Strategically Speaking: How Will E-books Impact Your Bottom Line?
The end of a calendar year is always an interesting time for the publishing industry and perhaps never more so than the close of 2010. Industry insiders as well as Wall Street types are particularly interested in the full year's results because of the explosive growth of e-books and the prospects of this year's gains in e-book share and e-reader proliferation as a harbinger of days to come.
In late January, Amazon announced that, since the beginning of 2010, for every 100 paperback books it has sold, 115 Kindle books were sold. During this same period, Amazon sold three times as many Kindle books as hardcover books, sales that are across Amazon's entire U.S. book business.
While greeted with less media attention than Amazon's news, Barnes & Noble reported that 2010 holiday season results significantly exceeded both online and in-store sales forecasts, led by strong consumer demand for B&N's e-reading products, including both hardware and e-books. The company reported selling "virtually its entire inventory of NOOKcolor and E Ink" devices during the holiday season.
And perhaps most interesting of all is the continued surge in e-book sales as reported by the Association of American Publishers (AAP). 2010 e-book sales grew by 164.4 percent over 2009, as reported by a mere 14 AAP member companies, reaching more than $441 million.
None of this should come as a surprise to anyone who pays attention to media and technology news—surging Kindle, Nook and iPad sales, and analysts predicting big things for the new tablet devices now reaching the market—all auguring well for the continued migration from print to electronic. But what does this high-profile migration mean for the traditional business models of the book publishing industry?
It means that it is time to sit back, take a long, hard, unemotional look at your business' current structure and financial metrics (i.e., income statement, balance sheet and cash flow statement), give serious consideration to how e-books might affect business as we now know it, and consider potential structural and organizational changes as you plan for the long-term.
To be clear, the timing of e-books' impact on a particular business will vary based on the sector of publishing being considered—but the end result, whether it be in a year, five years, 10 years, etc., will likely be the same, regardless of the market. So, where might we expect to feel both the gains and the pains?
Revenue is another word for sales and, in the book publishers' dictionary, there are three major components:
1. Gross Sales. Revenue per unit will likely decline as market pressure and dramatically lower production and operating costs—due to the elimination of the obvious costs associated with the print text, such as paper, printing, binding and components, as well as the value of unsold inventory (also known as obsolescence costs)—put pressure on publishers to reduce suggested retail prices to reflect the lower cost of doing business. Speculation is that the impact on suggested retail prices will likely vary by product type, with the academic and professional business having the strongest prospects for maintaining current price levels, or at least mitigating the pressure to discount.
2. Returns. Returns, as we have come to know them, will come to an end—with the exception of customer returns because of bad e-book files. E-books mean there is no inventory for the intermediaries between the publisher and the consumer to return. Not a bad thing, because all of the costs currently incurred on both sides of the returns process—picking, packing, shipping, restocking, reconciling and the associated toll in damaged goods—go away.
3. Net Sales. Net sales (defined as gross sales minus returns) will likely decrease as reductions in selling price exceed the gains from eliminating returns.
Cost of Goods Sold
Cost of goods sold is defined as the direct costs associated with the production of goods sold by a company. There are four major components to cost of goods sold:
1. Plant Cost. Plant spending (aka product development costs) will likely remain flat or decline—the prepress process for e-books has much in common with print—so there's unlikely to be any big money squeezed out from this line.
2. Manufacturing Cost. Paper, printing, binding and component expenses disappear. The printing press becomes a thing of the past.
3. Inventory Obsolescence. Obsolescence represents the cost of unsold inventory—product manufactured that never leaves the warehouse or is returned. Once the product has been deemed unsalable or only salable at a price well below its manufacturing cost (i.e., a remainder sale), the value of the unsold inventory is charged against the income statement.
4. Royalty Cost. Royalties may turn out to be the 800-pound gorilla in the room with authors demanding a larger share of publishers' revenues on the grounds that the publishers' costs and risks have both been reduced and, consequently, a more balanced sharing of the revenues is appropriate. Odds are that publishers will give ground here and increase royalty rates, as the alternative is more direct relationships between e-booksellers and big-name authors (e.g., Stephen Covey's exclusive digital rights deal with Amazon).
Gross margin is the difference between net sales and the four major components of cost of goods sold. With the elimination of manufacturing and obsolescence costs, gross margin is likely to grow, despite anticipated increases in royalty rates. Put another way, odds are that publishers will eventually see e-book gross margins equal or superior to the current business model because the major components of the costs of producing the printed product will disappear entirely.
Operating costs are defined as the recurring expenses connected with a business' operation. Operating expenses typically have both a large, fixed component (i.e., costs that don't change dramatically with the level of activity, sometimes described as "overhead," and include expenses such as salaries, rent, insurance costs, etc.) and variable costs, which vary with the level of activity. Major components of operating costs include:
1. Production Cost. Production cost refers to the personnel expenses associated with managing the processes of print-book manufacturing. It includes the cost of production management, manufacturing staff, inventory planning and expeditors—all of the folks who support the traditional production process. When (not if) e-books become the primary form to deliver publishers' content, the traditional production department is likely to be one of the first components of the organization to face substantial restructuring.
2. Distribution Cost. Distribution cost refers to the personnel associated with warehouse and customer-service activities associated with the order intake, fulfillment and returns processes—in short, the folks who pick, pack, bill and collect on behalf of the current business processes. When e-books become the primary form to deliver content, the traditional distribution organization, like the production department, is likely to undergo dramatic change and may potentially become completely extraneous in a world dominated by e-books. Many publishers have already taken steps to convert the fixed cost of distribution to variable by outsourcing their distribution needs to third-party providers.
3. Editorial Cost. Editorial cost is the cost of acquiring and developing content—the folks who identify the product, find the authors and edit the manuscripts. The e-book's impact on editorial cost is likely to be significant, with some suggesting that the improved gross margins and lower operating costs resulting from a significant shift from print to e-books will be more funding available for product development—with less risk and lower investment required to bring the product to market.
4. Information Technology Cost. Technology costs are likely to change in both scale and nature as the functions associated with publishing change with the transition from print to digital. Investments in large enterprise resource planning systems designed to manage inventory, track production costs and manage the physical fulfillment (and returns) processes will become largely extraneous.
While many publishers are investing in some measure of technological infrastructure to support e-books, many third-party providers are creating and fulfilling e-books. E-books technology is still in its relative infancy, and most publishers are unlikely to commit to replacing their existing infrastructure to support e-publication when there are so many capable third-party providers—many with far lower labor costs then U.S.-based publishers face.
Different technology skills may become more important, including product enrichment of e-books, but for the most part, information technology will undergo changes that may prove to be as significant as those faced by production and distribution.
5. Sales and Marketing Cost. The impact on publishers' sales and marketing organizations may be as sweeping as the changes faced by other functional specialists. The sales rep's role will change dramatically, and the expertise required from the marketing organization will place continued and expanded emphasis on e-marketing for securing shelf space and driving sell-through to consumers.
6. General and Administrative Cost. General and administrative costs are expenses associated with the executive, accounting, human resources and legal staffs.
Publishers' infrastructures—design to support the printed product—include accounting and procurement personnel whose roles include placing purchase orders to manufacture books, recording cost information associated with each purchase order placed, tracking inventory in and out of the warehouse, evaluating inventory balances and making reprint recommendations. What role, if any, do these resources play in a world dominated by the e-book?
Little doubt exists that a significant move from print to electronic has the potential to result in a dramatic reduction in these resources as a business transitions from labor- and process-intensive to digital.
The total, shown on an organization's income statement, details the profits generated by a company's principal business. In the previous discussion, operating profit would be calculated based on the following equation:
Net Sales - Cost of Goods Sold - Operating Expenses = Operating Profit
I believe there is no question that the e-book has the potential to replace a long-cherished cultural icon—the printed book—and little doubt that the e-book is here to stay and destined to experience steady and potentially spectacular growth.
That said, the real opportunity of e-books is the reshaping of the financial characteristics of the industry as we now know it. But this is a transformation that will neither be quick nor painless, and much can be gained by understanding and planning for the potentially significant personal and organizational change that will follow. BB
David Hetherington is director of major account sales for Baker & Taylor's Digital Service Group and an adjunct professor at the Pace University Graduate School of Book and Magazine Publishing. He was previously managing director for strategic business development for Integrated Book Technology, and has held senior positions in finance, operations and manufacturing with some of the industry's largest firms, including Simon & Schuster, Reader's Digest Association, BearingPoint Consulting, Wolters Kluwer Health and Columbia University Press.