Yesterday, I focused on the customer file dynamics required to grow Netflix. Netflix keeps maybe 70% of existing subscribers, on an annual basis. In order to grow, and grow quickly, Netflix must focus marketing efforts on customer acquisition.
We would all grow our businesses rapidly, if there weren't significant costs associated with customer acquisition. In 2003, Netflix spent $31.79 per new customer. In 2004, Netflix spent $36.09 per new customer. In 2005, Netflix spent $38.08 per new customer. And in the second quarter of 2006, Netflix is spending five dollars more to acquire new customers than last year.
In other words, it is getting harder and harder for Netflix to find new customers. Folks who run direct-to-consumer or direct-to-business organizations thoroughly measure the cost to acquire customers. Some leaders develop relationships that help estimate how much it would cost to acquire customers, if spending is really ramped-up.
Each company has a different relationship between marketing spend and cost per customer acquired. A quick rule-of-thumb (remember, this is different for every company), a starting point, is to take the square root of your spending increase. For instance, if your company wanted to double marketing spend, you take the square root of two, yielding a forty-one percent increase in cost per new customer.
By looking at my Netflix Customer File Dynamics Worksheet, you can see how I chose to trend the increase in cost per new customer. Using a statistical model (instead of the square root rule), I estimated a $41.50 cost in 2006, $44.15 in 2007, $46.33 in 2008, and $48.06 in 2009. Next, I estimated the marketing spend required to grow the file at an acceptable rate. These figures are estimated in the Marketing expense line.
By applying the customer file dynamics illustrated in yesterday's post, and cost per new customer estimates as outlined in this post, scenarios can be outlined for Netflix growth. In this case, I outlined total revenue and profit through 2009. The scenario I outlined takes the business from $682 million in 2005 to nearly $2 billion in 2009. Marketing expense would increase from $142 million in 2005 to $485 million in 2009. In order for Netflix to grow, it would have to continue to focus all efforts on customer acquisition.
And this growth comes at a cost. The scenario indicates that spending so much money on customer acquisition, to grow quickly, limits pre-tax profit to no more than around eight percent. Slower growth results in a greater rate of pre-tax profit. Faster growth results in a lower rate of pre-tax profit.
So those are the scenarios that executives at companies like Netflix need to run. By understanding the retention rate of existing customers, the cost per new customer, and the elements of a profit and loss statement, an executive can chart a course to success for an organization.
This exercise illustrates the growth potential that exists for Netflix, as long as they continue to focus on affordable customer acquisition activities. The exercise clearly illustrates how much effort must be put into customer acquisition, for Netflix to succeed. What none of us can identify is the limit to customer acquisition at Netflix. None of us really know how many families want DVDs sent to them through the mail. Is it the 14,500,000 subscribers needed by the end of 2009 to make this scenario work? Or is it a much smaller number, like 9,000,000? Only time will tell.