Innovation Lessons from Amazon’s Shareholder Letters

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With Jeff Bezos in a news a fair bit right now, I thought it would a good time to look at some of the important innovation lessons that we can draw from his annual letters to Amazon shareholders. It’s worthwhile to read them all, but here are some highlights:

It’s All About the Long Term

The first letter is from 1997, and Bezos has included it as an appendix to every other annual letter that Amazon has sent out because it includes a summary of the firm’s long-run view.

Here are a couple of the key parts of that:

We will continue to make investment decisions in light of long-term market leadership considerations rather than short-term profitability considerations or short-term Wall Street reactions.

We will continue to measure our programs and the effectiveness of our investments analytically, to jettison those that do not provide acceptable returns, and to step up our investment in those that work best. We will continue to learn from both our successes and our failures.

The first point reflects the portfolio approach that Amazon takes – which is a very useful innovation tool. It means that while they continue to improve current operations, they also invest pretty heavily in initiatives that build new adjacent businesses and also those that will turn markets on their heads.

The second point is a great example of how to approach experiments – a critical innovation skill. Saul Kaplan describes the principles of experimenting as think big, start small and scale fast – you can see these components in Bezos’ statement. The other important idea here is that one key element of experimenting is learning from the ideas that don’t work.

Are Our Strategy Models Obsolete?

For years we’ve been thinking that there is a trade-off between low prices and excellent customer service. And yet, once their business model started firing on all cylinders, Amazon has had both. In 2002, Bezos said:

One of our most exciting peculiarities is poorly understood. People see that we’re determined to offer both world-leading customer experience and the lowest possible prices, but to some this dual goal seems paradoxical if not downright quixotic. Traditional stores face a time-tested tradeoff between offering high-touch customer experience on the one hand and the lowest possible prices on the other. How can Amazon.com be trying to do both?

The answer is that we transform much of customer experience—such as unmatched selection, extensive product information, personalized recommendations, and other new software features—into largely a fixed expense. With customer experience costs largely fixed (more like a publishing model than a retailing model), our costs as a percentage of sales can shrink rapidly as we grow our business. Moreover, customer experience costs that remain variable—such as the variable portion of fulfillment costs—improve in our model as we reduce defects. Eliminating defects improves costs and leads to better customer experience.

We believe our ability to lower prices and simultaneously drive customer experience is a big deal, and this past year offers evidence that the strategy is working.

That was the year that Amazon recorded the highest score to date for a service firm on the American Consumer Satisfaction Index, and also the year that they dropped prices on bestsellers by about 30% and introduced free shipping on orders over $25.

Ben Thompson does a great job of explaining how Amazon has been able to execute this dominant strategy (and he made the drawing below too).

You Need Judgement Even When You’re Data-Driven

The customer focus of the firm and the long-run view come together in many of the initiatives that Amazon has undertaken over the years. Here is an example from 2003:

As we design our customer experience, we do so with long-term owners in mind. We try to make all of our customer experience decisions—big and small—in that framework.

For instance, shortly after launching Amazon.com in 1995, we empowered customers to review products. While now a routine Amazon.com practice, at the time we received complaints from a few vendors, basically wondering if we understood our business: “You make money when you sell things—why would you allow negative reviews on your website?” Speaking as a focus group of one, I know I’ve sometimes changed my mind before making purchases on Amazon.com as a result of negative or lukewarm customer reviews. Though negative reviews cost us some sales in the short term, helping customers make better purchase decisions ultimately pays off for the company.

But you can’t always go by numbers – at least not the short-term ones. In 2005 Bezos says:

As our shareholders know, we have made a decision to continuously and significantly lower prices for customers year after year as our efficiency and scale make it possible. This is an example of a very important decision that cannot be made in a math-based way. In fact, when we lower prices, we go against the math that we can do, which always says that the smart move is to raise prices. We have significant data related to price elasticity. With fair accuracy, we can predict that a price reduction of a certain percentage will result in an increase in units sold of a certain percentage. With rare exceptions, the volume increase in the short term is never enough to pay for the price decrease. However, our quantitative understanding of elasticity is short-term. We can estimate what a price reduction will do this week and this quarter. But we cannot numerically estimate the effect that consistently lowering prices will have on our business over five years or ten years or more. Our judgment is that relentlessly returning efficiency improvements and scale economies to customers in the form of lower prices creates a virtuous cycle that leads over the long term to a much larger dollar amount of free cash flow, and thereby to a much more valuable Amazon.com. We’ve made similar judgments around Free Super Saver Shipping and Amazon Prime, both of which are expensive in the short term and—we believe—important and valuable in the long term.

It’s this long-term customer focus that has enabled the dominant strategy execution.

Innovation is Harder When You’re Bigger

As you get bigger, innovation is harder. Consider this from 2006:

I remember how excited we were in 1996 as we crossed $10 million in book sales. It wasn’t hard to be excited—we had grown to $10 million from zero. Today, when a new business inside Amazon grows to
$10 million, the overall company is growing from $10 billion to $10.01 billion. It would be easy for the senior executives who run our established billion dollar businesses to scoff. But they don’t. They watch the growth rates of the emerging businesses and send emails of congratulations. That’s pretty cool, and we’re proud it’s a part of our culture.

In our experience, if a new business enjoys runaway success, it can only begin to be meaningful to the overall company economics in something like three to seven years.

This makes the “start small, scale fast” parts of Saul’s experimenting mantra more difficult to execute. The way that Amazon has attacked this is with business model innovation. Things like Amazon Web Services, Prime and even the Kindle are all basically business model innovations. That’s about the only way that they can generate revenue streams big enough to have an impact on a firm as big as Amazon has become.

It’s not as though everything is perfect – there are obviously issues at Amazon. I have a friend working there right now, and his experiences don’t match up to all of the rhetoric in the letters to shareholders. And there are real questions about what Amazon’s dominance will do to the publishing and writing industries over the long-term. Amazon has delivered a lot of benefits to me as a (heavy!) consumer of books over the past few years, but will this continue if they’re the only player in the game?

But of the current big four technology firms, I do find Amazon to be the most interesting. And the letters to shareholders from Bezos provide a lot of insight into why.

(the Channeling Jeff Bezos picture is from flicker/anandc1 under a Creative Commons License.)