On Free Kindle

It appears, at least to Farhad Manjoo, Kindle is going to be free. He writes in recent Slate colum,

I can’t tell you when this will happen. But it will happen. Mark my words: The Kindle will be free.

Let us not delve into how he arrived at such a certainty couched as a measured statement with uncertainties.  Let us take his word for it and look at what it would mean to Amazon’s profits. According to Manjoo, who seems to have a window into Amazon decision maker’s mind and their business strategy,

First, why? Well, that’s easy—because Amazon’s long-term goal is to make money from selling content and general merchandise, not by peddling its own devices.

The case in point is the low-end $79 Kindle that will be free. So what kind of money should Amazon make by selling content and general merchandise by not peddling its device? Let us be aggressive and assume that this low-end Kindle is going to be great to sell general merchandise and not just content.

Again according to Manjoo, Amazon makes no profit on these devices or may be even losing money. Let us say they are indeed selling $79 Kindles at their marginal cost.

Say by making the Kindle free, they sell 20 million of them.

Cost? $1.58B for 20 million units. Just to stay where there are with current gross margin, they have to gain gross margin(not sales) of $1.58B from content and merchandise sales.  To put that in perspective, Amazon’s 2011 gross margin is $10.8B from sales of $48B. At its 22.4% gross margin, this $1.58B means $7B in sales.

And this $7B  sales will all have to be incremental new sales, sales that are made possible only because of the free Kindles. Sales that would have any way happened, because customers do shop even without free Kindle, cannot be counted towards these numbers.

On a per Kindle basis that means every free Kindle user must spend additional $350, above and beyond what they are already spending with Amazon. How likely is that scenario? Say amazon now has 100 million shoppers, its current revenue of $47B means, each shopper spends an average of $470 per year. Can a free kindle somehow add $175 per year (assuming device lifetime of 2 years) to this $470?

Now this is just the simplest of the math. You can see how unfavorable it gets when you add in lost profit from those who buy other Kindle models and Kindle Fire switching to free version.

On the flip side, say if Amazon were able to sell 5 million of the $79 Kindles. As per our marginal cost assumption they are no costs. If Amazon were able to generate the same $175/y in incremental sales from these 5 million customers that is $875 million in new sales and $196 million in new profit – not just the profit they had to make stay at same place but something that actually moves the needle.

Why wouldn’t they do that? If somehow a free Kindle buyer could be coaxed to spend $350 more why is not possible with the one that bought Kindle for $79?

I don’t have the window into Amazon’s strategic mind or the data they are looking at.May be you should ask Manjoo.  Amazon has said before, “economics don’t work for a free Kindle”. That appears as a bluff to Manjoo.

What appears like a bluff to us outsiders may really be the result of strategy guys doing their job – evaluating all possible paths ahead of them and making choices with constraints.

That is the difference between writing something based on one’s wishful thinking and having to make decisions that affects shareholder value.

 

Watered Down Profits – Shifting Demand Curves

I saw a commercial for PUR water purifier that makes a value proposition on savings from bottled water. There was another commercial by Wal Mart that showed people buying their private label bottled water and taking it with their brown bag lunch. There is yet another commercial by Brita that takes a green approach by showcasing the ill effects of plastic bottles. The net is bottled water sales are down due to a variety of reasons.

  1. How should the marketers handle the shift in consumer preference?
  2. Should they drive down prices to keep their customers from switching to tap water?
  3. How much will the sales volume increase with price change? i.e., what is the price elasticity of demand?
  4. Is raising prices an option?

It is almost out of luck there is data on all these (from WSJ) that one can find without searching too hard. It is as if do all of us a favor, one of the biggest brands, Coke, did not change its prices and another biggest brand, Pepsi, lowered its prices. For all practical purposes we can treat that there is no differentiation between these brand for bottled water and they represent the overall market.

Coke, kept its prices stead and saw its sales drop by 26%. Note that this is sales in dollars not units, but at constant prices we can assume that this represents volume drop. I am no Greg Mankiw or Andy Rose, but to me this drop in demand at constant prices seems like  a shift in the demand curve. So let us treat this as the shift in the demand curve due to income effect (people switching to tap water or store brands as part of their cost cutting). See Figure 1 and 2 for the shift in demand curve.

demand1
Figure-1 Demand Curve
Figure-2
Figure-2 Demand Curve Shift

Figure-1 were the demand curve before recession, Figure-2 shows the shift. It is an approximation and not an accurate drawing.

Next, Pepsi cut its prices by 5%, and its sales (dollars) fell only by 13.8%. This is shown in Figure-3. But that is based on the previous demand curve. Since we assumed the demand shifted down, the 13.8% drop is actually 12.2% (26% – 13.8% = 12.2%) increase in volume. That is the price elasticity of demand on the new curve at the same price point before the price cut is 12.2/5 = 2.44.

Figure-3
Figure-3 Price drop results in sales increase (along shifted demand curve)

Not all of this 12.2% sales increase translate into profit. Pepsi and Coke do not break out their earnings to show revenues and profit from bottled water. Luckily, Nestle does. If use their numbers EBDITA numbers, the margin as a percentage of sales is 7.3%. This seems on the lower side. In 2003, MorganStanley reported that the margin is around 20% for US bottlers. So we can take the margin to be in-between these two estimates, say 15%. So Pepsi earned a gross profit of  12.2%*15% = 1.83% of the total sales.

Not a bad move, better than Coke which did not change its prices. But could they have done better? What if they had raised priced by 5%? That is a 5% of sales added to profit.  But their sales volume would fall. If we take the price elasticity of demand to be the same (2.44) in the other direction, then their volume would have fallen 12.2% with a profit loss of 12.2% * 15% = 1.83%. This translates  to a incremental gross profit of 2.6% from price increase despite a 12.2% drop in sales. If Coke or Pepsi were to reduce capacity and operational expenses to account for this 38.2% (26%+12.2%) drop in volume, the cost savings will add to the gross profit from price increase for a higher operational profit.

This leads us to conclude, that  price increase at lower volume would have delivered higher profits than sales increase from lower prices. But recommending price increase when the sales just fell 26% is going against the “conventional wisdom” – one needs data, conviction to act on it and limitless courage to go against “conventional wisdom”.

Free – Ignoring Forgone Profits

Mr. Chris Anderson, author of the book “Free” and proponent of “free as the future of radical new price” and “free + premium = freemium” model,  says how  the decline of marginal cost (incremental cost to produce/store/distribute one additional item) makes $0 price as the inevitable price. I have not read his book and have only read his writings on this in other media and seen his speeches (on video). I am sure I will be told that I misunderstood his book and that he is not saying “free as the new price” (despite the subtitle for the book).  So let us stick to his discussion of freemium model.

According to Mr.Anderson, freemium is about having a free version and a premier version for which you can charge a premium. The reason a business should go for this model, according to Mr.Anderson (or at least my interpretation of his argument), is that making it free enables the product/service to go viral and significantly increases is uptake. In other words a product that did not have a market (or market share) will have the opportunity to capture a large market share when made free. Once you grab these free customer’s attention, which according to Mr.Anderson is he scarce quantity, a business can find other ways to monetize. His examples include up-selling customers to subscription, and a band giving away its songs to sell concert tickets and other items like T-shirts. In the digital world, since the cost to produce/store/sell one additional item approaches $0 (or already $0), he argues, free makes sense.

Mr. Anderson’s argument is valid and true, if we only looked at one side of the equation. It is absolutely true that a business can reach new customers, when none existed, and can monetize them through other ways. The question Mr.Anderson chose not to ask, but any decision maker will always ask, is how much profit am I giving up by charging $0. Failure to do the incremental analysis makes this not “freeconomics” or “economics of abundance” rather “halfonomics”.

Let us try to breakdown the profit to individual customer level. The metric is over the lifetime and not just transactional. Breaking this down to individual customer level and adding them all up,  the decision maker must ask

  1. What is the Lifetime Value of the customer when I make $0 as the price  (LV0)
  2. What is the Lifetime value of the customer when I charge for the product (LV1)
  3. Is  sum of all LV0  greater than sum of all LV1

If (3) above is true, it is no brainer. Choose the option that maximizes total profit over the long term.  But Mr.Anderson’s argument simply asks,

is Σ (LV0)i   > $0?  rather the right question is Σ (LV0)i > Σ (LV1)i

Mr. Anderson talks in absolutes and assumes that Σ (LV1)i = 0.  It is not true. Note that, just because a band sells its music for a non-zero price does not mean it cannot or does not sell concert tickets and T-shirts. One should only look at the additional profit from the new sales that were made possible because of the $0 price. If it still makes sense, then by all means make it free. But then this is basic decision making, nothing new or radical about it.