Zero marginal cost business models

How does the business model of the Google search engine differ from those of DAX-listed companies such as Siemens, BASF or adidas? The answer from the point of view of a business economist is quite simple and is: through the cost structure. While Siemens & Co. have to spend a not inconsiderable portion of their sales on financing their manufacturing costs, Google's service provision costs almost nothing.

Cost structures: Digital vs. Classic

We compare Google's business model with that of a traditional industrial company - specifically an automotive manufacturer such as VW - using a simple numerical example.

In order to ensure comparability of the two different models, we focus on the relationship between variable production costs (see below for explanation), which are incurred in the creation of services or products, and sales. Overhead and fixed costs are not included in the analysis in either case.

Cost structure of a search engine

The only variable costs incurred by the search engine in providing the service are the energy costs for processing the search query. Transmission costs are not incurred by the provider, as these are borne by the customer.

• The estimated energy consumption for processing a search query is 0.0003 kilowatt hours.
• Converted to the current German price of a kilowatt hour of about EUR 0.13 (as of November 2018), the estimated cost of a single search query is EUR 0.000039.

Wir stellen nun die Energiekosten dem potenziellen Umsatz pro Suchanfrage gegenüber. Dazu müssen wir die Frage beantworten, wie viel Prozent der Klicks auf Google letztlich auf den bezahlten Anzeigen (Google AdWords) landen.

• We assume that about 1.68% of Google search queries result in a click on a Google AdWords ad.
• The click on a Google ad usually brings the company between 0.4 and 2.00 EUR (average value: 1.2 EUR).
• Google therefore converts an average of 0.02016 EUR per search query - i.e. about 2 cents.

That doesn't sound like much at first. Nevertheless, the turnover of a search query exceeds the costs by more than a factor of 500 (specifically: 516,923!).

Cost structure in automotive production

To enable a fair comparison between the business models, in a second step we determine the relationship between variable costs and sales in car production. Variable costs of car production include the consumption of goods and the energy costs for processing the materials.

• Based on current estimates, the cost of materials in the automotive industry is around 50% of the selling price.
• The exact figures are a closely guarded trade secret. In addition, the ratio between sales and cost of materials is generally higher in the luxury and premium classes than in the compact class.

Regardless of whether you are at the top end or the bottom end of the scale - the ratio of sales to variable costs hovers around the number 2. The factor is thus about 250 worse than at Google. And it doesn't matter whether we're talking about a new Bugatti model or a Skoda model that has been in production for years.

Falling marginal costs through digitization

Digital cost structures therefore have a decisive advantage over industrial cost structures. This applies not only to the Google vs. VW comparison, but to all companies that implement their business models on a digital basis. This creates a worrying gap between the business models of numerous large German companies and the potential business models that will shape the way people live and work in the future.

The reason for the change lies in the reduction of marginal costs of production triggered by software-driven production and sales processes. To understand this connection, the concept of marginal costs must first be examined in more detail.

What are marginal costs?

The cost structure of a company consists of fixed costs and variable costs.

Fixed costs are the unchanging cost components of production that are incurred month after month. These include, for example, wages and rents.

In addition, there are cost items of production that only occur when a product is actually created. The individual parts (e.g. the steering wheel) of a new VW are variable costs. These are assigned to the creation of the individual product.

Marginal costs (GK) are the costs that arise when one unit of a product is produced more. They are thus the first derivative of the cost function, i.e. the addition of fixed costs and variable costs. At first glance, this sounds complicated, but it is not.

The average costs (DK) and the variable average costs (DVK) are shown. The cost function (K(x)) is a degressive cost function - i.e. it is a cost curve in which the costs (total costs) increase to a lesser extent in relation to the change in the number of units produced.

How traditional companies are already benefiting from falling marginal costs

This will be explained by means of a simple example: A newspaper publisher can profit from the principle of decreasing marginal costs if the publisher significantly expands its output volume. Because of economies of scale, it makes a difference in price whether the publisher prints 11 newspapers instead of 10 or 1,000,001 newspapers instead of 1,000,000. It stands to reason that the 1,000,001 newspaper is significantly cheaper for the publisher than the 11.

In business administration, this relationship is referred to as "volume degression" or "economics of scale". What Bruce Henderson, the founder of the Boston Consulting Group, discovered as early as the 1970s still applies today in industrial production: the more of a product you create, the cheaper the individual components become.

Where do zero marginal cost models already work today?

Digitization in general and software development in particular are now ensuring that the rules of the game in business are changing dramatically. This is because the marginal costs of companies that rely on digital business models are almost zero from the very first product or service. And this is already the case with low output volumes.

Another example is provided by the cost accounting of the Internet giant Facebook: To understand Facebook's specific cost structure, we need to ask how much an additional customer costs Facebook to process and support. The answer is similar to Google: almost nothing.

• Admittedly, the costs for transferring and operating the servers add up over the course of a year. And heavy users with high upload data volumes cost the company more than occasional consumers.
• Nevertheless, the added energy and server costs bear no relation to the marketing revenue generated by a single user on average.
• To illustrate this relationship, it is sufficient to divide the current advertising revenues (2017: USD 10.1 billion) by the number of regular users (2.07 billion monthly users).
• The result: just under EUR 5 per year.

That doesn't sound like much at first. However, given that Facebook has a zero marginal cost business model, it is still lucrative to operate the social network. After all, Facebook was able to report a profit of almost USD 5 billion in 2017.

Zero marginal cost model affects entire industries

Now, zero marginal cost business models will not be limited to classic B2C Internet companies in the future, but will expand to more and more industries. The mobility industry (Uber) and the hotel industry (Airbnb) already have this development behind them. The extent to which other industries will be affected by this development toward the zero marginal cost model in the future will be illustrated by means of a model.

How transactions work in the market

Overall, two basic market actors and two interaction processes around the product or service can be identified for each market transaction.

• The two market players involved in an exchange process are the manufacturers and the customers.
• The producer or service provider creates and sells the product.
• At the end of each market transaction is the customer, who satisfies a specific need with his purchase.

In this model, it does not matter which product category and which market players are involved. This results in the following representation of each possible market transaction.

The definition of a zero marginal cost model states that there is a radical change in the actor and process steps. Thus, a large part of the exchange process - at least two of the three exchange levels - must change in order to trigger a change of a market towards a zero marginal cost market.

How the music industry became a zero marginal cost business model

This principle can be illustrated by the development of the music industry: The change from the vinyl record to the CD was not a change to a zero marginal cost business model. Although the product itself was digitized, the CD also ended up back in the store as a physical product. The manufacturing and distribution channels initially remained the same as before.

The change from CD to MP3, on the other hand, represented a true zero marginal cost change for the music market: For this purpose, the product "piece of music" was digitized a second time. This time in such an efficient form that it was possible to exchange music tracks on the World Wide Web even with low bandwidths. In 1999, Napster was founded by Shawn Fanning. Music could now be copied and exchanged by anyone. And all with a simple click.

This new type of file sharing changed the music industry in a dramatic way. The traditional business models of the music industry collapsed and new market players entered the market. Apple revolutionized the music market with the introduction of the IPod in 2001. Both the product "piece of music" and the distribution process were now digitized. And within a few years, the music industry had entered the age of zero marginal cost business models.

Which industries are becoming zero marginal cost markets

The industries that will be affected by this development in the future can already be guessed at today. Banks and insurance companies have long been on the threshold of the zero marginal cost market. But industrial sectors such as the automotive industry will also be affected by the change to a zero marginal cost business model. And only if the companies in the affected sectors start to deal with the implementation options and the associated technology change today will they be able to take up the race with Silicon Valley for the business models of the future.