CISB 6219

Netflix: Where did they go wrong?Lessons Learned from the 2011 Fiasco

George Billingsley, Kyle Hughes, Christopher Winn, Leigh Parker and

Travis Wolther

“Nothing defines humans better than their willingness to do irrational things in the pursuit of

phenomenally unlikely payoffs. This is the principle behind lotteries, dating, and religion.”

- The Dilbert Principle by Scott Adams, 1995

Introduction:

The story of Netflix’s demise is something that has been well-documented and

broadcast across the globe by many media outlets and outraged customers. In the off-case that

If you are unfamiliar with the situation, we will fill you in on the details behind the debacle and

try and shed light as to discuss what missteps the company made that , and how these

mistakes could have been avoided by implementing the use of theories and principles that

embody the emerging field of of strategic decision making. After taking a A closer look into at

the timeline sequence of events over the course of the few during the key months that sent of

Netflix’s spiraling into a massive crisis, shows many customers and observers alike were left

with a sense of, “What were they thinking?”. By analyzing common biases and fallacies in

cognitive and heuristically-influenced decision making we will try to answer just that attempt to

explain the companies’ actions.

Ten Common Biases:

In order tTo fully understand the magnitude of the Netflix debacle, it is useful to review

ten of the ten most common causes of poor decision making. Many of these biases are present

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in the Netflix case and, had the CEO of Netflix, Reed Hastings, been more cognizant of them, he

may have been able to avoid making a multi-billion dollar mistake. First, there is the

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fundamental attribution error. This is the tendency to over-emphasize someone’s

personality in explaining his or her behavior without considering situational factors. Hastings

may have been guilty of this as he tried to predict how his customers would respond to Netflix’s

decision to raise prices and bifurcate its business. Second, there is the illusion of control. As the

name suggests, this bias is the tendency to overestimate your ability to control something over

which you actually have little or no influence. Hastings was unquestionably guilty of this

decision-making faux pas because he would not have made such a bold move had he better

understood his lack of control. Third, there is the conformity bias, which is the tendency to align

oneself with group behaviors. Hastings and Netflix were guilty of this, since the move away

from physical media and towards streaming was an attempt to imitate Hulu and Apple iTunes.

Fourth, there is the availability bias, which is the tendency to magnify the importance of

something simply because there is information available. Again, Netflix was guilty of this as they

assumed they had enough information to make such a drastic change in their operating model.

Fifth, there is the endowment effect. This is the hypothesis that people will value something

more once they own it than they do before ownership is conferred. This bias does not appear

to have any direct relevance to the Netflix case. Sixth, there is dysfunctional competition, which

generally refers to counterproductive behavior between coworkers. This is less apparent in the

Netflix case than the other common decision-making fallacies. Seventh, there is

overconfidence. This is one of the more obvious flaws in the Netflix fiasco. Hastings greatly

overestimated his ability to predict the outcome of his decision to raise prices and bifurcate the

business. Eighth, there is confirmation bias. Similar to overconfidence, this bias is clearly

present with Netflix. Hastings neglected data and advice in making his decision to spinoff the 2

DVD business and sought out reasons to confirm his desire to move aggressively. Ninth, there is

egocentric bias. This cognitive bias may be present in the Netflix case as Hastings seemed to

want to make a personal statement to the world in undertaking this massive change to the

Netflix business model. Tenth, there is sunk cost bias. Hastings may have let this cloud his

judgment, given that Netflix had invested significant sums of money in accumulating its

extensive inventory of DVDs. Fearing that much of that capital may be wasted with the

inevitable decline of physical media, Hastings made an ill-advised decision to drastically alter

Netflix’s business model. From an outsider’s perspective, it seems that most of these decision-

making landmines appear in the Netflix case.

Timeline:

To briefly surmise, Reed Hastings unexpectedly caught customers off-guard by

announcing a six dollar per month price increase coupled with the announcement that he

would divide Netflix into two separate companies, one which would maintain the same name

and the other would be called Qwikster. Netflix would provide the online streaming service

while Qwikster would offer the mail order DVD service. This announcement was made in a blog

post by Hastings and forwarded to customer’s inboxes. They would now be paying more

money for less service, and those that chose to use Qwikster were also burdened by creating

additional usernames and passwords to view their accounts. The next gaffe in the head-

scratching series of events would come in the form of a second e-mail to customers from

Hastings admitting fault and announcing the decision to do-away with Qwikster. Missing

however from this communication was a decision to go back on the subscription-price increase.

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By the time financial statements were made public on September 15th, 2011 the damage had

been done. Total subscribers to Netflix were short 1 million users from projections and four

days later the stock price had bottomed to $143.75; down more than 100 dollars from just two

months prior.

Mistakes Made:

In theory, it is better to make mistakes in the hypothetical than it is in real life. This is a

notion that most of us become familiar with in childhood. Unfortunately for Netflix, Hastings

forgot this critical lesson in making his decision to bifurcate the business. Had they used

scenario-planning techniques to estimate both the potential backlash from customers and the

potential value of acting swiftly to capture a larger part of the streaming market, they may have

been able to avoid this disaster. In a scenario plan, Hastings could have weighed the good that

could come from his decision with the bad. Had he assigned the appropriate probabilities and

values to each outcome, he may have been able to foresee the folly of splitting Netflix into two

companies and raising prices. This is a process that all decision makers should be familiar with,

especially when the outcomes of their choices could result in the loss of several billion dollars in

market capitalization. It seems that Hastings and Netflix destroyed this shareholder value

because they were too lazy or too arrogant to completely assess multiple scenarios.

Netflix also suffered from an organizational structure that was void of any goal

congruence. From the top down, Hastings set the tone of creating an organization which

operated in a bureaucratic way that proved counterproductive. It was also one that opened

itself up to being very susceptible to suffering from the fallout of making rash decisions. By

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relying on his own gut and past experiences to drive change agents at Netflix, Hastings

inadvertently helped foster a culture where agents within the company were at odds with the

principles. By failing to capture the input and feedback from agents within Netflix, the agents

are inclined to respond negatively. The damage is two-fold, disincentivizing the raising of red

flags and key issues, and acting in self-fulfilling ways that weaken the organization as a whole.

In the end, that is what occurred. Hastings inside view neglected the drivers of his business and

led to a culture that could not make optimal decisions because new information was not shared

with many of the other leaders who could have utilized it to make more informed decisions.

People tend to be a good judge of how they will feel but not the intensity of the feeling.

Similarly, Netflix executives knew their customer base would dislike the price increase, but they

underestimated the degree to which they would dislike it. In hindsight, it is easy to assert that

Netflix should have known that their decision would make customers, particularly their most

loyal customers, irate. The problem worsened with the subsequent reversal of the decision to

split the business in two. The precipitous decline in subscriptions and revenue is in large part

due to Hastings underestimation of his customers’ reaction. He demonstrated a severe

overconfidence bias in this process as well as an illusion of control bias. As a result, his letter to

customers announcing the price increase was received with confusion and anger rather than

acceptance.

One of the most common decision-making biases that individuals succumb to is that of

overconfidence. Hastings, by his own admission was overconfident. His pattern of successes in

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business made him that way. He had considerable success with his first company, Pure

Software, and was also added onto Microsoft’s board at a relatively early age. Enormous

accomplishments such as these ironically contributed to his biggest failures, because they led

him to be overconfident. Another attribute of overconfidence is an overreliance on primary

knowledge. This seems to be the case with Hastings decision to unveil Qwikster without first

having consulted with customers or entrusting marketing and public relations professionals to

get a sense of the backlash that could result from the move. Had Hastings developed greater

meta-knowledge he could’ve been more aware of the scope of his abilities in the areas relating

to customer sentiment and at least been prepared to realize possible consequences of the

Qwikster fiasco. As it were though, the overconfidence bias came into play and Qwikster

launched in early September 2011. We can learn more about how Hastings became

overconfident by studying the culture of his company. Hastings fostered a culture at Netflix

where “average performers” were let-go with generous severance packages. Perhaps it were

these average performers who’d have been the ones most likely to speak out against status-

quo and decrease the probability of developing false consensus had they not feared for their

jobs.

Throughout this self-inflicted ordeal, Reed Hastings exhibited an almost offensive

confirmation bias. According to an article in the New York Times, (1)“Mr. Hastings ignored the

warning believing that chief executives should generally discount what their friends say.”

Against the counsel of his advisors, he moved forward with a plan that was unnecessary and

destructive. He chose to weigh the value of the information that confirmed his plan to bifurcate

the business and to ignore, or at least undervalue, the information that contradicted 6

(1) Wingfield, Nick and Stelter, Brian “How Netflix Lost 800,000 Members, and Good Will” New York Times October, 24 2011.

it. The use of advisors is a critical component of any major decision-making process. By

incorporating numerous, trustworthy opinions in his decision, Hastings could have avoided

disaster. The fact that Hastings disregarded the opinions of his advisors simply because he felt

he should discount input from his friends is inexcusable.

Netflix Spokesman, Steve Swasey may have said it best when he put it that, (2) “we

underestimated the appeal of the single web site and a single service…we greatly

underestimated it.” People are very likely to underestimate the expected disutility and value

resulting from rash decisions they make. The use of a decision tree can be very helpful when

making decisions that one way or another will have such a large impact on organizations. Had

Netflix considered the resulting outcomes from a Bayesian formula after conducting market

research tied to customer response to Qwikster or used utility theory to weigh negative

outcomes against successful ones then they would probably have given their decision more

thought before going forth with their gut on Qwikster. Hastings in particular would have been

well advised to spend more time framing the problem. A broader view of the choice involving

Qwikster would have considered all of the consequences associated with backlash from the

decision. Such consequences that would have been reasonable to assume would be customer

attrition, and a decrease to shareholder’s value.

Prior to making the split, Netflix felt that it was approaching a crossroads. One path was

delivering DVDs to customers through the US Postal Service and the other was to stream video.

In Reed Hastings’ view, there was no middle road. Furthermore, he believed that the future of

movie consumption was in streaming video, not in physical media. To remain primarily in the

(2) Stelter, Brian “Netflix Reverses Course on a Breakup Plan” New York Times October 11, 2011 7

business of delivering DVDs was to choose a future of slow, but inevitable extinction. According

to the New York Times, Hastings said (3)“companies rarely die from moving too fast, and they

frequently die from moving too slowly.” In his view, streaming video was an innovation that

could not be overlooked. He felt that with Netflix’s size, streaming video could be a disruptive

technology. Confirmation bias clearly played a major role in swaying Hastings’ decision as he

pushed the company down a road that was replete with warning signs. First, the content

agreements Netflix had for DVDs were not necessarily relevant to streaming. They would

essentially be forced to reinvent the wheel in shifting to a streaming business. Second,

disruptive technologies typically only work when they can be used to undercut the competitors.

In this case, by shifting to a streaming model, Netflix actually became dependent upon their

competitors to popularize streaming video. Third, disruptive technologies are typically only

successful when you have a first mover advantage. In this case, Netflix was on the trailing edge

of the technology. The potential for economic benefit was small and far-fetched.

Parallel Story:

Another component of avoiding potential mistakes is found by looking to the past in

business history. When taking a look at the following case involving Coca-Cola we can draw

parallels to the situation at Netflix and analyze reasons companies fail. Coca-Cola launched

New Coke in 1985. New Coke was a deviation from the original formula of Coca-Cola and was

meant as a replacement from Coke’s previous taste. Public reaction was overwhelmingly

negative. Some people likened the change to trampling the American Flag. The change

bordered on sacrilege and as Coke President Donald R. Keough conceded, (4)“we did not

8(3) Stelter, Brian “Netflix Reverses Course on a Breakup Plan” New York Times October 11, 2011

understand the deep emotions of so many of our customers for Coca-Cola.” Much like the

hasty introduction to Qwikster by Netflix, Coke didn’t ask the critical question of its’ users of

“do you want a new Coke”? By failing to do so, Coke as well as Netflix found they had to

backpedal very quickly. The good news for Netflix however is that Coke recovered. Within

months of New Coke’s arrival on store shelves, the people of Coke re-released the original

Coke, rebranding it as Coca-Cola Classic. It would be wise for Netflix to return to its’ previous

form, much like Coca-Cola, and go-back to offering streaming videos and mail-order DVDs to

its’ customers at the original subscription price. Like Coca-cola did with New Coke, Netflix could

continue to develop Qwikster but create more differentiation and see if it materializes into

something profitable in the near future. However, looking back to history suggests otherwise.

While New Coke was kept around for a few years and morphed into several different names

and can designs, the experiment eventually failed and all the abominations of New Coke were

pulled from the shelves for good. Similarly, Netflix leadership might be well advised to disregard

the Qwikster initiative all together.

Lessons Learned:

Perhaps the one positive outcome among the many negative ones of the Netflix fiasco is

that others will learn vicariously from the Netflix errors. There are several valuable takeaways

for observers. First, a clear transition plan should precede any evolutionary process for a

company. It was not wrong for Netflix to want to adapt to changes in demand, but it was

inexcusable to do so without a concrete strategy to guide them through the process. The

decision Netflix made seems to have been driven out of paranoia rather than sound business

9(4) Ross, Michael. “It Seemed Like a Good Idea at The Time” MSNBC.com. April 22, 2005.

logic. Second, before making any decision that fundamentally changes the customers’

experience, it is wise to seek input from them. Had Netflix asked its loyal customer base what

they would think about this drastic change, they would have had many extremely compelling

reasons to fine tune both the timing and the implementation of their strategy. Third, most

people spend too little time framing the problem and too much time trying to solve it. It is well

advised to spend a lot of time making sure that the problem is framed correctly. Any one of

these lessons could have averted, or at least mitigated, Netflix’s self-inflicted nightmare.

Conclusion:

While iIt is easy to conclude that Hastings made one of the biggest follies in the history

of corporate America, butit is almost impossible not to consider the notion that he was being

influenced by unknown factors one must consider unknown factors that also influenced his

decision process. Is it possible that Reed Hastings was acting acted rationally when he

destroyed billions of dollars in shareholder value? One potential explanation is that Netflix was

in talks secret meetings with one of its rivals, like Amazon, to sell-off its streaming business. If

this were the case is true, then Hastings may have been doing the right thing acted correctly

with his decitsion to split by splitting the business into a physical media business and a

streaming business. This likely would have been a condition precedent to a transaction.

Assuming there are iron-clad confidentiality agreements in place, we may never know the

whole truth.

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Bibliography

Goldman, Andrew. “Reed Hastings Knows He Messed Up” New York Times. October 20,

2011

Ross, Michael. “It Seemed Like a Good Idea at The Time” MSNBC.com. April 22, 2005.

Stelter, Brian “Netflix Reverses Course on a Breakup Plan” New York Times October 11,

2011

Wingfield, Nick and Stelter, Brian “How Netflix Lost 800,000 Members, and Good Will”

New York Times October, 24 2011.

Wingfield, Nick “Netflix Market Value Shrivels” New York Times October 25, 2011

“Netflix Shares Hit 20-Month Low as Debt Worries Mount” Los Angeles Times.

November 23, 2011

“Netflix Messes Up: The Terror of the film and televisions business has become a lot Less

Scary” The Economist. September 24, 2011.

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Exhibit A – A brief biography of Reed Hastings, Founder and CEO of Netflix

Reed Hastings

Chairman, president and chief executive officer, Netflix Inc.

Reed Hastings founded Netflix in 1997 and launched the subscription service in 1999. Netflix grew to one million subscribers in less than four years, and surpassed 6.3 million subscribers in December 2006.

In five consecutive surveys over three years Netflix has been independently ranked number one in customer satisfaction across all of ecommerce by ForeSee Results. In the fall of 2005, Netflix was the winner of Fast Company's national Customers First Award, with Reed appearing on the cover of the October issue.

Also in 2005, Time magazine added Reed to its "Time 100" list of the one hundred most influential global citizens. Newsweek wrote that "Netflix revolutionized the way we watch movies."

In March 2007 Reed was appointed to Microsoft Corp.'s board of directors.

Earlier in his career, Reed founded Pure Software, which he built into one of the world's 50 largest public software companies. After a successful public offering and a number of acquisitions, Pure was acquired by Rational Software in 1997.

Reed is an active educational philanthropist and board member of many non-profits. In addition, he was President of the California State Board of Education from 2000 to 2004. He has led successful statewide political campaigns for more charter public schools and easier passage of local school bonds.

Reed received a BA from Bowdoin College in 1983 and an MSCS degree from Stanford University in 1988. He holds several patents. Between Bowdoin and Stanford, Reed served in the U.S. Peace Corps as a high school math teacher in Swaziland.

Source: http://topics.wsj.com/person/h/reed-hastings/800

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Exhibit B - Netflix Stock fell 71% between August and October of 2011

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