Companies like Facebook, Apple, Amazon, and Google have achieved enormous scale in a matter of decades. Often their success is attributed to their tech and innovative cultures. However, while superior technology and innovation certainly help companies grow, it’s not the primary reason why these companies have reached such enormous valuations. Tech monopolies owe their success to their platform business model.
In order to understand the value of platform business models, you need to be clear about what is and isn’t a platform, and how they differ from traditional linear business.
So what do you call traditional, non-platform companies? We call them linear businesses, because their operations are well-described by the typical linear supply chain. Linear companies create value in the form of goods or services and then sell them to someone downstream in their supply chain.
Linear Business: a business that takes in components, creates finished products/services and sells that good/service to consumers.
Linear businesses own their inventory and it shows up on their balance sheets, whether it’s a car manufacturer like GM or a subscription content provider like HBO, which either creates or directly licenses all of its content. It also includes resellers like Walmart, Macy’s or Target.
All of the titans of industry from the early twentieth century were linear businesses, including Standard Oil, General Motors (GM), U.S. Steel, General Electric, Walmart, Toyota, and ExxonMobil.
Note that not all tech companies today are platform businesses. Technology is an important enabler for platforms, but using modern technology does not automatically make a business a platform.
Netflix, for example, is not a platform business despite being a technology company. It’s essentially a linear TV channel with a modern interface. Like HBO, it licenses or creates all its content. Watch the video below for more on why Netflix is as linear in its business as any other.
Technology is an important enabler for platforms, but using modern technology does not automatically make a business a platform.
The platform is solely focused on building and facilitating a network. Platforms don’t own the means of production – instead, they create the means of connection.
Platforms don’t own the means of production – instead, they create the means of connection.
To understand how platform business scale, we need to understand two major contributing factors: network effects and the economics of information goods.
Network effects are the incremental benefit gained by an existing user for each new user that joins the network. For example, when a new rider joins Uber, it benefits drivers on the platform. We’ve written an article that gets into the weeds about network effects that’s essential reading for anyone who intends to build and manage a platform.
The economics of information goods refers to the fact that information goods such as apps, digital music, and ebooks can be replicated at a near zero cost. For example, to create a mobile app, it might cost $500,000 to produce the original version, but creating a copy of that app for user #2 will cost next to nothing. In the language of economics, the app has near-zero marginal cost.
In addition to a near-zero marginal cost of manufacturing, information goods today also have a near-zero marginal cost of distribution. Thanks to the Internet and connected technology, the cost to serve one additional customer is basically zero. Each customer visits a website (no rent!) or downloads the app from the cloud or a remote server (no shipping fees for catalogs or CDs).
While the economics of information goods has long been benefiting costs on the supply side (e.g. eBooks sales), platforms take this advantage a step further by bringing near-zero cost benefits to the supply side.
Compare Hyatt and Airbnb. If Hyatt wants to add rooms, it needs to build more hotels, or as Marriott did, it needs to acquire them at great cost. When Airbnb wants to add more rooms, it just needs someone to create a new listing on its website. This costs the platform is next to nothing. It doesn’t have to build rooms or acquire companies – it needs to acquire users.
Linear businesses generally grow by adding human capital or physical assets, or both. Since these tactics create value by controlling production, linear companies have to invest significant resources in expanding their capacity in order to sell more inventory. But physical assets and employees don’t scale well. Networks do.
Physical assets and employees don’t scale well. Networks do.
The costs of a linear business will initially decrease as the company achieves economies of scale, but as it expands into the total addressable market, the costs to acquire each additional customers will rise again leading to the typical U-shaped curve. Thus, a linear business’ market cap is constrained by its ability to serve customers cost efficiently.
In contrast, successful platforms aren’t constrained by the typical U-shaped cost curve that describes most linear businesses. Instead, due to network effects and the low marginal cost of production and distribution, expenses typically don’t grow as fast as revenue does, even as the platform business expands into the limits of the total addressable market. The costs of production and distribution will remain near-zero into the tail end of a platform business’s growth. In short, the costs of a platform’s growth tend to level off logarithmically.
Not every platform company takes a pure platform approach,and not all aspects of products and services are best served through a platform. Some companies like Apple and Amazon take a hybrid approach that combines linear and platform business models. Combining these two business models can be tremendously effective and lucrative – allowing a business to capitalize on the strengths of each business model.
For example, Apple’s core revenue generator is still a linear business: designing and selling hardware, most notably the iPhone. Even though Apple still earns most of its revenue from selling devices, it differentiates from other smartphone manufacturers with its development platform, iOS.
Remember the slogan for the early iPhone? “There’s an app for that.” Apple knew that its core value to consumers was its large network of apps and app developers. The company had learned the hard way that failing to embrace the platform business model can be fatal. In the desktop computer era, it opted for an entirely closed, linear approach wherein it developed all its own apps, and it ultimately lost to Microsoft, who supported third-party apps on its operating systems. Apple nearly went out of business, and applied the lessons learned in the smartphone era quickly and to great success.
After opening up the iPhone’s operating system, iPhone sales increased 300% (5.4 million to 15.7 million) with 2 billion iOS app downloads in the first year alone after the App Store was launched.
To this day, Apple’s millions-strong network of app developers is the key reason it has retained its status as a premium smartphone seller. While its hardware innovations are quickly commoditized and replicated by competitors, its network can’t be.
Amazon also has combined a linear and platform approach in its B2C e-commerce business. Its marketplace consists of both products owned by Amazon (linear), and products sold by third-party sellers who list items Amazon (platform, connecting third-party sellers to customers directly).
The marketplace has been one of the fastest growing areas of Amazon’s e-commerce business, as well as one of the most profitable. In 2018, Amazon said that more than half of units sold on its marketplace were sold by third-party sellers. By developing a strong relationship with sellers, Amazon is also in a position to offer additional services to sellers such as, and most notably, Fulfillment By Amazon.
Fulfillment by Amazon is yet another (and linear) source of revenue for Amazon that also improves the platform experience overall by ensuring that customers quickly receive items ordered on Amazon’s marketplace, no matter who sold the item. The Fulfillment By Amazon service allows sellers to store their inventory in Amazon warehouses and let Amazon handle shipping when a customer places an order, for a fee.
Amazon also offers advertisers ad space on its marketplace. In 2018, Amazon was projected to make $4.61 billion in advertising revenue. Amazon’s revenue share from ads is growing on the back of its marketplace’s success. The marketplace commands the attention of over 300 million active users, making it attractive to potential advertisers.
On the B2C side, over 100 million users subscribe to Amazon Prime and thereby access an entertainment streaming library (with both licensed and original content), free 2-day shipping on products bought on the marketplace, and other perks.
By combining its platform and linear approach, Amazon captures the best of both worlds. It gets the quality and price control of a linear business along with the wide selection and profit margins of a marketplace. And it’s uniquely poised to offer B2B and B2C services to sellers and buyers who transact on the marketplace, thereby multiplying revenue streams.
Additionally, more than 80% of all items listed on Amazon are from third-party sellers, meaning the marketplace is a significant factor in enabling the company to capture long-tail sales. Amazon also can use data on third-party sales to help it identify where to invest in its linear e-commerce business.
Amazon’s linear-platform hybrid model has forced many traditional brick-and-mortar retailers to shutter their windows (e.g. Sears, Kmart). Those who have managed to hold onto market share and grow despite the threat of Amazon managed to do so by adapting a linear-platform hybrid business of their own. Walmart launched its own marketplace in 2009, and after recovering from some early stumbles in platform mismanagement, has cemented itself as a really challenger to Amazon’s eCommerce dominance.
Traditional companies in other sectors such as the auto industry, media, and B2B distribution would do well to anticipate tech giant’s big moves into their industry. Already Amazon Business has achieved $10 billion in annualized B2B sales. Twitch has signed deals with live TV broadcasters to stream live programs on their platform so that Twitch users can provide personalized commentary to their fans, thereby fundamentally reshaping the way live TV media is consumed.
Applico’s expertise in platform design, validation, and execution can help traditional companies build or acquire their own platform, without making costly mistakes early on in the process. Contact us today to learn more about how Applico can help a linear business develop its own platform.
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