The most common business model discussed in business school is the venerable "razor and razor blade" model. The basic idea is that you sell the razor cheaply (or even give it away) in order to make a profit on the blades. While a customer buys one razor, they buy blades forever which creates a nice, continuous revenue stream. Moreover the razor also locks you into the products of a single company because the blades only work with a specific kind of razor.

This business model has been around for decades and is an interesting way to look at the products that we all buy. What has struck me recently is the companies that are defying the razor-blade model. I am particularly intrigued by Apple's twist on the model for the emerging digital media industry.

Printer companies and Kodak

Since I worked in the printer business, I have known for a long time that printer companies sell printers basically at cost and then make their profits from the ink or toner needed to run them. The true cost of a printer is the cost of the printer (razor) and the cost of the ink or toner used (blades) over its lifetime.

Since there is a lot of profit in the ink/toner, new companies spring up selling generic ink/toner for a steep discount. Printer companies fight this trend with branding and the fear that if you dont buy their specific brand, it might not work well or even damage your printer.

This past month however, Kodak has broken with tradition and reversed the model. They have announced a more expensive printer that has much cheaper ink. Their gamble is that customers now understand how expensive ink is to the total cost of a printer system and will be willing to spend more up front for lower total cost. It is unclear how well this strategy will work for Kodak but it is hugely profitable for Nintendo.

Video game consoles and Nintendo

Another industry that has long used the razor-blade model is the video game console industry. With video games, companies invests billions of dollars in creating a new console system (razor) and then they sell that system at an initial loss in order to build the install base. The manufacturers then charge a small license fee (roughly $10) for each game (blade) that is sold. Over time, the cost to manufacture the system itself goes down and they start to turn a profit on the system while at the same time the install base goes up and they make real money on all the games sold.

The PS3 and Xbox 360 are following that model but the Nintendo Wii is bucking the trend. While Sony and Microsoft invested massively in the build a new system-build a base-make profits eventually model, Nintendo has built a new system that is very inexpensive to build. Nintendo is both making a profit on the razor and on the blades from day one. This is one reason why Nintendo is far and away the most porfitable video game company.

Digital media and Apple/iTunes

Which brings us to Apple. I think Apple is the most interesting company example of the razor-blade model with their downloadable music and video business. Moreover, Apple's digital media offerings have an impact on far more than their own company profits; their actions are shaping the emerging industry itself.

Before focusing on Apple, let's look at the economics of digital media.

With a physical CD, you pay $16 at a store; the store takes their 20% retail cut and the record company takes the rest. The record company pays for the physical item, the delivery, and the content, of which the actual usually artist gets a small amount.

In the digital media scenario, one buys a song or movie via a digital download over the internet instead of buying a physical CD or DVD. The system involves a website which you buy from, bandwidth to deliver the content to your home, and a charge for the content itself. Anything left over after these three costs can be considered company profit for the digital media store, iTunes for example.

Apple's digital media system is the iTunes website, iTunes software and players like the iPod. It is said that Apple forgoes any profit on digital media and basically handles the website and content delivery at cost which means everything left over is for the content owner. If you pay 99 cents for a song, Apple would take 20 cents for the website and bandwidth delivery and give the rest to the content owner.

In other words, Apple basically gives away the content (razor blades) in order to sell their hardware (razors) - iPods and computers. And if Apple's sales numbers are any indicator, their model is both hugely successful with consumers and profitable.

In any business model, the money left over after costs is called economic profits. If a business is very profitable, other companies will enter the market with a lower price which in turn causes economic profits to shrink. In economic theory, competition will continue to lower prices until there is no profit at all and companies begin to fail. Think about the printer+ink situation and you see this theory in action.

But what about digital media?

Digital media is an emerging industry that involves a ton of money. Putting aside the question of those companies that stand to lose from digital media, a lot of companies want to enter this market. How will they compete with Apple and iTunes?

By giving selling digital media at cost and giving all the money left over to the content providers, Apple theoretically should always be able to pay content owners more for their content than any other company. This should help Apple secure and maintain good relations with content owners. Moreover, by reducing the economic profits of digital media sales to nil Apple seems to have poisoned the well for 2nd movers.

If you are a software company and want to provide the website and bandwidth but still match Apple's fee to content providers, then where will you make your money? Apple makes it on hardware but where will you? Amazon might make it by selling other items. Microsoft might make it by a license fee for their DRM to hardware companies or by selling their own Zune players. Lot's of maybes. With no profit in the digital sales itself, overall profits are likely to be small.

Many people talk about Apple's DRM as the key to Apple's success, (the DRM locks you into using Apple hardware (razor) to play the media files (blades)) but Apple has quietly created an even stronger and more long-term advantage through their business model. Unlike printer companies, you cannot sell the ink any cheaper than Apple already is.

This ought to put Apple in a good position with content providers and force potential competitors to find other ways to make money such as building their own hardware. Since there are few companies that build hardware+software systems as well as Apple does, that should limit competition.

2007

But who knows. People are amazingly creative. Moreover legal contracts with content providers are perhaps the most important factor in any digital media system. Legal issues not technical ones are arguable the key to the entire industry and those contracts are prone to emotions and other factors. Contracts are also where existing media companies are most likely to push back on digital media providers.

What is clear is that at the start of 2007 is that a lot of companies are going to compete in the digital media marketplace, including Microsoft, Amazon, Wal-Mart and Netflix. It will be interesting to see how many of them survive more than 3 years.