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March 10, 1999 Event
Zero Margin Business Models: Internet Fad or Economic Future? At a time when profit-challenged Internet companies have become the rule rather than the exception, zero margin business models are gaining tremendous popularity. The entrenched perception that everything online should cost nothing (or at least less) has inspired a full spectrum of zero margin offerings from content (Yahoo!), to software (Netscape), to hardware (FreePC), to services (NetZero), and even hard goods (Buy.com). Yet how can these companies make money while surrendering the very business tenet, margin, which begets profit? Clearly, there is a changing mindset toward conducting business in the new economy. Companies must adapt to a world where free is not just an attribute of the medium, it is the very engine that drives sales. Amidst fierce short-term competition, the best formula for ensuring long-term success may reside at the intersection of the classical economic maxim "there's no such thing as a free lunch" and the freedom intrinsically associated with the Internet. Zero margin strategies uproot traditional economic pricing theories. The classic example of giving away the razor to sell the blades has changed to giving away the razor and blades and then making money on blade cleaning, shaving classes, and nick-and-cut insurance. Businesses begin by forgoing profit in the name of building brand and market share. Low margin investments that push the price asymptote to near zero then are financed with ancillary services rich in margin and frequent trips to Wall Street ATMs. Traditional definitions of product costs are reexamined and even reclassified as marketing costs while value chains for goods and services shift from free core products to higher-priced services. Ultimately, free products become loss leaders and accessory offerings become the drivers of financial success (e.g. Sun distributes Java to sell hardware; Netscape hands out browsers to drive server software sales). For the consumer, the mindset shifts from "I pay you" to "you pay me." In sum, razor-thin or nonexistent margins serve to accelerate demand and help customers make peace with paying for auxiliary products and services. What is truly behind the movement to (be) free? Perhaps the concept offers a beeline path to the virtues of ubiquity and sharing at the core of the Internet's value proposition. The Internet was built alongside generations of free content disseminated via television and radio. Free indisputably acted as the amniotic fluid the consumer market fed on while the Internet was in its non-commercial womb. The influence of this paradigm has now pierced the sheath of e-business, but has the advent of zero margin business signified that we have arrived at perfect competition? If so, successful companies must adjust to this economic evolution. In the free world, brand and endurance may supplant pricing and geography as the ultimate keys to success. Skeptics may argue that consumers are the only winners in zero margin business, and in the short term they might be right. However, businesses may find that giving customers their free lunch today will open up a profitable buffet of long term revenue opportunities tomorrow.
Key Learnings
DEFINITION OF ZMBM
Money for Nothing Cuz the 'Net Is Free
Zero margin business models leverage the allure of "lowest price" or "free" to capture the attention - and ultimately, the wallet - of the consumer. In the short term, they forego the tangibility of product margin for the intangibility of customer interest. These businesses are not really free; the consumer either pays through higher margin auxiliary products or alternative currencies such as time and personal information.
Zero margin business models are not an Internet innovation; the Internet is an innovation to zero margin business models. Traditional retailers have proven the success of these methods through the use of loss leaders (e.g. movie theaters that make more money on popcorn and candy than on tickets). However, the higher stakes and dynamic nature of the Web have driven these efforts to an entirely new level.
Because all business eventually must generate profits, zero margin "business models" should be considered zero margin "marketing strategies." Money hemorrhaging businesses may work today in a URL (ubiquity first, revenues later) world, but they ultimately are unsustainable. There is one exception: the company that never turns a profit and is acquired - in this case the company itself is the zero margin product.
KEYS TO SUCCESS
Customers Get What You Pay For
Zero margin companies must optimize value through both operating efficiency (sales, marketing, customer service) and consumption efficiency (location, ordering, delivery). They must increase the rate at which a consumer's awareness is converted into a purchase. Products with high switching costs are most effective at capturing consumers, since the time and effort required to learn new habits are major usage deterrents.
Wherever brand is king, zero margin marketing strategies quickly will find a home. In a world of decreasing time and increasing opportunities, brand is the default heuristic for making quick decisions. In addition, first mover advantage may be more pronounced as marketing costs (including subsidizing products) for new entrants skyrocket in industries with entrenched brands.
Zero margin businesses that emphasize consumer convenience demonstrate the knowledge that consumers do not want products, they want solutions. As a result, services such as shipping, which are high in margin, necessarily should be at the heart of the business equation. A quality customer experience also instills trust and loyalty and creates customer stickiness, the ultimate goal in e-commerce.
COMPETITIVE LANDSCAPE
Winning the Battle Does Not Mean Winning the War
In the ongoing mad dash for Internet market share, margins are bound to compress. Yet in the long term, the keys to success may shift from hard parameters such as cutthroat pricing, to softer ones such as relationship management (satisfaction and quality of service). While customer acquisition is the short-term goal, the real challenge facing zero margin business is converting users to profits.
Companies that provide outsourced services such as shipping, call center support, and customer care may be the major winners in zero margin business. Their activities are critical to both consumer and merchant regardless of price because infrastructure cannot be compromised. These vendors are not unlike the arms dealers in a war: they don't care who wins as long as they fighting is long and intense.
For every zero margin business, a non-zero margin business exists with better service or support. As the price asymptote approaches zero, incremental differences in cost may not be as critical to the consumer value proposition as incremental differences in experience. Still, a market opportunity always will exist for the lowest price vendor in every category.
EVOLUTION OF THE VALUE CHAIN
Turning Desire Into Dollars in a Priceless World
A major challenge for zero margin merchants is to build consumer affinity by offering bargains in price without sacrifices in value. Since consumers perceive free products as cheap in quality, the best zero margin strategies employ products with high worth but low marginal costs, such as content, software, and services. Strategies involving hard goods are much riskier due to up-front capital requirements.
Surprisingly, brick and mortar stores can be an asset rather than a liability to zero margin business. Physical locations serve the experiential needs of consumers who enjoy shopping in a touchy feely world (browsing in a bookstore instead of clicking away on Amazon.com). In addition, brick and mortar stores can offer high margin auxiliary services (warranty work) that complement their zero margin counterparts.
Today, consumers are the true winners of zero margin business. We may not have arrived at perfect competition just yet, but the increasing power of the consumer indicates that we are getting closer. The more efficient the economy, the greater the total consumption, therefore everyone wins in the long term. The intrinsic benefits of the Internet - economies of scale, global distribution, usage tracking - are the very factors that allow zero margin business models to thrive.
QUOTES OF THE NIGHT
"The Internet is like a bar where ladies get in free. If enough show up, the bar will attract guys who are willing to pay for the women's drinks. It may be zero margin on the ladies, but the business definitely makes money. The key to understanding the model is to determine who the ladies are and who pays for the alcohol."
"Consumers are nothing more than lazy creatures of habit who blindly follow brand consciousness."
"Free is an illusion. It's simply a postponement of payment."