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).

Comments

[Shawn]

Niche products can be very lucrative, in marketing terms, because the market is more predicatable and a premium can be charged. The customer is willing to pay for quality.
The old model involved mostly mass-marketing, which doesn't seem like the optimal situation at all, unless their are obstacles to getting the niche product out.. but the long-tail smashes those obstacles.

Mass market might still be the way to go for commodities, but for music and video, niches are just a natural thing. Music lovers don't like music made to sell to everyone on the planet; they like music in the various genres they are fans of. Oh mass market stuff is going to stick around and be listend to by the crowd that doesn't know much and wants to be led along... wants to be part of a big group so they feel secure in numbers that they have good taste... and I think there is a charm to knowing a big audience is grooving on the same song at a dance club, etc...

However, producers of niche products will gain ground fast. I note that they should always charge a premium - they are providing a better, more useful product. Big conglomerates will probably try to through a monkey wrench into this process. But if niches products maintain the pay for quality status, what might then happen, is that their sales would begin to detract from the mass market stuff by drawing more disposable income away on the higher price, while at the same time causing tastes to become more refined and migrate away from the herd. It's a real threat to the mass-market concept (in music, video, and the like)....

[Niki Scevak]

Interesting analysis but isn't this simply a temporary situation of industries that are in flux? i.e. the reason why hits are less profitable are that studios/publishers demand a higher revenue share because they know exactly how much retailers make off them. As soon as Netflix, Amazon et al become hugely profitable (that is, when online retail hits critical mass or 20% of total retail) and as soon as the economic opportunity of the long tail is quantified (perhaps 10 years from now) the studios/publsihers will start demanding higher revenue share for tail titles too?

At the moment the majority of retail makes very little from the tail. But soon that will presumably change as commerce shifts online. You can bet as soon as it does the studios will be raising their prices.

So although the profit breakdown looks as it does today, as soon as the long tail reaches scale hits and niche titles will be equally profitable.

[Trova Hellstrom]

The same is very, very true of automobiles. There is much more margin in used cars than in new. Among the reasons: Most consumers know, or can easily find out the dealer's cost on a new car, but with used cars the lowball when buying, then have a lot of pricing flexibility when selling.

You could probably do a whole chapter on cars as an example of the long tail.

[Aron]

I believe there is a logical reason that tail products can provide a higher gross margin in the longterm. Namely, there is an innovation challenge in connecting the products to the buyers. Profit is the reward for the effective application of recommendation engines and other website merchandising techniques to generate sales from these otherwise 'dead' products.

But I agree with the commenter that said studios would eventually move to soak up the margins in the tail products. However, I believe they will always have a relatively higher margin because there is so much more room for innovative merchandising.

Any one can sell Spiderman 2. Not everyone can sell 'My Left Foot'.

(BTW, the gross margin line in the first graph is mathematically incorrect. 12$ revenue and 6$ cost is 50% margin).

[chris anderson]

Aron,

Good catch on the margin thing; I put a wrong number in the spreadsheet. The current graphic is corrected.

[T J Neville]

The comments that the studios will soak up Tail margins are very astute. On the business side their entire culture focuses on avoiding being leveraged (“being HBOed”) over the long haul, sometimes to the point of irrationality. More importantly, in this era of great uncertainty, most are very reluctant to do long term or exclusive deals; and the nature of the web makes it difficult even to make long term commitments for small territories. This means that almost every deal will be essentially structured as a research project to learn their distributor’s business, and then to renegotiate.

You are also probably underestimating the incremental revenue/margin advantages Hit products have as promotional platforms for Tail products. With the transition to pure electronic distribution, you can assume that dynamic integration of AdSense-like contextual promotions/advertising within (or side-by-side) presentations of Hit product will be healthy sources of incremental revenue. Also, this revenue stream will probably grow as screen sizes get larger.

It’s a good bet that these “cross promotion” opportunities will both increase margins for Hit products (…whose owners will quickly calculate their value to distributors), while simultaneously extracting revenue/margin slices from niche distributors anxious to grow their audiences.

Tom

[brian]

Chris,

Are you confusing niche being the same thing as back catalog? Niche products (like anime and Bollywood) do release new products and I assume they follow the same cost-price cycle as more marketed/well known products (Hollywood blockbusters). So, if I deal with niche products it doesn't mean that NEW releases cost me any less (and may cost more because they don't get economies of scale) than non-niche products. Back catalog products follow the same path as well.

[chris anderson]

Brian,

I'm not confusing niche with back catalog; I'm giving back catalogs as *one example* of niche. In general, however, retailers have more pricing power in most niche categories because they are not, by definition, commodities. So I think the case holds true across all sorts of niche categories, not just older media titles.

[web design india]

Niche product and services has always been more profitable than hits. though at times niche comes from hits only. for example google created a niche industry for search engine optimization.

[web design india]

Niche product and services has always been more profitable than hits. though at times niche comes from hits only. for example google created a niche industry for search engine optimization.