Amazon Economics, Exploring Ultimate Capital Efficiency

Published: October 24, 2018

Tech companies adopt a unique economics for their strategy. It looks strange for traditional companies. Tech companies have used this economics to disrupt traditional business. Let's look at Amazon Go from the viewpoint of economics.

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Cashier Generates marginal cost

We must understand the difference between fixed cost and marginal cost in order to understand the economics of tech companies. Marginal cost refers to the increase of expense caused by the increase in production. It is not fixed, it is variable, depending on the amount of production.

A certain amount of time is required for cashing out, in order for convenience stores to sell more than one item. Time can be converted to wages of cashier at convenience stores. Time limits selling capacities and could effects consumer psychology. When trying to sell a lot of items, the number of cashiers required and the time spent push up the total cost.

On the other hand, fixed cost is not related with cashers. rent is fixed cost. 
Seven Eleven pays the same rent whether to serve 100 customers monthly or 1000 people. We can respond to the increase in the number of customers with the same fixed cost. Specifically, in Amazon Go, not only rent but also many cameras, sensors, and gates are all fixed costs.

There are two fixed costs of Amazon Go. The first is the actual cost of purchasing and installing equipment. Regardless of how much revenue the store finally produces, costs like rent are always incurred. The other fixed costs is the development cost of the underlying system. R & D expenses, the cost to develop a foundation system that enables Amazon Go. That is treated as different from fixed costs such as rent and equipment on the balance sheet.

Marginal costs and fixed costs

These different types of costs affect management's decision-making. For example, if marginal cost when selling products is greater than the revenue obtained by selling them (for example, if the cost to pay to the cashier to sell the item is higher), that's a mistake. If monthly rent of store exceeds the store's monthly gross profit, the store will be closed. Owners will go bankrupt if depreciation and equipment costs (in the case of small and medium enterprises, this is usually the monthly repayment of the loan) exceeds net profit.

Most business starts from financial deficit. Initially, loans are usually made to purchase everything necessary to open a business. The company has been regarded as unprofitable, until the stage where it no longer needs its funding. All fixed costs doesn’t have nature that you don’t have to pay again once they were paid. Physical objects such as shelves, refrigerators and lighting can be tired and need to be replaced. Until it happens, you can earn money by using what you have already paid. It is so-called depreciation. Well, Amazon Go succeeded in removing the source of the marginal cost of cash register. Therefore, even if Amazon expands the store network and increases the number of sales, it is possible to scale without the additional cost of cash register. This way is common characteristic to successful Tech companies.

Burden the cost at one time, expand the profit rapidly

This principle governs the tremendous profitability of Tech companies. It was expensive to develop mainframes, but IBM was able to reuse its expertise. Every new mainframe was more profitable than the last one. It was expensive to develop Windows, but Microsoft was able to reuse this software on all computers. Every new computer sold in market brought profit to Microsoft.

Building Google was expensive as well, but you can extend the search to everyone connected to the Internet. All new users were opportunities for google to show more ads. The development of iOS was also expensive, but the software was used on billions of iPhones, each of which produced enormous profits. Building Facebook was also expensive, but network size reached 2 billion people. Facebook can display ads to all of them.

Vast amount of fixed costs are prepaid. In all cases, supplemented with continuous funding capacity. Tech companies will burden a large fixed cost first, but they can realize the expansion of production without raising costs (without generating marginal costs). They are clearly more profitable than regular companies is.This competitive advantage is overwhelming.

Amazon Go also follows this tactic. It is foolish to build a complex system just for one store. Amazon expects this technology to widespread and hopes to create additional revenue opportunities without increasing corresponding fixed costs. As with regular retail stores, fixed costs for shelves and refrigerators are generated for each new store, but this point makes Amazon Go unique. And it takes time for others to copy the structure of Amazon Go. In the meanwhile, amazon can expand application of the system.

Typical Strategy of Tech Companies

The most important difference between Amazon and many other high-tech companies is that the latter is generally investing exclusively in R&D. That is, software.

As I mentioned earlier, software development has the magical nature of preserving value and infinite use. Successful tech companies Development is limited to those with high value density, and at least in the short term, those with lower value density and higher risk are externalized.

Microsoft builds OS and applications, leaving the computer manufacturing to the manufacturer.

Google builds a search engine able to index ocean of web pages, and leaves the creation of web pages to others.

Facebook has built up human network infrastructure and leaves people content posting.

Three companies are pure software companies at least in terms of core business. It means that match “economics of software”.

Microsoft's market was limited by the price of computers, but Google and Facebook are extensible transcendental aggregators reaching anyone connected to the Internet thanks to advertising business model. Both companies also enjoy a powerful network effect in terms of supply and demand. These network effects are established by the ability to expand indefinitely. In other words, three companies have "moat" for other players.

On the other hand, Apple and IBM are adopting a "vertical integration" mechanism. In particular, in the mainframe era, IBM built everything from components to OS and applications, sold it as a package with a long-term service contract. In doing so, all competitors were excluded from the IBM market. Although Apple is not nearly as vertical as IBM in the 1960s, it builds both software and hardware to eliminate competitors. Apple can sell products at a higher price than competitors, with overwhelming branding, rich customer experience and enclosure of good customers. All sweet parts of the market are concentrated to Apple.

horizontal and vertical

Amazon will leverage the software to build a horizontal business that will benefit from network effects.

In e-commerce business, more buyers call more suppliers, which also attract more buyers. There is no physical limitation. Amazon doesn’t have to be concerned of over-capacities of shopping floor or parking pool.

Amazon contributes to the expansion of business scale of user companies through not only servers and data centers capabilities, but also adding complicated functions in AWS. If user company business expands, it will bring benefit of AWS. Amazon is rapidly evolving the stack of micro services that completely eliminates the need for server management for users.

Amazon also invests in vertical integration. The tech company are building supply chain consistent from manufacturing to sales with private brands. In logistics, Amazon owns planes, trucks, and delivery service, continuing challenge to deliver by drone.

Vertical and horizontal are pretty conflicting strategies. However, Amazon does not maximize short-term profits, while adopting a horizontal business model. Amazon seeks a thorough vertical integration for the area where Amazon found high value. The firm will try to overcome vertical constraints imposed on horizontal companies.

Moat eliminate competition

In 2012, Amazon acquired Kiva Systems for $ 775 million. Kiva Systems manufactures robots for logistics centers. Many analysts were puzzled by the purchase. Kiva Systems already has many customers, Amazon was able to purchase robots for free at less than $ 775 million dollars. Amazon argued that stopping sales of Kiva Systems to existing customers would be valuable. Amazon was not interested in sharing the robot of Kiva Systems with its competitors and paid eight times of the revenue. The company strengthened the logistics processing capacity and absorbed all the capabilities of Kiva Systems.

Amazon made a "short-term error” for long-term benefits. Instead, Amazon were able to develop a distribution processing system that is superior to competitors. This is definitely differentiating Amazon, and reward is tremendous.

The vertical communication company's "power" is a result of large amount of capital investment. However, differentiation is difficult, so it can not be "strongest". Unlike this, Amazon started with a software-based horizontal model, and extended vertically, and spends a huge amount of money on it. The expenditure is painful in the short term, and most software companies avoid it. however, it will provide "large moats" to eliminate competition in the future. It creates a market where it is difficult for others to enter and competition is eliminated.

If Amazon aims for horizontal growth of Amazon Go, the company should open Amazon Go technology. But it is clear that Amazon aims for vertical integration. The best way to build a moat is actually to dig it, in other words to spend a lot of money. This will betray the usual corporate common sense. Moreover, Amazon has avoided to lose efficinecy using the tax system which doesn’t tax R&D expenses.

Ultimate capital efficiency

Amazon Go's "Cashierless" reduces the marginal cost and is trying to maximize the returns generated by the invested capital. In other words, it is a strategy familiar with capital engineering. This is Jeff Bezos- like strategy who were SVP of hedge fund, after majoring Computer Science at Princeton.