The Razor Blade Model?
In many ways this post is inspired by a former boss of mine, Professor Randall Picker of the University of Chicago Law School, whom I worked for in the early 2000s. You can find a link to the original publication (which I had nothing to do with) entitled The Razors and Blades Myth, below.
The “razor blade” business model has become commonplace in business lexicon. It indicates a business model with few upfront costs for the customer that creates an exclusive relationship with the selling company in the future. In many ways the razor blade business model has been reinvented in the technology space as software/infrastructure/platform as a service (XaaS) currently used by many of the most successful technology companies of the past decade.
It’s important to remember that the real benefit of these business models for the customer is that it turns a large upfront payment into a small upfront payment and a string of small payments in the future. It’s a service tied to a loan, where in exchange for the loan, the customer promises to use the company’s products. The customer’s use over time pays off the loan and provides a positive return to the company. Customers are accustomed to this transaction. For decades cell phones were purchased by customers for a subsidized rate, with a wireless service provider covering the remaining cost in exchange for a contract that provided a guaranteed return. People have also leased cars or rented apartments. They understand taking on a liability to afford large purchases in exchange for monthly payments.
But while some transactions are contract based, others are more informal. Consider the wet shaving market – the inspiration for the razor blade model. When buying a razor and a blade, there is no contractual relationship between a customer and a company. Yet the company, in this case Gillette, sells customers Gillette branded blades for years after they buy the razor, while enjoying gross margins estimated at over 70%.
It turns out the business practices adopted in the early part of the 20th century might not be right 100 years later though. As brands have become easier to build, distribution easier to obtain, and capital easier to access, the cost to enter a new market has declined. For instance, Gillette has seen its market share and profits erode while challenger brands such as Dollar Shave Club and Harry’s have entered the market. Both companies were able to relatively cheaply acquire blades, introduce cheaper, substantially similar products, and take market share. Competing on the same basis as Gillette, just cheaper, worked exceedingly well for these new entrants. Economic theory suggests over time, with no change in business model, similar dynamics should continue to occur, and profit margins continue to be competed away. After all, the low cost of the razor means there are few reasons for customers not to switch when confronted with a similar product and the low cost to produce the blades means that companies may continue to offer similar products at ever lower prices and continue to earn a return.
At the same time Keurig in the single serving coffee market has done well with a substantially similar business model over the past 5 years. While competition has emerged, Keurig continues to dominate. Perhaps this market isn’t so different from Gillette, but I believe there is a key difference that will manifest over time - razors are cheap, coffee machines are not. While razors sell at a loss, it’s a relatively small one on an absolute and relative basis compared to the profit dollars generated by selling blades. In contrast, many coffee pods must be sold to break even on selling a single serve coffee machine. Moreover, first mover advantage effects are relatively strong in the latter’s market with the ability to “capture” the sales of a location from multiple users by having a machine on site. Facing such a large deficit at the outset, potential new entrants are more easily dissuaded and the market’s competitive development is less fierce.
From an investors perspective, understanding these dynamics is interesting because unlike the cell phone contract, the car lease, or the rental property, the company is responsible for the “loan” not the consumer. With many companies adopting the business model for various ventures, the recognition that success for those ventures is more sophisticated than knowing a few metrics is increasingly important. At the same time the risks of adopting the business model are more varied than I believe many assume.
http://chicagounbound.uchicago.edu/cgi/viewcontent.cgi?article=2716&context=journal_articles