Netflix Inc. is the leading provider of movies and series on a subscription basis globally. Founded in 1997, it has taken advantage of the internet age to obtain a worldwide market. It boasts of over 93 million subscribers who have more than 125 million hours of TV shows and movies, including original content, to enjoy daily. Its services are currently available in more than 190 countries (“About Netflix”). It is a huge company, and it faces various costs. Therefore, it would be prudent to understand these costs as well as its market.
Costs of production
According to a CNBC article, Netflix planned to spend $6 billion on content in 2017 (Castillo). This budget alludes to high costs of production for the firm. The company faces several costs with licensing taking the biggest share. It engages in commitments spreading several years with studios among other content providers, which is a fixed cost. The impact of this cost on profitability is contingent on the success of the programs it rolls out. Some of the agreements require up-front payments posing a risk on profitability were the consumers’ reception of the content not to be favorable. In addition to licensing, the corporation spends funds in production, development, marketing and distribution of their own content. The company faces operating expenses, which include technology and development, general administrative costs, interest expense, taxes, among other expenses. The graph below shows the cost of generating revenues for the company from 2012 to 2016.
Graph 1: A graph showing the major costs Netflix incurs
Source: Netflix 2011-2016 Annual Reports
From the graph, it is evident that the cost of production has been on the upward trend over the years. One of the most obvious explanations is that as the sales and revenue increase, costs are more often than not expected to rise as well. The company continues to invest heavily in technology and development. Operating in such a competitive industry demands constant innovation. The money is used in testing; maintaining and improving service delivery to its customers in addition to telecommunication systems and necessary infrastructure. On the other hand, general and administrative expenses mostly comprise of payroll for company personnel and professional fees. As the graph above illustrates, all these costs are increasing evidence of the continued growth of the enterprise. However, the rate at which the cost of goods grows is higher in comparison to the rate at which all the other expenses increase as seen from the steepness of the graphs. This trend can explain the inconsistency experienced on the accounting profit. Data from the financial statements indicate that although the company remains profitable, the growth rate has been both irregular and slow since 2013.
Fixed costs include the money spent on the production of a good or service and changes with the change in output. On the other hand, fixed costs will a business will always incur fixed costs whether there is the production of goods or services or not. Most of the operating costs Netflix incurs are fixed costs. In addition, there are contractual licensing obligations the company gets into that it must honor whether producing or not. Being a business that mostly offers digital content and less of physical products, linking costs directly to a unit of the final service provided is quite difficult. However, some of the variable costs that it incurs include the cost of DVDs provision in its DVDs segment of business, postage expenses, and cost of running DVD shipment centers, content sharing and content acquisition cost. In contrast, the fixed costs include research and development, general and administration costs and marketing expenses. The company should maximize the benefits it derives from licensing and own production activities through providing superior quality content ensuring that it maintains its subscribers as well as acquiring new customers.
Netflix operates in the television industry. The industry has undergone a rapid transformation in this digital era. Online video streaming, with the help of the internet, has brought a change to an industry that was previously about offline TV watching. Despite being the ‘king’ in the industry, competition is fierce with some of their competitors doing their best to eat into the company’s share. Some of its rivals include Amazon.com, Hulu, Time Warner’s, HBO, CBS, Disney and to some extent YouTube. A survey by RBC Capital showed that 54% of Americans watched something on Netflix in 2016 (Levy). In the streaming category, Netflix enjoys 35.15% of the market share, which is a drop from 2015, followed by YouTube with 17.53%, and Amazon coming third at 4.26% (Nickelsberg).
Graph 2: Market share of online streaming as of 2015
Source: Market Realist
The barriers to entry of any firm in the industry were initially strong. However, with the current advancements in technology, content providers are finding it easier to maneuver their way into the industry with ease. The strongest barrier remains the ability to acquire, create and license content. The second barrier that firms wishing to join the sector faces is having inadequate infrastructural capacity to hold a huge load of content while at the same time accommodating the online viewers without crushing. It requires huge capital outlays to roll out such programs ensuring the number of competitors remains low. A good example is the Netflix’s first licensing deal which cost them an annual fee of 30 million dollars. It also pays CBS and Fox 250 million dollars to air their archive programs (Netflix Inc. Annual Report 2015).
Netflix can be categorized as part of the oligopoly structure. Given that, there only a few service providers and millions of subscribers. There are only a few firms that control the market, making it concentrated. Using the four-firm concentration ratios method, it is evident that the market share of the four largest firms approximates 60%. A concentration ratio of between 50% and 80% indicates an oligopoly market structure.
Due to the increased competition, Netflix’s growth has dipped. To ensure this weak growth is not the case for prolonged periods, the firm should engage more in original programming. Focusing on original content delivery would give the corporation an upper hand over the competitors. As of now, the company is still paying CBS and Fox to air repeat content, which may not be very attractive to consumers. However, it must ensure to strike a balance. Producing more of its content and reducing licensing may disappoint some viewers who still enjoy shows from cable networks.
Netflix being the leading provider of streaming content has a lot of influence on the market including pricing decisions. It acts as a leader. It also has enough resources at its disposal to roll out the strategy of increasing its original content. To sustain its profitability going forward, Netflix has to maintain an optimal pricing strategy. In 2015, it raised its monthly subscription fee from $7.99 to $9.99. Now, it offers three subscription packages including $7.99, $9.99, and $11.99 package (Ballantyne). Being a luxury activity, the price elasticity of streaming viewership should be inelastic. However, it has to ensure its prices are competitive, as it cannot risk losing subscribers to rivals.