Are niches more profitable than hits?
After I posted my new 80/20 graphic last week (thumbnailed at right; click to expand), a number of readers queried the bar on the bottom right, which shows that in Long Tail markets profits can follow revenues equally into the niches, something that isn’t true for traditional retail and is thus a big deal. But readers think I’ve actually understated the effect and the advantages are even more dramatic than I showed. And it looks like they’re right.
I’ve argued that profit parity is a key advantage of the Long Tail. In bricks-and-mortar stores, economics favor the hits because they use shelf space so efficiently, briskly whizzing off the rack nearly as soon as they’re placed there. But in Long Tail markets, where the costs of shelf space are very low, the niches have the same costs as the hits, and potentially the same profit margins. This explains that last profit bar in this graphic, which is the same as the revenue bar that comes before it.
But I underestimated the effect of lower niche content acquisition costs. The readers were right. The economics of niches turn out to be even better than the hits. Way better, as it happens.
To see why, let’s look at the DVD retail market. Here’s a rough sense of the financial picture (the estimates are based on input from a number of retail experts, including William Fisher of DVDStation):
What you see here is that the economics of new releases these days are simply awful. The studios charge $17-$19 for the DVDs and the “big box” retailers (Wal-mart, Best Buy) sell them for $15-$17 for the first week or two, for an average loss of $2 per DVD (this is before overheads; the actual loss is larger).After the first month or so, the wholesale price of the DVDs goes down faster than the retail price, and they gradually move into profitability. Yet 70% of DVD sales are of titles within their first two months of release, before they’re profitable. Why do stores sell new releases so cheaply? Because for the big-box retailers, at least, they’re a loss leader, designed to draw people to other titles in DVD section and elsewhere in the store, where the margins are better.
DVD distributors encourage this by allowing unsold new releases to be returned, lowering the risk for retailers (but increasing it for the studios, as Dreamworks and Pixar have just learned to their cost).
The problem is that while this makes sense of the big-box retailers who have other things to sell, it has the effect of setting the price for everyone else, including the specialty DVD retailers like Blockbuster. The big-box retailers have thus driven down the margins for new releases across the industry, making the economics of the Head even tougher. No wonder Blockbuster’s stock is down 50% this year.
But if you could shift demand further into the Tail, creating a market that wasn’t so dependent on new releases, you could improve the profit picture immensely. People move in herds, so this doesn’t happen overnight, but it’s not impossible. This is why recommendations and other filters are so important to Long Tail markets. By encouraging people to venture from the hits world (high acquisition costs) to the niche world (low acquisition costs), smart retailers have the potential to improve the economics of retail dramatically.
(This is, by the way, exactly what Netflix does: It underbuys new releases, despite the fact that such unavailability and delay annoys some customers and increases churn, because it allows Netflix to maintain its margins.)
Note that while I’ve given the case of DVDs, the exact same is true for music and books, and probably a lot of other things. The bulk of the revenues may still be in the hits, but increasingly the profits are in the niches.
So, chastened by this lesson, I’ve redrawn that graphic, reflecting the improved profit picture in the Tail (the numbers are for illustration purposes only; they would vary in diferent markets).
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