Strategy in the Post-fixed Costs Economy

Strategy in the Post fixed costs economy

Strategy in the Post-fixed Costs Economy

Evaluating strategic options in a world where businesses have never been easier to start, but never been harder to scale

by Ben Robinson, October 2020 | 15 minute read

We’ve talked often about the diminishing importance of supply-side economies of scale. In its simplest expression, digitization flips the industrial age equation. What was scarce in the industrial age was supply; what is scarce in the digital age is demand (attention).

In the industrial age, to scale supply meant mass production to spread the fixed cost of large capital investments over large volumes. And the industrial age was an age of mass produced, relatively standardized goods. This applied to goods and services provided by the private sector, but also to state-provided services, such as education and public services.

Since the advent of the internet, this is changing. We first noticed the shift in industries where both supply and distribution could be digitized (e.g. media) because supply became abundant faster and this highlighted our limited attention sooner.  But it’s becoming increasingly apparent that all industries are being disrupted as software has eaten the world. More and more physical goods have software components to them, making supply more digitized. Where supply cannot be digitized, distribution nearly always can. And where supply-side economies of scale remain important, they can be borrowed.

Renting scale and the end of fixed costs

AWS was not originally intended to be a platform on which third-parties would run their businesses. But, thanks to Amazon’s business model, it was possible to open up that infrastructure service to others. In doing so, Amazon created a massive and highly profitable business which contributes 65% of group operating profits.

But, as big as the impact has been on Amazon, the broader societal impact has been truly dramatic.

Before AWS, companies had to make large upfront investments in computing hardware – a significant barrier to entry. Even buying hardware was a major source of risk: buying too much could bankrupt a company while buying too little could cause a major bottleneck to growth. And so, AWS removed both risk and cost for new businesses. As a direct consequence, it also contributed to the creation and success of hundreds of thousands of new businesses.

This boost to global GDP over and above the value captured by Amazon itself is difficult to calculate, but it’s certainly very significant. It’s probably not an overstatement to suggest, as Charlie Songhurst does, that AWS has been the single biggest factor in the rise of angel investing.

But AWS is not the only internet era platform. From Shopify to Stripe, examples abound of platforms that share their scale economies to remove the cost and complexity of doing ecommerce – allowing companies to form and start trading faster, with reduced risk and at lower volumes than would have ever been possible.

And not all internet-era platforms are providing digital services. As Rita McGrath, Columbia Business School Professor, discussed on a recent Structural Shifts podcast, by helping establish prices and create trust, digitization is making more and more non-digital assets tradeable on marketplaces. As she put it:

“What we’re seeing with the advent of the digital economy is that more and more transactions can be conducted in markets that used to require a firm.”P

Uber was a pioneer in this regard, but we now see this “uber of x” phenomenon everywhere – even in the enterprise market. At aperture, we are very much an embodiment of this, providing strategy and go-to-market as-a-service that enables companies to avoid the fixed costs and risk of underutilization and underperformance in these functions.

In effect, it’s becoming easier to rent all services, physical and digital. All become liquid and on-demand. Capex gives way to opex or, as Younes Rharbaoui says: we have entered the post-fixed costs economy.

“Signs of a post-fixed costs economy are all around us: companies switching to full remote, increased reliance on independent workers & freelancers, on-demand software where cost matches usage, are all creating lean financial structures for growth.”

And, of course, like many other secular trends, the impact of the pandemic has been to accelerate it. If COVID-19 drew a binary distinction between online and offline services, lifting the former and sinking the latter, then it was disproportionately brutal in its treatment of those offline businesses with high fixed costs – oil companies, airlines, hotel chains and so on. From now on, all fixed cost investments will be more heavily scrutinized and, where they exist, variable costs alternatives will be more actively considered. Even Warren Buffett, a regular character in aperture blogs, is starting to consider the wisdom of some high fixed-cost business models.

The fact is, if fixed costs were already becoming passé, they definitely will be in the post-pandemic world – ushering in a faster transition to a new, internet-era economic structure.

Platforms, aggregators and the long tail

For the best explanation of the difference between platforms and aggregators, we recommend this classic essay from Ben Thompson. In it, he uses the Bill Gates platform definition, namely that: “A platform is when the economic value of everybody that uses it exceeds the value of the company that creates it. Then it’s a platform.”

Bill Gates quote platform vs. aggregators

On this definition, the business we have already mentioned – AWS, Stripe, Shopify – are all platforms. They make the large investments in fixed costs – datacenters, fulfilment centers, payment networks, etc. – that mean their clients don’t have to. They make it cheaper and simpler to do business.

It’s this commoditization of supply and associated end of fixed costs that’s now starting to give rise to a long tail of providers. Thanks to lower and variable input costs, it’s possible to make money at lower volumes than in the past, which in turn means a higher number of providers can co-exist.

Take newspaper publishing, for example. The massive costs of producing and distributing physical newspapers gave rise to significant economies of scale and produced an oligarchical market structure. Compare that with today, when a platform like Substack allows independent writers easily and cheaply to publish, distribute, and monetize paid newsletters. These writers can make a living with only a small audience, allowing potentially tens of thousands of them to co-exist – and giving rise to a broader phenomenon, the “Passion Economy”, where more of us can pursue our craft or our talent and make a living from it.

However, the difference between the long tail as it’s conceived now and the original theory, is that supply is abundant, not demand. The constraint on all digital-era businesses is demand and the gatekeepers of demand – the most profitable actors in the digital ecosystem – are aggregators.

In a world of abundant supply, aggregators help match buyers and sellers. They are in a position to do so because they provide interactive content that rises above the noise to command our attention. When in possession of our attention, they can monetize it by charging advertisers to reach us. This has become the biggest cost for many online companies, accounting for 40% or 50% of the investments they make in growing their business.

As Clayton Christensen predicted in the Law of Conservation of Attractive Profits, as one part of the value chain commoditizes, the value is captured elsewhere. As platforms helped generate an economic surplus, aggregators increasingly captured that value – especially Google and Facebook.

While it has become cheaper to start a business, a sharp increase in customer acquisition costs more than offset these savings.

More precarious

But it’s not just high customer acquisition costs that prevent long tail companies from rising to a size where they exploit scale effects. There are other factors at play.

First, the falling costs of starting a business is a double-edge sword. If one online retailer can set up on Shopify, so can any other. Platform companies are lowering the barriers to entry for everyone, making it harder to defend a business than in the past.

Second, if a business model has network effects and a company can grow large enough to exploit them, this market leader becomes more powerful than an industrial-age leader. This is because, unlike supply-side economies of scale, demand-side economies of scale are subject to increasing returns to scale; the more they exist, the stronger they become. And so, where the industrial age gave way to oligopolies with clearly defined industry boundaries, the internet age gives way to winner-takes-most aggregators, large-scale platforms, and a long tail of suppliers operating across the economy in general.

Third, there’s also one important supply-side economy of scale which makes size important even in the absence of network effects – and reinforces them where they exist. This is the ad score. Basically, the bigger a company gets, the cheaper its relative cost of customer acquisition becomes because it pays a lower cost per lead thanks to a higher ad score (the algorithm that advertising platforms like Facebook and Google use to calculate the likelihood of a customer clicking on an ad).

Effectively, the post-fixed cost digital economy is one where is it simultaneously cheaper than ever to start a business, harder than ever to defend and scale it, and where the returns to scale have never been more important.

If it was hard to cross the chasm from startup to large, scaled business in the industrial era, in the digital age it is harder still.

So where to next?

Let’s look at strategic options for new entrants, from where to play to how to scale.

Where to play

Marc Gruber, a professor at EPFL and former podcast guest, wrote a book on “Where to Play”. At the risk of grossly oversimplifying the narrative, it argues that companies spend too little time thinking about which market opportunity to pursue – assuming a good product eventually finds a market – and instead provides a framework to select the right market before commencing activities.

Like Marc, we believe it makes sense to invest the time upfront to consider carefully where to play, even more so in the post-fixed cost economy. Marc’s book provides the methodologies for this choice, so we limit ourselves here to explaining the rationale.

In a digital world, where returns to scale are bigger, incumbents will be harder to displace. Therefore, it follows that any startup should focus either on creating a new market or, more likely, on market blind spots: the niches where consumers are underserved or overserved.

Underserved and overserved markets

In the digital age, underserved markets are likely bigger opportunities than in the past because geographical limitations are removed. A micro market in one country might be a big market when addressing all countries collectively.

B2B marketplaces are a classic example of this phenomenon.

While there are B2C marketplaces for seemingly everything, many entrepreneurs overlook B2B marketplaces because they seem less scalable. They think that it will be difficult to build a big business if your buyers and sellers are very specialized; that there won’t be a generalized pull effect. Buyers of fish are unlikely to be drawn to a specialist marketplace for, say, cement and building materials. But when you are dealing with a global B2B vertical, a two-sided network is more than sufficient to build a massive business: the wholesale fish market, for example, is worth USD150bn!

Another reason B2B marketplaces are sometimes overlooked is because it can be a long game. Many of the businesses we work with are patiently helping incumbents digitize their offering as a precursor to enabling one-to-many transactions. But their ultimate goal is to become a platform for enabling a many-to-many marketplace.

Trade Ledger Business Finance Lending Platform

There are also plenty of opportunities to target overserved customers. As Gary Pisano discussed on another episode of Structural Shifts, companies often push so far with innovation with an existing product or within an existing business model that they overshoot customer demands and leave themselves open to disruption from new entrants providing more user-friendly products or offering more convenience. He gives the example of subscription-based razor blade services like Dollar Shave Club disrupting the overengineered and expensive Gillette razors (“I can only shave so close before it’s scary!”). But this concept of overshooting is especially prevalent in B2B software where, in order to meet the enterprise buyer’s demands, traditional companies have overshot the demands of the end user creating the opportunity for disruptive innovation. This idea is brilliantly expressed in the following excerpt from an a16z article:

“Since effective top-down sales require a highly choreographed (and costly!) dance between pre-sales and the customer, product teams are incented to add more nobs to the product so these teams can sell more value and extract more dollars. Vendors get crossed off the list in vendor discovery if their product doesn’t check all the right boxes for the enterprise buyer, even if many of the boxes don’t actually deliver any value. This often creates a vicious cycle where more complex products give rise to longer sales cycles for more dollars, which then incentivizes even more complex products. For any user of legacy enterprise software, it doesn’t take long to realize that designing a seamless user experience is by no means a top priority for the vendor.”

Direct to consumer

Targeting underserved and overserved customers is what Clayton Christensen refers to as “disruptive innovation” and, as he tells us in the Innovator’s Dilemma, disruptive innovation is about simpler and cheaper products, but it’s also about marketing:

“disruptive technology should be framed as a marketing challenge, not a technological one”

This is even truer today than when Christensen wrote it because digitization opens up new routes to customer. As a result, product, monetization and customer acquisition have to align seamlessly around these new distribution opportunities.

The big trend is direct-to-consumer.

In the retail space, this mostly refers to the phenomenon of avoiding any intermediation – retailers or wholesalers or even any physical retail footprint – to sell directly to the consumer.

In the enterprise space, direct-to-consumer is different. Historically, it was not worth going directly to end users because they didn’t have much influence – or budget. Therefore, it was necessary to go through procurement teams and the choreographed dance of RFI, RFPs and workshops mentioned above.

But what is changing now is that technology products are not just sold directly, but are consumed directly. This makes software-as-a-service a much more disruptive phenomenon than people think: it’s more than a cheaper deployment method, it is a way to circumvent the central buying function and reach the end user.

In this context, it’s clear SaaS companies should have products marketed to end users, simple enough for them to consume without heavy configuration, and priced so they won’t appear on the central procurement team’s radar (e.g. freemium models to test and deliver value ahead of the paywall).

Slack is the example many cite. It markets directly to end users, who can try it for free. Once it has taken hold in an enterprise, it spreads virally thanks to strong network effects (even across enterprises). All the while Slack reaps the benefits by having a pricing structure that reflects usage.

Some argue that it’s harder to make this bottoms-up, direct-to-consumer approach work in areas like fintech, where regulation is important and IT security teams have more muscle. But we see it happening everywhere.

One fintech example that we came across recently, in the context of our upcoming wealth management report, is Hydrogen.

Hydrogen offers a classic bottoms-up approach: a user can provision for themselves a free sandbox environment from the Hydrogen website, pre-integrated with the services they’ll need (like Plaid). The customer only begins paying once they cross certain thresholds, such as API calls. In addition, that also take a jobs-to-be-done approach to solving end user problems by offering discrete services as no-code plug-ins to existing applications, meaning an end user can add a service like tax optimization in minutes.

Blake Bartlett OpenView partners quote

Avoiding the aggregator tax

Going direct to underserved or overserved consumers is the new playbook for disruptive innovation, but it doesn’t mean companies can avoid the aggregator tax. In fact, costs just get reallocated: in retail, CAC is the new rent, while in enterprise, CAC is becoming the new senior sales rep.

Nonetheless, while unavoidable, businesses can minimize the aggregator tax.

One way is to invest in brand.

A lot of startups seem to believe investing in brand is a luxury. We don’t agree. Marketing is like a pump: first, you have to fill it, if you want to draw it down. Sure, you can generate some leads from well-targeted paid campaigns, but it’s not a sustainable endeavor and you’ll end up paying more to aggregators over time. Instead, you want to run paid campaigns into a customer demographic that’s heard of your company and thinks positively about it, which will improve your ad score and lower your ad cost.

You should also invest in data. Going direct to consumers means you know more about your customers than your industrial age predecessors ever did. It’s critical to capture this information in order to:

– build proprietary routes to customers

– learn more about your users to better target and to aid self-discovery through recommendations

– learn how consumers use the solution so you can constantly improve the utility of the product, everything from ease of purchase to completeness of solving user’s problems.

You must leverage the power of networked buyers.  At the most basic level, your product should be differentiated enough that customers will want to advertise it on your behalf. That customer advocacy might come in the form of a positive review or post, but as former podcast guest Julian Lehr highlights, it may also come in the form of signaling.

In addition to advertising, the networked customer can be an acquisition channel.

Wherever possible, you should try to build into your solution the viral features that make the product better when it’s used together with others (e.g. messaging), that lead to customers acquiring other customers. And, even when it’s not possible to build these viral features into the product, it’s possible to build them around the product. A Nike running shoe has no inherently viral features, but the community it has built around its products, the millions who share fitness information, definitely does. And it’s not just consumer brands that can create communities. Consider Salesforce, for instance, which has a community of over 2 million organizing events and sharing content. This attracts others, but also binds together the users in a way which makes it hard to leave the community (by choosing a different product).

Don’t just rent commodities, rent luxuries

If you’ve read this far, it probably won’t come as a surprise that we advocate for renting commodities. Don’t buy your own servers, for example, or write your own accounting software. This will keep operating costs low and variable.

However, we also advocate for renting specialist skills. It allows more cost flexibility and avoids underutilization, but it also reflects a structural shift.

The best people increasingly don’t want to work for a single company. They like the variety and the speed of learning that comes from working across multiple companies and projects. And, platforms are emerging that go further than just matching companies with freelancers – platforms that put together, manage and take responsibility for (the output of) interdisciplinary teams. Effectively, they give businesses greater flexibility and quality at scale and specialists the security and freedom to keep learning.

Achieving internet escape velocity

Brett Bivens, a venture capitalist at TechNexus, came on the Structural Shifts podcast earlier this year to talk about his theory of “Internet Escape Velocity”.

Essentially, internet escape velocity is what happens when a company successfully executes the strategy playbook described above. That is:

– it identifies an underserved or overserved niche

– it leverages internet distribution to reach those customers directly

– it unleashes a growth loop by combining the reinforcing properties of product, distribution and monetization, and

– it uses data and marketing to avoid the aggregator tax

At that point, it hits internet escape velocity, becoming capable of crossing the chasm of precarious long tail supplier to become an aggregator itself, using the pull of its loyal customer base to pull in more suppliers or to launch new own-label services. Brett uses the example of Spotify, which he describes as follows:

“over time, as they expand and gain leverage, podcasts are a higher margin business, social products are a higher margin business, marketplace products are a higher margin business for them. And so, by owning the consumer demand via the lower margin streaming business, they have the opportunity to expand into those areas.”

When a company hits internet escape velocity, it also has the option to invest in fixed assets. As we showed in a paper we wrote with Dave Galbraith in 2016, internet-era companies tend to become asset heavier over time as they seek to entrench their position and deliver better customer fulfillment. But the critical point is that they invest after they achieve a sustainable route to customers. Assets grow like the roots of a tree, downwards from distribution rather than upwards from production.

If, however, a company that hits internet escape velocity doesn’t want to invest in fixed assets, the good news is that it’s never been easier to rent supply in the post fixed-cost economy.