In order to understand the value of platform business models, you need to be clear about what is and isn’t a platform.
As we’ve defined before, a platform is a business model that facilitates the exchange of value between two or more user groups, typically a consumer and a producer.
An important part of the platform business model is that inventory is owned by third parties and is not on the balance sheet of the platform. The platform is solely focused on building and facilitating an external network. Platforms don’t own, to use a common phrase, the means of production – instead, they create the means of connection.
So what do we 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.
DEFINITION: Linear Business: (n)
A business that takes in components, creates finished products/services and sells to consumer.
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.
Additionally, it’s important to note that not all tech companies 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 and business model. 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.
Not every platform company takes a pure platform approach. Some like Apple and Amazon take a hybrid approach that combines linear and platform business models. While not right for every company or industry, combining these two business models can be tremendously effective and lucrative – allowing a business to capitalize on the strengths of each business model.
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. It opted for an entirely closed, linear approach in the desktop computer era and it ultimately lost to Microsoft, nearly going out of business.
While the iPhone was initially closed and linear, Apple quickly built up its development platform and opened it to third-party software developers. Smart move for Apple, as 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.
Still today, Apple’s millions-strong network of app developers is the key reason it has stayed in the lead as a premium smartphone seller. Its hardware innovations are quickly commoditized or replicated by competitors. Its network can’t be.
Amazon also has combined a linear and platform approach in its B2C e-commerce business. While Amazon started as a linear bookseller, much of its success in other areas of e-commerce has come from combining its linear approach with Amazon Marketplace, which consists of third-party sellers listing items on Amazon and has been one of the fastest growing areas of Amazon’s e-commerce business.
The marketplace also is one of the most profitable parts of its business. Amazon takes a cut on all third-party sales on the marketplace, typically 14-30% depending on the product category. It also makes considerable revenue from additional services offer to sellers, most notably Fulfillment By Amazon.
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 with the wide selection and profit margins and wide selection of a marketplace.
The Fulfillment By Amazon service allows sellers to house their inventory in Amazon warehouses and let Amazon handle shipping when a customer places an order – meaning all FBA items are eligible for Amazon Prime shipping when consumers buy them. Sellers are charged a fulfillment fee per item based on weight, and they are charged a monthly inventory storage cost for each item stored in an Amazon warehouse.
Fulfillment By Amazon is a key reason that Amazon’s third-party marketplace has grown so quickly. The Amazon Marketplace had a record year in 2016 and now surpasses 40% of all sales made on Amazon.com.
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.
That’s why Amazon still generates the majority of its e-commerce revenue (though less of its profit margin) from the relatively small number of items it sells directly. These items are ones that Amazon has identified as major sellers and where it is strategically important for Amazon to have quality, inexpensive items available. Its white-label Amazon Basics products are a key example, but Amazon also acts as a reseller on a number of other top-selling items.
By combining its platform and linear approach, Amazon captures the best of both worlds. It captures the quality and price control of a linear business with the wide selection and profit margins of a marketplace. Its linear business also effectively subsidizes the marketplace, acting as the “first customer” for all of Amazon’s logistics, warehousing, and shipping services that it offers to sellers.
To understand how platform business models scale, we need to start with the economics of information goods, such as apps, music, or e-books. To create a mobile app, it might cost $250,000 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.
Thanks to the Internet and connected technology, information goods today have a near-zero marginal cost of distribution. The cost to serve one additional customer is basically zero.
A typical e-commerce site benefits from this dynamic on the consumer side – serving a large number of customers becomes much cheaper and more efficient than in the past.
Platforms take this advantage a step further. They remove the high fixed cost of creation and extend zero marginal costs to the supply side of the business. 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 next to nothing. It doesn’t have to build rooms or acquire companies – it needs to acquire users.
Linear businesses generally grow by adding staff 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.
For platforms, the nature of networked growth and the low marginal cost of production means that expenses typically don’t grow as fast as revenue does. The costs of a linear business will always continue to rise as it grows, while the costs of a platform’s growth tend to level off logarithmically. Thus, the potential market size explodes.
Successful platforms aren’t constrained by the typical U-shaped cost curve that describes most linear businesses. Instead, the unit economics make it possible for successful platforms to grow to near the total size of the market. This means that usually only one or two platform companies will come to dominate a market.
Linear businesses don’t cease to exist in platform markets. But their growth potential is often severely hindered. Niche players still survive by serving segments of the market the platform doesn’t address adequately. Nonetheless, there’s typically one dominant platform, with at most one other business enjoying a sizable share of the market.
As more and more industries become integrated with connected technology, platforms will take over more of the global economy, including traditional industries that have been mostly exempt from the brunt of Silicon Valley’s furor.
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