

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 information systems. Its supply chain is able to respond quickly to fill a wide
variety of products to keep merchandise on Walmart’s shelves. Walmart’s level of
coordination along the supply chain is excellent; it would be difficult to point out
areas where true intercompany interfunctional scope of strategic fit has not been
achieved. The sole supply chain criticism that surfaces is an occasional report that
suppliers feel as if supply chain surplus is not shared equitably.

6. Give arguments to support the statement that Walmart has achieved very good
strategic fit between its competitive and supply chain strategies. What challenges
does it face as it works to open smaller format stores?

The best argument to support the statement that Walmart has achieved very good
strategic fit is its success as a company. Competition today is supply chain versus
supply chain, not company versus company, so a company’s partners in the
supply chain often determine the company’s success. Walmart’s strategic focus
on cost is evident in its competitive, product development, supply chain, and
marketing strategy. Its marketing strategy of advertising everyday low prices
appeals to consumers and does not disrupt the supply chain by causing surges in
demand. Visiting one of its big box stores reveals low-priced merchandise, both
national and store brands, stacked from floor to ceiling without elaborate displays
or decoration. Walmart’s logistics and information systems are famous for
coordinating its entire supply chain and allowing it to meet customer needs at
minimal cost.

Walmart has had difficulty both with small format stores and its online sales.
Challenges have arisen because the supply chain structure that is ideal for the
standard Walmart stores is not as effective for both small format stores and online
sales. Small format stores require replenishment in much smaller quantities and
online sales requires the ability to handle a wide variety of slow moving items.
The current supply chain structure is not very good at handling either.

7. What are some factors that influence implied uncertainty? How does the implied
uncertainty differ between an integrated steel mill that measures lead times in
months and requires large orders and a steel service center that promises 24-hour
lead times and sells orders of any size?

From a customer perspective, implied demand uncertainty increases when the

customer’s range of quantity required increases, lead times decrease, variety of
product increases, rate of innovation increases, and required service levels
increase. We also see high implied uncertainty attributed with high product
margins, forecast errors above 40 percent, stockout rates above 10 percent and
forced season-end markdowns. On the supply side we see increased supply
uncertainty when the supply source has frequent breakdowns, unpredictable and
low yields, poor quality, limited supply capacity, and evolving production
processes.

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 For the steel mill that requires large orders and has lead times measured in months
both the implied demand and supply uncertainty is less due to a better predictable
capability and a better defined schedule for production. Due to the increasing
number of sizes and the shorter response time associated with the steel service
center, implied uncertainty is high.

8. What is the difference in implied uncertainty faced by a convenience store chain

such as 7-Eleven, a supermarket chain, and a discount retailer such as Costco?

When customers go to a convenience store chain such as 7-Eleven, they go there

for the convenience of a nearby store and are not necessarily looking for the
lowest price. Implied demand uncertainty would be high as customers are looking
for a variety of products and convenience versus cost and demand levels are hard
to predict.

A supermarket chain focuses on cost and quality, with some specialty chains
adding flexibility by carrying a broader range of products that may be targeted
toward customers interested in organic products or ethnic cuisine. Implied
demand uncertainty for a supermarket chain tends to be low; shoppers are
typically repeat customers and have a constant demand level. The supermarket
supply chain must be responsive by receiving produce quickly to ensure freshness
and have a high service level. Supermarket supply chains tend to be well-
established and can improve strategic fit by emphasizing speed to maintain
freshness, hence perceived quality.

Low price is very important to customers of discount retailers such as Costco.

This customer is willing to tolerate less variety and even purchase very large
package sizes as long as the price is low. Customer demand can be more
predictable and supply side needs are large and fairly stable.

9. What are some problems that can arise when each stage of a supply chain focuses
solely on its own profits when making decisions? Identify some actions that can
help a retailer and a manufacturer work together to expand the scope of strategic
fit.

High inventories, poor quality, low customer service, increased returns are just a
number of problems that occur when each stage of a supply chain focuses solely
on its own profits. The trucking company requires full truck loads for delivery
forcing the retailer to carry more inventory than wanted or needed. The supplier
offers discounts to their buyers to maximize production but forcing the buyers to
purchase in larger quantities than desired. Ordering in large batches was very
prevalent during the 1950s and 1960s as companies to minimize local costs and
maximize their own profits.

Today, retailers and manufacturers have the opportunity to plan promotions

jointly such as Walmart and P&G. They can share sales information to determine

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 customer trends. Joint product development opportunities are being explored
throughout the supply chain among retailers, manufacturers, and raw material
suppliers.

10. For each of the five levers—capacity, inventory, time, information, and price—
identify an example where a supply chain has focused on this lever to deal with
uncertainty. In each case, identify reasons why you think it is or is not an
appropriate choice.

The paint supply chain carries mixing capacity at every paint store to deal with
demand uncertainty across colors. This is an appropriate choice because the
relative cost of a mixer is low and the inventory saved by carrying base colors is
large.

W.W. Grainger and McMaster Carr carry inventory in centralized warehouses to

meet demand. This is an appropriate choice because pooling allows them to lower
the inventory required and they carry products that have a long shelf life.
Zara uses speedy replenishment to deal with uncertain demand for its trendy
products. This is appropriate because demand for its products is highly
unpredictable and the ability to match supply and demand more than makes up for
the higher cost of speedy replenishment.

Seven-Eleven Japan and Zara use current demand information to drive

replenishment. The investment in information coupled with speedy replenishment
allows them to deal with uncertainty.

The airline and hotel industries use price variation as the main lever to deal with
uncertain demand with prices falling when demand is low and prices rising when
demand is high.

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 CASE STUDY—The Demise of Blockbuster
Teaching Objectives

The objective of this case is to discuss how different business models and supply chain
structures impact the financials of the firms in the DVD rental business. In particular, the
goal is to convey that the characteristics of the movie (recent/big hit or old/eclectic) affect
whether it is best rented from a centralized or decentralized model. By comparing the
financials of Blockbuster, Netflix and Redbox, we identify the strengths and weaknesses
of each model. The centralized Netflix model displays strategic fit for a wide variety of
somewhat older movies whose demand is hard to predict. The decentralized Redbox
model displays strategic fit for a few new releases whose demand is large and
predictable. The growth of both companies left Blockbuster squeezed in the middle
because its model did not have the same level of strategic fit.

Case Questions and Discussions

1. In what ways did Blockbuster achieve better strategic fit than local stores?

Blockbuster started with the business model of having large physical storefronts in high-
traffic neighborhood locations. By building stores that were larger than existing mom-
and-pop rental stores, Blockbuster offered customers a wider choice of movies and better
product availability. Movies were typically rented out for about $5 for five nights.
Given that mom-and-pop stores were much smaller, even though they carried only a few
hundred titles, it was very difficult for them to provide availability of these movies given
the high cost of inventory (VHS tapes sold for $60–$80 each at that time) and space.
Blockbuster built larger stores that aggregated demand across a wider area than a typical
mom-and-pop store. The larger store allowed Blockbuster to provide greater variety and
better availability at lower cost than mom-and-pop stores. The aggregation of inventory
and physical space allowed Blockbuster to fill demand from its customers better than
mom-and-pop stores.
2. How much implied uncertainty do Netflix and Redbox face? What levers do they use to
deal with this uncertainty?

Redbox focuses on a few new releases. The demand for these movies is large and
relatively predictable. As a result, Redbox faces a relatively low level of implied
uncertainty that can effectively be served using decentralized inventory that is close to
customers. In contrast, Netflix provides a very wide variety of older movies whose
demand can be difficult to predict. The wide variety increases the level of implied
uncertainty. Netflix, however, makes its customer wait a bit to get their movies, allowing
it to lower the implied uncertainty to some extent. Netflix then pools this uncertainty and
serves its customers using inventory that is stored in centralized warehouses, allowing it
to further reduce the uncertainty it must absorb.
3. How did Netflix and Redbox achieve better strategic fit than Blockbuster?

Netflix and Redbox achieved better strategic fit than Blockbuster by targeting different
segments of movie rentals. Whereas Blockbuster attempted to provide its customers both

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new releases as well as older movies, Netflix and Redbox divided the market among
themselves. Netflix primarily targeted a wide variety of older movies while Redbox
primarily targeted a much smaller variety of new releases. Blockbuster’s attempt to serve
both markets increased its cost for both new releases and older movies. In contrast,
Netflix was able to provide variety to its customers more effectively (100,000 titles rather
than 5,000 at Blockbuster) and at lower cost through its aggregate model of shipping
from DCs. Redbox was able to provide new releases at lower cost than Blockbuster by
using vending machines.
Whereas a Blockbuster store carried around 3,000 titles that were not recent releases, this
represented a very small fraction of old movies. In contrast, Netflix carried a very wide
variety of titles but in centralized distribution centers. Netflix had about 60 distribution
centers (at its peak of mailing DVDs), where DVDs were processed and shipped all over
the United States. Thus, Netflix had much lower facility costs than Blockbuster while
providing a much higher variety of movies.
Only a single wall at a Blockbuster store was dedicated to new releases, (which
constituted a significant fraction of the rentals). Given that Blockbuster was paying for
the whole store, this increased the facility cost per rental because most of the space was
used by other movies that rented at a much lower rate than the new releases. Redbox, in
contrast, used very low cost vending machines (with low fixed installation costs of
$15,000) in high-trafficked locations such as grocery stores, supermarkets, and malls to
rent the same recent releases (much lower PP&E/SG&A) compared to Blockbuster. As a
result, the facility cost per rental was much lower at Redbox compared to Blockbuster.
Inventories at Blockbuster were high (relative to revenues) because of the decentralized
nature of its operations. In particular, carrying many low-volume rental titles (after all,
there were perhaps only about 30 movies at any given time that were renting in large
quantities) exacerbated the inventory requirements. This increased the cost of both
inventory and space for Blockbuster. Netflix carried a wider selection of titles in its
distribution centers, but was able to carry lower inventories because of aggregation at its
DCs. Redbox stocked newly released DVDs, which rented in large volumes with
relatively predictable demand. As a result, there was much less inventory sitting around.
Each Redbox kiosk carried close to 630 DVDs comprising 200 of the newest movie titles.
Each DVD was rented out on average 15 times, after which it was sold to the customer.
Netflix used a centralized supply chain structure to provide variety in the form of old
movies (high uncertainty) to its customers at low cost. Redbox used a decentralized
supply chain structure to provide predictability in the form of new releases (low
uncertainty) close to its customers at low cost. A combination of the two focused supply
chains performed significantly better than the Blockbuster supply chain as illustrated in a
comparison of the financials in Exhibits 1 and 2 (in the absence of Redbox financials, we
use Coinstar financials).

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Exhibit 1: Company Comparisons (%)
Metric Blockbuster Netflix Coinstar
SG&A (% of Revenue) 49.50 24.16 13.60
COGS (% of Revenue) 46.30 49.20 69.60
Inventories (% of Revenue) 15.73 2.21 9.12
Inventories (% of COGS) 33.98 4.50 13.10
PP&E (% of Revenue) 58.47 15.92 66.57
PP&E with Depreciation (% of Revenue) 6.13 7.90 35.08
Liabilities (% of Revenue) 45.64 28.80 71.05

Exhibit 2: Blockbuster

Both Netflix and Redbox operated with lower costs because they were not burdened with
the heavy fees of leasing thousands of retail locations as Blockbuster was. The table
below shows that the general and administrative expenses for Blockbuster were 47.48
percent and 44.13 percent of revenues in 2009 and 2008, respectively.1 The figures for
Netflix for the same period were 3.1 percent and 3.6 percent, respectively.2
Fiscal Year Ended
3-Jan-2010 4-Jan-2009
($ in millions) ($ in millions)
Total Revenues 4,062.4 5,065.4

Operating Expenses
General and Administrative 1,928.7 2,235.3
Advertising 91.4 117.7
Depreciation/Amortization 144.1 146.6
Impairment of Goodwill 369.2 435

General and Administrative Expenses as a Percentage of Revenue 47.48% 44.13%

Source: Blockbuster 2009 Annual Report.

SUNIL CHOPRA

1
Blockbuster 2009 Annual Report.
2
Netflix 2009 Annual Report.

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Teaching Note:
Movie Rental Business: Blockbuster, Netflix, and Redbox

Teaching Objectives

The objective of this case is to discuss how different business models and supply chain
structures impact the financials of the firms in the DVD rental business. In particular, the
goal is to convey that the characteristics of the movie (recent/big hit or old/eclectic) affect
whether it is best rented from a centralized or decentralized model. By comparing the
financials of Blockbuster, Netflix, and Redbox, we identify the strengths and weaknesses
of each model. In addition, as streaming gains market share, the impact will be different
for movie types and business models.

Case Questions and Discussions

1. How do the different players in the movie rental value chain provide and capture value?
Movie Studios

Studios were the creators and owners of the content. Most of their costs (stars,
production, and marketing) were incurred up front, but revenues did not begin coming in
until the movie was released. Revenues arose from a variety of channels, including
theaters, DVD and digital releases, and video on demand/pay per view. Studios had
recently moved to sharing more risk with their stars, with smaller upfront payments for
the star accompanied by a share of the revenue. After about a decade of high revenues
from DVD sales, studios had seen a recent decline. In recent years, the international
market had come to represent a large fraction of theater sales for studios. For example,
Avatar had worldwide box office revenues of $2.78 billion, only $0.76 billion of which
was from the U.S. market.
Movie Theaters

Movies were released first to movie theaters. Studios tended to enjoy a greater cut (as
high as 70 to 90 percent) of the ticket sales in the opening weeks of the movie release,
and the theater owners enjoyed an increased share in the later weeks of the release. The
studio’s cut had declined over time, now averaging about 50–55 percent of ticket sales.
Consequently, the length of the theatrical window also had declined in recent years.
Movie theaters were increasingly adopting measures to increase revenue by releasing
movies as “premiere experience” screenings such as in IMAX or 3D. This allowed movie
theaters to charge an additional $2–3 per movie ticket.
In addition, a significant fraction of theater revenues had started to come from
concessions and onscreen advertising.
DVD Retail Stores

A period of three or more months after the movie was released in theaters, it was released
in DVD format to retail stores such as Walmart and Best Buy. These retail stores sourced
DVDs from movie studios at a discounted wholesale rate. Movie studios were most
attracted to this channel, as it offered them a higher profit margin/revenue than any other
channel. Movie studios delayed the DVD release to the rental chains and other channels

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in order to tap the revenue from the retail channel as much as possible. (Studios received
up to $18 on each DVD sold compared to less than $4 for a rental.) Studios also tended to
actively promote and advertise the DVDs when they were released.
Blockbuster

Blockbuster started with the business model of having physical storefronts in high-traffic
neighborhood locations. Its primary value addition was to bring recent content close to
the customer in the form of a VHS tape (originally) or DVD. By building stores that were
larger than existing mom-and-pop rental stores, Blockbuster offered customers a wider
choice of movies and better availability on recent releases. Movies were typically rented
out for $5 for five nights. Blockbuster had difficulty with older or niche movies that did
not have a broad audience. Even with nearly 8,000 titles in a store, a store could only
keep a small fraction of old titles.
Netflix

Netflix started as a mail-order DVD rental service that later turned into a mail-based
subscription service (eventually with a greater focus on streaming) that offered customers
greater choice in the variety of movies they were able to rent and watch. Due to physical
limitations of the store size, Blockbuster’s storefront model could not offer customers as
wide a variety of movies to choose from. (Netflix offered more than 100,000 titles
compared to less than 8,000 at the largest Blockbuster store.)
In addition, Netflix had a robust recommendation system that could suggest movies for
customers. Netflix customers were requested to rate the movies they watched, and a taste
profile was generated for each customer based on these ratings. Movies were then
recommended to customers based on their taste profiles and what other customers with
similar profiles seemed to enjoy. Thus, Netflix reduced the search cost that customers had
to bear in identifying movies to watch (among the over 100,000 titles they carried). By
introducing customers to older or less-known movies, Netflix was also profitable for
movie studios, as they would get a share of the rental revenues from these titles.
Netflix also solved an important problem for studios by generating demand for its catalog
of older movies. If a studio were to offer a Netflix-like monthly subscription plan for its
movies, it would be not as attractive to customers, as studios only had access to the
movies in their own catalogs. By consolidating and sourcing movie titles from various
studios, Netflix effectively generated demand for a wider variety of movies, including
older titles.
Netflix focused on adding value through inventory aggregation (for DVDs), search
efficiency, and content aggregation (for video on demand). From a financial perspective,
we will argue that Netflix (with its centralized business model that aggregates
inventories) adds much more value for older movies with small and sporadic demand
compared to hit movies with large and predictable demand. Netflix therefore served the
“long tail” of the customer demand corresponding to a wide variety of movies with
relatively low demand.
Redbox

Redbox’s primary value proposition was to deliver content in the form of a recently
released DVD very close to the customer (much closer than Blockbuster historically
accomplished). Redbox offered customers a cheap and easy way to rent movies through

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its vending machines that were located in high-trafficked locations such as fast food
restaurants and supermarkets. Because Redbox vending machines were located at places
people tended to frequent, the service offered the easiest way to rent DVDs.
Redbox’s vending machines tended to stock newly released DVDs, which were rented
out at $1.20 a night. Redbox thus offered customers the cheapest way to watch new
movies. Thus far, the company had stayed away from the long tail and focused on recent
releases. Its recently announced partnership with Verizon, however, could represent a
channel for distributing long-tail content.
Video on Demand

Video on demand (VOD) services offered customers the most convenience in renting and
watching movies. As long as they had a cable subscription and set-top box available,
customers could rent movies directly through their TV sets and start watching. No
additional hardware or separate boxes were necessary. Movie studios also preferred the
VOD channel to DVD rentals, as they received higher revenue than through DVD rentals.
There was also a strong push from the on-demand players to make studios release movies
on VOD channels on the same day as the DVD release. The major value additions
provided by cable companies were content aggregation, fund transfer aggregation, along
with access to customer TVs.
Digital on-Demand

Players such as Apple, Amazon, and Google were becoming increasingly active in the
digital pay-per-view and on-demand rental channel. Most of their offerings could be
streamed directly from the Internet and watched on computers. New devices had been
developed (Apple TV, Google TV, Roku, etc.) that allowed the digital content from these
companies to be streamed to TVs. Netflix was also an active player in this field; it
allowed its monthly subscription plan customers to watch movies by streaming through
devices such as Roku, PlayStation, Xbox, and Wii. The value additions provided by these
digital channels were content aggregation, fund transfer aggregation, and strong brand
recognition to get customer access.
2. What factors led to Netflix’s growth? How should Blockbuster have responded to the challenge
posed by Netflix?
The factors that led to Netflix’s success were:
 Transition from VHS to DVD. Transition from the VHS to DVD storage of movies
coincided with the emergence of Netflix as a major player in the movie rental business.
DVDs were cheaper and easier to handle and transport. This allowed Netflix to introduce
the DVD-by-mail subscription plans. Sending VHS tapes by mail would have been much
more expensive.
 Low costs. Blockbuster incurred high operating costs due to its storefront rental
model (in the form of PP&E, inventory, and SG&A). Netflix, through its distribution
center–based delivery model, was able to reduce its costs of operation and PP&E.
Netflix’s PP&E was one-tenth that of Blockbuster, whereas its revenue was just 40
percent that of Blockbuster.
Netflix also had low inventory costs (2.21 percent of revenue or 4.5 percent of COGS)
compared to that of Blockbuster (15.73 percent of revenue or 33.98 percent of COGS), as
well as a much lower SG&A (see Exhibit 1 for details).

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  Wide inventory selection. Compared to Blockbuster, Netflix carried a wider variety of
older titles sourced from studios at a cheaper rate compared to the cost of new releases.
The Blockbuster model was not well suited to carrying a wide variety of older movies
because a typical store carried only 3,000 titles (compared to more than 100,000 available
at Netflix). The centralized Netflix model, in contrast, was much better suited to carrying
large variety.
 Recommendation system. Netflix’s model of providing high variety (for both DVDs
and streaming) was bolstered by a robust recommendation system, which suggested
movies to customers based on their interests and rental history. With high variety,
reducing search costs becomes important (something that the recommendation engine
helped with).
 Subscription model. Netflix’s subscription model of renting DVDs for a fixed
monthly fee was attractive to customers who wanted the privilege or comfort of watching
as many movies as they wanted for a fixed subscription price. Blockbuster’s high-cost
store rental ($5 for five nights per DVD) was not attractive to those customers. In 2010,
Netflix’s monthly subscription fee of $8.99 was lower than two rentals at Blockbuster.
Even when the service was priced at $19.95 a month (in 2000), it was comparable to
renting four videos at Blockbuster.

Some Challenges for Netflix

High transportation cost was one of the biggest challenges Netflix faced for its DVD
business. Shipping a DVD (to the customer and back) can cost as much as 75 cents per
disc. This increases the SG&A costs for Netflix for its DVD business. The cost of
streaming has been estimated to be significantly lower (around 5 to 10 cents to deliver a
movie online). As a result, Netflix tried to encourage users of DVDs to transition to
streaming by increasing the price of the service (it charged $7.99 for the DVD service
and a separate $7.99 for streaming instead of the previous $8.99 for both).
The challenge in both cases has been new content. The DVD service is ideally suited for
a wide variety of old content. It can be argued that streaming a wide variety of old
content allows Netflix to reduce its distribution costs while maintaining its advantages.
With new content, however, there is a problem using DVDs (high transportation cost). In
fact, the company had been accused of “throttling” in a class action lawsuit (Frank
Chavez v. Netflix). The company gave preference to customers who used a few DVDs
each month over others that used many DVDs each month for new releases. This is
because frequent users increase transportation costs (even though Netflix denied that this
was the cause in its settlement). New releases also have higher acquisition costs for
streaming. In fact, Netflix has had to pay significantly higher prices for acquiring new
digital content.
Another challenge for Netflix for DVD rentals comes from the difficulties faced by the
Postal Service. As the Postal Service raises prices and cuts service, costs at Netflix will
rise while response time will get worse for DVD delivery.
Netflix did not transition to streaming without difficulties. The company briefly separated
its DVD and streaming business in 2011, but pulled back based on customer response. Its
DVD rental business continued to generate profits, but Netflix had to pay increasing costs
for its streaming rights, especially for newer content.
Moving forward, Netflix’s biggest challenge continues to be the cost of new content
especially for its streaming service. It can be argued that Netflix would be better off

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continuing to focus on only the long tail for both its DVD and streaming service. This
would keep the cost of content acquisition low while taking advantage of the aggregate
distribution model that Netflix has.
Blockbuster’s Response

In response to Netflix, Blockbuster should have pressed its advantage in multiple

channels. It should have utilized its physical storefronts and the newly introduced mail-
subscription service (in response to Netflix’s mail offering) much more effectively and as
complements to each other.
In addition, Blockbuster did not move into the mail-subscription online model early
enough, as it had invested heavily in its physical storefront model. Once Blockbuster
introduced its own offering in the DVD-by-mail category, Netflix already had a firm
lead. Further, Netflix’s mail offering had many more DVD titles than Blockbuster had,
and was also complemented by a robust recommendation engine, which Blockbuster’s
service lacked.
In short, Blockbuster should have been looking to move into the low-cost (online) models
much sooner and should have diversified from its high-cost (physical storefront) model.
The company could also have brought in vending machines to rent and return the high-
volume rental movies. Its stores already had slots where customers could return DVDs.
Once the movie was dropped into a slot, however, more work had to be done by
employees to update inventory records and restock shelves. A vending machine would
have reduced Blockbuster’s cost of rentals and return while also making rentals available
when the store was closed.
Blockbuster effectively missed an opportunity to create a hybrid system that both
improved customer service and reduced costs.
3. What factors led to Redbox’s growth? How and why was it able to capture market already
dominated by big players such as Blockbuster and Netflix?
Although Netflix already occupied a strong position in renting a wide variety of titles,
Redbox attacked Blockbuster in the new-movie segment. Its business model provided
greater convenience to customers while also reducing both price and cost. The factors
that led to Redbox’s success were:
 Low fixed and variable costs. Redbox’s kiosks offered a low fixed-cost business
model compared to the high-cost physical storefront rental business model of
Blockbuster. Each vending kiosk was relatively inexpensive at $15,000 and generated
$30,000 revenue in the first year, rising to $40,000 and $50,000 in Years 2 and 3. The
company had very low fixed investment in PP&E (this is not entirely reflected in the
Coinstar financial statement) and also relatively low operating costs, as Redbox
employees only came once a week to restock the vending machines when new DVDs
were released. The model incurred virtually no variable cost in renting DVDs or
accepting returns (all the work was done by the customer).
 Access and availability. Redbox’s kiosks were accessible close to customers in high-
trafficked locations such as grocery stores, restaurants, and supermarkets Redbox had
around 30,000 vending machines by early 2012). As a result, a Redbox vending machine
was typically much closer to customers than the closest Blockbuster store. The locations
also allowed customers to get a DVD while shopping instead of making a special trip to
rent a DVD. Redbox implemented an online reservation system that allowed customers to

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 find the closest vending machine with their desired movie in stock and to reserve the
movie for a night. This ensured that customers did not waste a trip.
 Low pricing. Redbox’s $1-a-night model of DVD rental, (which increased to $1.20 a
night by 2012) was attractive to customers. Customers were more likely to prefer to pick
up the DVD for $1 and return it at their convenience.

Blockbuster improved availability of its titles (despite holding them in vending machines
with only a few hundred DVDs each) by allowing customers to go online and identify the
closest vending machine with the desired title in stock. Overall, the Redbox model was
ideally suited to provide recent movies, (which rented at high and predictable rates) to
customers at low cost.

4. What are key success factors in the movie rental business? How do Redbox, Blockbuster, and
Netflix compare along those dimensions?
The key success factors in the movie rental business were costs, which included fixed and
operational costs (facilities, transport), content (acquisition and inventories), delivery
channels, and pricing. Companies needed to adequately control all of these factors to be
profitable in this business.
In addition, customers were increasingly moving away from the physical storefront
model rentals to online and on-demand viewing. As seen from Exhibit 4 in this case, in-
store rentals were forecasted to decline going forward, but vending, online subscription,
and VOD channels were expected to continue to grow. This shift in customer behavior
had a greater impact on the costs, delivery channels, content, and pricing models adopted
by the firms in the movie rental industry.
Facilities

Blockbuster had a high-cost physical storefront model of movie rental. Blockbuster

leased the storefronts at high costs in high-trafficked neighborhood locations (this
increased SG&A and PP&E). Only a single wall at a Blockbuster store was dedicated to
new releases, (which constituted a significant fraction of the rentals). Redbox, in contrast,
used very low cost vending machines (with low fixed installation costs of $15,000) in
high-trafficked locations such as grocery stores, supermarkets, and malls to rent the same
recent releases (much lower PP&E/SG&A) compared to Blockbuster.
Whereas a Blockbuster store carried around 3,000 titles that were not recent releases, this
represented a very small fraction of old movies. In contrast, Netflix carried a very wide
variety of titles but in centralized distribution centers. Netflix had about 60 distribution
centers, where DVDs were processed and shipped all over the United States. These
distribution centers were located close to post office locations, allowing Netflix to afford
timely processing and delivery at relatively low cost. Thus, Netflix had much lower
facility costs than Blockbuster while providing a much higher variety of movies.
Inventories

Inventories at Blockbuster were high (relative to revenues) because of the decentralized

nature of its operations. In particular, carrying many low-volume rental titles (after all,
there were perhaps only about 30 movies at any given time that were renting in large
quantities) exacerbated the inventory requirements. This increased the cost of both
inventory and space for Blockbuster. Netflix carried a wider selection of titles in its

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distribution centers, but was able to carry lower inventories because of aggregation.
Redbox stocked newly released DVDs, which rented in large volumes with relatively
predictable demand. As a result, there was much less inventory sitting around. Each
Redbox kiosk carried close to 630 DVDs comprising 200 of the newest movie titles. Each
DVD was rented out on average 15 times, after which it was sold to the customer.
Transportation

Blockbuster’s physical storefront model incurred low transportation costs, whereas

Netflix bore the high shipping and handling costs of processing DVDs by mail. As per an
MSNBC article by Ethan Epstein, Netflix estimated an expenditure of $600 million on
postage in 2010. Redbox incurred low replenishment costs in restocking its vending
kiosks.
Delivery Channels

Netflix offered customers the choice of renting DVD titles by mail and streaming movies
directly through a Netflix-enabled home entertainment device. Redbox’s focus was on
renting DVDs through its vending kiosks. (It recently partnered with Verizon to offer
streaming services.) Blockbuster followed the physical storefront rental model, and later
tried to match Netflix’s DVD-by-mail offering. Blockbuster did not develop significant
capabilities and partnerships for streaming movies. Toward the end, through a partnership
with NCR, Blockbuster started installing its own brand of vending kiosks throughout the
United States. Blockbuster never took effective advantage of a multichannel hybrid
strategy.
Pricing

Redbox followed a pricing model of $1 a night per DVD (the price increased to $1.20 in
2011), while Netflix followed an all-you-can-watch monthly subscription model.
Redbox’s offering was attractive to users who wanted to watch new movies and return
them quickly. Netflix’s plan was geared toward heavy users who were attracted to
particular movie genres and interested in discovering movies based on their tastes. Both
pricing schemes significantly undercut Blockbuster’s model of $5 per DVD for five
nights for its in-store rentals.
After comparing the firms on the above dimensional factors it is clear that Blockbuster,
Netflix, and Redbox had their own advantages in their offerings. Redbox’s model was
suitable for the price-value customer looking to watch recent titles, whereas customers
who valued variety and choice and also were attracted to a simple fixed monthly
subscription plan would appreciate Netflix’s offering. Blockbuster’s emphasis of
storefront rentals was highly successful during the era of VHS tapes (and little other
competition) but was found wanting when DVDs became the preferred storage medium
and new competition arrived in the form of Netflix. Blockbuster had the opportunity to
implement a multichannel strategy using each channel for the type of movies it was best
suited for. Unfortunately Blockbuster took no action until it was too late.
5. How would you advise these companies to modify their strategies and structures going
forward?
An explosion of online on-demand rental options had recently become available.
Companies such as Apple, Amazon, and Google were providing their own on-demand
stores. Many more new devices were being introduced to the market (Apple TV, Google

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TV, Roku, Boxee, etc.) that could stream on-demand content to TVs. It became
increasingly likely that DVDs would be replaced in the future as a content storage
medium, and more and more content would be directly streamed or accessed from the
cloud.
Netflix understood this development and was increasingly offering the online streaming
option to its existing monthly subscription plan customers. Netflix was also pursuing
more and more licensing deals with movie studios to be able to offer an increased
selection of streaming titles for its customers. (Netflix recently signed a licensing deal to
pay close to $1 billion to the Epix movie channel to add Paramount, Lions Gate, and
MGM movies to its catalog.)
The challenge for Netflix was the cost of acquiring content, as well as deciding which
content it should focus on. For existing old content and eclectic content (e.g., Iranian
movies), the move from DVD to streaming could help Netflix because it significantly
reduced shipping cost while keeping the acquisition cost of content low. For new content,
however, acquisition costs for streaming were likely to be much higher for Netflix (as has
been the case), making this a segment that Netflix was better off staying away from.
From a strategic perspective, the Netflix model (DVD rentals plus streaming) was best
suited for older and more eclectic titles rather than newer titles. In addition, Netflix might
have had more to gain by sticking to this segment and offering some discount for
customers that used the DVD service and wanted to add streaming (the cost of both at
$15.98 was the sum of the costs of each). This was because offering a discount would
likely have customers streaming instead of getting a DVD, thus lowering transportation
cost.
Netflix’s efforts to buy recent content for streaming and to pay for original content
seemed misplaced because it did not leverage the company’s existing strengths with
DVD rentals. Instead it put the company in head-to-head competition with much bigger
players for the streaming business.
Redbox enjoyed a competitive advantage in that it allowed people to rent recent movies
cheaply. It continued to grow its number of vending machines (recently acquiring NCR’s
machines as well) and recently announced a partnership with Verizon for streaming
content. A hybrid model in which Redbox rented recent DVDs through its vending
machines and streamed older content through the Verizon partnership could be quite
powerful because it would allow Redbox to use each channel to serve the appropriate
product/customer. The vending machine model could serve price-sensitive customers
looking for recent content while the streaming model could serve customers looking for
variety (while keeping acquisition costs low if they stayed away from recent content).
Blockbuster unfortunately missed its opportunities to create the hybrid model that
Redbox seemed to be aiming for.

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Copyright © 2019 Pearson Education, Inc.
Exhibit 1: Company Comparisons (%)
Metric Blockbuster Netflix Coinstar
SG&A (% of Revenue) 49.50 24.16 13.60
COGS (% of Revenue) 46.30 49.20 69.60
Inventories (% of Revenue) 15.73 2.21 9.12
Inventories (% of COGS) 33.98 4.50 13.10
PP&E (% of Revenue) 58.47 15.92 66.57
PP&E with Depreciation (% of Revenue) 6.13 7.90 35.08
Liabilities (% of Revenue) 45.64 28.80 71.05

Exhibit 2: Blockbuster

Both Netflix and Redbox operated with lower costs because they were not burdened with
the heavy fees of leasing thousands of retail locations as Blockbuster was. The table
below shows that the general and administrative expenses for Blockbuster were 47.48
percent and 44.13 percent of revenues in 2009 and 2008, respectively.3 The figures for
Netflix for the same period were 3.1 percent and 3.6 percent, respectively.4
Fiscal Year Ended
3-Jan-2010 4-Jan-2009
($ in millions) ($ in millions)
Total Revenues 4,062.4 5,065.4

Operating Expenses
General and Administrative 1,928.7 2,235.3
Advertising 91.4 117.7
Depreciation/Amortization 144.1 146.6
Impairment of Goodwill 369.2 435

General and Administrative Expenses as a Percentage of Revenue 47.48% 44.13%

Source: Blockbuster 2009 Annual Report.

3
Blockbuster 2009 Annual Report.
4
Netflix 2009 Annual Report.

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Exhibit 3: Netflix
Economic of Shift from DVDs to Digital

The shift from physical DVD mailing to digital delivery for older eclectic titles (the long
tail) would help Netflix lower its high shipping cost in mailing out DVDs. Netflix
estimated that it will spend $600 million on postage expenses in 2010, and the expense
would rise to $800 million within the next few years. For Netflix, the cost of subscription
was 54.4 percent and 55.8 percent of revenues in 2009 and 2008, respectively (see table
below). Internet streaming was considerably cheaper, and it was estimated that the costs
would be as low as 5 cents a gigabyte for bandwidth—about a nickel a movie.
Year Ended December 31
2009 2008
Cost of subscription ($ in thousands) 909,461 761,133
As a percentage of revenues 54.40% 55.80%

Source: Netflix 2009 Annual Report.

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Exhibit 4: Digital File Purchase and Rentals
Amazon

Amazon’s catalog of more than 50,000 movies and TV shows was available for rental or
purchase. These titles could be rented and watched online, through desktop software, or
via compatible devices from Panasonic, Roku, Samsung, Sony, and TiVo. Amazon
streams at 720p, like Netflix, or HD (1080p) on HD devices.
iTunes

iTunes dominated the online music download market and enjoyed a popular premium
positioning. The store carried more than 30,000 TV episodes and more than 2,500 films,
including 600 in HD. Apple also sold Apple TV hardware for transferring files from
computers to TV screens.
Convergence of TV and Internet

Consumers, particularly young consumers, increasingly viewed the Internet as their

primary source of entertainment. This trend in attitude was the driving force between
innovations that sought to merge the functionality of TVs and computers. Players in this
new space focused on ways to facilitate the watching of downloaded or streaming movies
on TV:
 Online vendors Netflix, Amazon, and Blockbuster all partnered with third-party
hardware manufacturers such as TiVo and Roku to launch low-cost set-top boxes for
video download and streaming. Movies could be downloaded through gaming consoles
such as the Xbox.
 Independent upstart VUDU offered HD movie downloads to the TV via its own set-
top box.
 Riding on the success of its iTunes application as a way to purchase music and video,
Apple offered Apple TV as a way to integrate computer and TV files. Users could view
any purchased media on their computers, video iPod, iPhone, or TV through a syncing
process, (which can be performed wirelessly within the home).
 The newest HDTVs on the market offered direct Ethernet connections to the TV set,
which allowed the viewer to watch streaming video or download from partnered services.
Panasonic’s Viera Cast service, for example, offered easy TV access to YouTube, Picasa
web albums, movie downloads from Amazon, and other programs (e.g., weather forecasts
and stock ticker data).
 Google, through its video-sharing site YouTube, started providing video rental
service, offering selections from more than 500 content partners.

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