Netflix*

Netflix, Inc. is the world’s leading television and movie streaming service, with approximately
220 million subscribers as of October 2022. The company was founded in 1997 by Reed
Hastings and Marc Randolph as a mail-order DVD rental and sales website. At first, customers
rented movies on a per-piece basis, but Netflix changed to a monthly subscription service in
1999. After achieving record sales of $75M in 2001, Netflix went public on May 29th, 2002, at
$15.00 per share.

Netflix’s growth since its IPO has largely been due to its ability to reinvent itself. After reaching
nearly $1B in revenue and over $49M in net income in 2006, Netflix launched a new product
offering in 2007: “instant-watching”, or as it’s now known, streaming. At the time, Netflix
shipped over 70,000 titles on DVD, but only about 1,000 titles were available for streaming.

Another important part of the company’s evolution has been its move into original content. In
2012, the first Netflix-exclusive streaming content arrived: Lilyhammer. Soon thereafter, Netflix
produced its first series, House of Cards, along with other hits such as Orange is the New Black
and Bojack Horseman. This slate of Netflix Originals drove U.S. streaming subscribers past
U.S. DVD subscribers for the first time by the end of 2013, and the company now produces
thousands of hours of original content per year.

Netflix’s streaming and original content strategy proved a boon. Revenues increased from $3.6
billion for fiscal year 2013 to $20.2 billion for fiscal year 2019, and streaming subscribers
(domestic and international) increased from 41.7 million at the end of 2013 to 167.1 million at
the end of 2019. The company’s financial success accelerated even further with the onset of the
COVID-19 pandemic, as many jobs went remote and quarantine restrictions went into effect.
With this increased time spent at home, Netflix’s streaming subscribers grew to over 200
million. The company’s cash flows finally turned positive, and its stock price rose by more than
50%.

But Netflix’s success has not gone unnoticed by its competition, including legacy media
companies with large content catalogs. Disney+ launched to fanfare at the end of 2019, and
other streaming services such as Peacock and HBO Max followed. Netflix shocked Wall Street
on April 19th, 2022, with news of a decline of 200,000 subscribers over the first quarter of 2022,
causing the stock price to drop by a third. In response, Netflix announced plans to bolster
subscriber counts. In their quarterly shareholder letter, Netflix acknowledged the company’s
historical leniency on password sharing as a means to getting people hooked on the service.
With household penetration at a high, management promised to crack down on password
sharing. Netflix also announced a new ad-supported tier of service, with a proposed launch date
of November 3rd, 2022.

*
Created by Assistant Professors Darren Bernard and Sarah Shaikh of the University of Washington. Please do
not quote or distribute. Revised October 2022.
As the company’s business model has changed dramatically over time, so has its cost structure.
Exhibit 1 provides abbreviated income statement information for the years 2001 to 2005, as per
Netflix’s 2006 10-K. Corresponding notes information from the 2006 10-K is presented in
Exhibit 2, specifically in relation to the firm’s cost of revenues.

Exhibit 3 provides abbreviated income statement information for the years 2019 to 2021, as per
Netflix’s 2022 10-K. Corresponding notes information related to the cost of revenues from the
2022 10-K is presented in Exhibit 4.

If you are interested in learning more about Netflix’s business and financial performance, refer
to the company’s investor relations website to see: 1) the latest letter to shareholders and 2) the
latest video interview, which the company holds every quarter in place of the more typical
audio-only earnings call. You can also find the firm’s SEC filings at the same website:
https://www.netflixinvestor.com/financials/quarterly-earnings/default.aspx.
Answer the following.

1. Gross margin (also known as gross profit) is a core financial accounting concept defined
under financial reporting standards.† Sometimes users of financial statements confuse
gross margin with contribution margin, a managerial accounting concept that is not
defined under financial reporting standards.
a. What, conceptually, is the difference between gross margin and contribution margin?
b. Suppose Netflix increases its contribution margin by reducing a particular cost. Holding
all else constant, does this necessarily imply that gross margin increases?
c. Suppose Netflix increases its gross margin by reducing a particular cost. Holding all else
constant, does this necessarily imply that contribution margin increases?
d. Calculate gross profit as a percent of revenues (“gross margin ratio”) for Netflix for the
years 2005 and 2021. Do you believe Netflix’s gross margin ratio is more similar to its
contribution margin ratio in 2005 or in 2021, given how the company’s structure of costs
included in “costs of revenues” has changed over time? Explain your answer.

2. Explain how you might try to approximate the company’s degree of operating leverage—the
ratio of fixed costs to total costs—given financial reporting requirements do not mandate
disclosure of fixed versus variable costs. Provide some intuition for the approach (i.e.,
metric) you propose. Do you believe Netflix’s executive team uses the same approach to
estimate operating leverage that you propose?

3. Many companies that saw business surge during the COVID-19 pandemic are now cutting
costs and finding ways to reduce operating leverage.‡ Which of the following would reduce
Netflix’s operating leverage? (Answer each part independently of the other parts, and assume
each change has no other effects on the business—i.e., assume all else is held equal.)
a. Renegotiating a non-cancelable licensing contract to be cancelable
b. Using variable-interest rate debt instead of fixed-interest rate debt
c. Increasing revenue by 5%
d. Paying employees with stock grants (which do not require a cash outflow) in lieu of
salaries

†
See, for example, the FASB’s Taxonomy Implementation Guide:
https://xbrl.fasb.org/impguidance/Rev_TIG/revenue_1.pdf.
‡
A good example is Peloton. See, for example: https://www.cnbc.com/2022/08/12/peloton-shares-jump-as-
company-announces-price-hikes-for-some-products.html.
Exhibit 1: Abbreviated Income Statement Information from Netflix 2006 10-K

Exhibit 2: Abbreviated Notes Information from Netflix 2006 10-K

Cost of Revenues:

Subscription:

We acquire titles for our library through traditional direct purchase and through revenue sharing
agreements with content providers. Traditional buying methods normally result in higher upfront
costs than titles obtained through revenue sharing agreements. Cost of subscription revenues
consists of revenue sharing expenses, amortization of our DVD library, amortization of
intangible assets related to equity instruments issued to certain studios in 2000 and 2001 and
postage and packaging costs related to shipping titles to paying subscribers. Costs related to free-
trial subscribers are allocated to marketing expenses.

Revenue Sharing Expenses. Our revenue sharing agreements generally commit us to pay an
initial upfront fee for each DVD acquired and also a percentage of revenue earned from such
DVD rentals for a defined period of time. A portion of the initial upfront fees are non-
recoupable for revenue sharing purposes and are capitalized and amortized in accordance with
our DVD library amortization policy. The remaining portion of the initial upfront fee represents
prepaid revenue sharing and this amount is expensed as revenue sharing expenses as DVDs
subject to revenue sharing agreements are shipped to subscribers. The terms of some revenue
sharing agreements with studios obligate us to make minimum revenue sharing payments for
certain titles. We amortize minimum revenue sharing prepayments (or accrete an amount payable
to studios if the payment is due in arrears) as revenue sharing obligations are incurred. A
provision for estimated shortfall, if any, on minimum revenue sharing payments is made in the
period in which the shortfall becomes probable and can be reasonably estimated. Additionally,
the terms of some revenue sharing agreement with studios provide for rebates based on achieving
specified performance levels. We accrue for these rebates as earned based on historical title
performance and estimates of demand for the titles over the remainder of the title term.
Amortization of DVD Library. On July 1, 2004, we revised the estimate of useful life for the
back-catalogue DVD library from one to three years. New releases will continue to be amortized
over a one-year period. We also revised our estimate of salvage values, on direct purchase
DVDs. For those direct purchase DVDs that we expect to sell at the end of their useful lives, a
salvage value of $3.00 per DVD has been provided effective July 1, 2004. For those DVDs that
we do not expect to sell, no salvage value is provided.

Amortization of Studio Intangible Assets. In 2000 and 2001, in connection with signing revenue
sharing agreements with certain studios, we agreed to issue to each of these studios our Series F
Non-Voting Preferred Stock. The studios’ Series F Preferred Stock automatically converted into
3,192,830 shares of common stock upon the closing of our initial public offering. We measured
the original issuances and any subsequent adjustments using the fair value of the securities at the
issuance and any subsequent adjustment dates. The fair value was recorded as an intangible asset
and is amortized to cost of subscription revenues ratably over the remaining term of the
agreements which initial terms were either three or five years. As of December 31, 2005, all
studio intangible assets were fully amortized.

Postage and Packaging. Postage and packaging expenses consist of the postage costs to mail
titles to and from our paying subscribers and the packaging and label costs for the mailers. The
rate for first-class postage was $0.37 between June 29, 2002 and January 7, 2006. The U.S.
Postal Service increased the rate of first class postage by 2 cents to $0.39 effective January 8,
2006. We receive discounts on outbound postage costs related to our mail preparation practices.

Fulfillment expenses:

Fulfillment expenses represent those expenses incurred in operating and staffing our shipping
and customer service centers, including costs attributable to receiving, inspecting and
warehousing our library. Fulfillment expenses also include credit card fees.

Exhibit 3: Abbreviated Income Statement Information from Netflix 2022 10-K

Exhibit 4: Abbreviated Notes Information from Netflix 2022 10-K

Cost of Revenues:

Amortization of content assets makes up the majority of cost of revenues. Expenses directly
associated with the acquisition, licensing and production of content (such as payroll and related
personnel expenses, costs associated with obtaining rights to music included in our content,
overall deals with talent, miscellaneous production related costs and participations and
residuals), streaming delivery costs and other operations costs make up the remainder of cost of
revenues. We have built our own global content delivery network (“Open Connect”) to help us
efficiently stream a high volume of content to our members over the internet. Delivery expenses,
therefore, include equipment costs related to Open Connect, payroll and related personnel
expenses and all third-party costs, such as cloud computing costs, associated with delivering
content over the internet. Other operations costs include customer service and payment
processing fees, including those we pay to our integrated payment partners, as well as other costs
directly incurred in making our content available to members.