From Stratechery, Jan. 23:
Amazon Go is the story of technology, and so is this tweet:
I’m in Seattle and there is currently a line to shop at the grocery store whose entire premise is that you won’t have to wait in line. pic.twitter.com/fWr80A0ZPV— Ryan Petersen (@typesfast) January 22, 2018
Yesterday the Amazon Go concept store in Seattle opened to the public, filled with sandwiches, salads, snacks, various groceries, and even beer and wine (Recode has a great set of pictures here). The trick is that you don’t pay, at least in person: a collection of cameras and sensors pair your selection to your Amazon account — registered at the door via smartphone app — which rather redefines the concept of “grab-and-go.”
The economics of Amazon Go define the tech industry; the strategy, though, is uniquely Amazon’s. Most of all, the implications of Amazon Go explain both the challenges and opportunities faced by society broadly by the rise of tech.
The Economics of Tech
This point is foundational to nearly all of the analysis of Stratechery, which is why it’s worth repeating. To understand the economics of tech companies one must understand the difference between fixed and marginal costs, and for this Amazon Go provides a perfect example.
A cashier — and forgive the bloodless language for what is flesh and blood — is a marginal cost. That is, for a convenience store to sell one more item requires some amount of time on the part of a cashier, and that time costs the convenience store operator money. To sell 100 more items requires even more time — costs increase in line with revenue.
Fixed costs, on the other hand, have no relation to revenue. In the case of convenience stores, rent is a fixed cost; 7-11 has to pay its lease whether it serves 100 customers or serves 1,000 in any given month. Certainly the more it serves the better: that means the store is achieving more “leverage” on its fixed costs.
In the case of Amazon Go specifically, all of those cameras and sensors and smartphone-reading gates are fixed costs as well — two types, in fact. The first is the actual cost of buying and installing the equipment; those costs, like rent, are incurred regardless of how much revenue the store ultimately produces.
Far more extensive, though, are the costs of developing the underlying systems that make Amazon Go even possible. These are R&D costs, and they are different enough from fixed costs like rent and equipment that they typically live in another place on the balance sheet entirely.
These different types of costs affect management decision-making at different levels (that is, there is a spectrum from purely marginal costs to purely fixed costs; it all depends on your time frame):
Keep in mind, most businesses start out in the red: it usually takes financing, often in the form of a loan, to buy everything necessary to even open the business in the first place; a company is not truly profitable until that financing is retired. Of course once everything is paid off a business is not entirely in the clear: physical objects like shelves or refrigeration units or lights break and wear out, and need to be replaced; until that happens, though, money can be made by utilizing what has already been paid for.
- If the marginal cost of selling an individual item is more than the marginal revenue gained from selling the item (i.e. it costs more to pay a cashier to sell an item than the gross profit earned from an item) then the item won’t be sold.
- If the monthly rent for a convenience store exceeds the monthly gross profit from the store, then the store will be closed.
- If the cost of renovations and equipment (in the case of small businesses, this cost is usually the monthly repayments on a loan) exceeds the net profit ex-financing, then the owner will go bankrupt.
This, though, is why the activity that is accounted for in R&D is so important to tech company profitability: while digital infrastructure obviously needs to be maintained, by-and-large the investment reaps dividends far longer than the purchase of any physical good. Amazon Go is a perfect example: the massive expense that went into developing the underlying system powering cashier-less purchasing does not need to be spent again; moreover, unlike shelving or refrigerators, the output of that expense can be duplicated infinitely without incurring any additional cost.
This principle undergirds the fantastic profitability of successful tech companies:
In every case a huge amount of fixed costs up front is overwhelmed by the ongoing ability to make money at scale; to put it another way, tech company combine fixed costs with marginal revenue opportunities, such that they make more money on additional customers without any corresponding rise in costs.
- It was expensive to develop mainframes, but IBM could reuse the expertise to build them and most importantly the software needed to run them; every new mainframe was more profitable than the last.
- It was expensive to develop Windows, but Microsoft could reuse the software on all computers; every new computer sold was pure profit.
- It was expensive to build Google, but search can be extended to anyone with an Internet connection; every new user was an opportunity to show more ads.
- It was expensive to develop iOS, but the software can be used on billions of iPhones, every one of which generates tremendous profit.
- It was expensive to build Facebook, but the network can scale to two billion people and counting, all of which can be shown ads.
This is clearly the goal with Amazon Go: to build out such a complex system for a single store would be foolhardy; Amazon expects the technology to be used broadly, unlocking additional revenue opportunities without any corresponding rise in fixed costs — of developing the software, that is; each new store will still require traditional fixed costs like shelving and refrigeration. That, though, is why this idea is so uniquely Amazonian.
The Strategy of Technology
The most important difference between Amazon and most other tech companies is that the latter generally invest exclusively in research and development — that is, to say, in software. And why not? As I just explained software development has the magical properties of value retention and infinite reproduction. Better to let others handle the less profitable and more risky (at least in the short term) marginal complements....MUCH MORE