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Theodore Bergquist

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Digital Bottom Line: The Key Driver

Posted: 05/06/10 01:52 PM ET

There are many reasons why digital distribution is far superior to physical distribution. Perhaps one of the strongest forces driving digital distribution to grow faster than expected is the fact that the profit margin for those who take the risk of going digital is significantly higher than if the product is sold in a physical store.

Publishers today hear how much money they can earn on the artists, games and movies relative to the small slice of the pie that goes to those who create the product. However, publishers bear the greatest risk in the value chain. They do not just fund the development while carrying all the associated risks, but they also must fund the marketing and promotion of the finished artist, game or movie. In addition, the publisher is responsible for the cost of the inventory, transportation, printing, and in-store marketing. In general, it is often said that publishers' cut in the entertainment industry today is around 30%. The risk of a profitable return, damaged goods, and price reductions is not taken into effect. It is important to note that not all artists, games or movies will be as successful as projected. Only a small fraction of all entertainment products will sell for millions of dollars. The road to successful publishing often requires investing in a portfolio of titles. To only receive 30% of the revenue in many cases is too little for the risk associated, which is why the industry is dominated by a few big giants and the rest of the market is highly segmented and catered to niche projects.

However, things have changed with digital distribution. The motto used is 1+1=4. Every two games sold digitally is typically the equivalent to four games sold at a physical retailer. The current business model for almost all portals that distribute online games (including the App Store) is that 70% of the revenue goes to the publisher and 30% to the portal. The profit margin drops slightly for either the publisher or the portal in cases requiring payment for DRM and payment services. Regardless, the gross profit for a digital sale is more than twice as large as a sale in a physical store.

It seems only rational with the increase of profit margins, there will be a greater willingness by publishers to cut prices and dare to engage in more innovative products. The increased profit margins will hopefully encourage publishers to embark on wild cards and untapped niches that give new life to the entertainment industry.

The bottom line for the entertainment industry clearly shows the increased need to push even further into a predominately digital world. When referring to e-commerce, experts often say that "consumer behavior" is the driving force. Once the consumers adopt the new model, digital sales will take off. However, in this case, the bottom line is so great and the risks are so limited that I believe the industry will force the consumer to adopt the new model whether they want to or not. This music industry has already seen this happen and film and games will follow.

So, will the price go down on entertainment products? To explain this one, you will not only have to look at the bottom line but also the new business model that dominates digital distribution, the revenue split model. Before it was quite simple; retailers bought finished goods for a fixed sum and could adjust their margins to create momentum and competitiveness through loss leaders and discounts as long as the distributor and publisher received their fixed price. However, in the new digital model, where the publisher gets 70% of the retail price, publishers have a huge influence on the pricing and aim to keep the price point as high as they can for as long as they can. Should they decide to drop the price in the digital channel, publishers would have to take a hit from physical retail from returns and markdowns. As such, the digital bottom line has shifted the pricing power from the retailer to the publisher.

My guess is that we will see a lot more "discount activities" for a short period of time rather than an overall price adjustment. The digital bottom line will create an opportunity for larger developments and franchises as well as for the smaller guys to be creative with their niche brands.


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