The “Breakage” Business Model

Today, I want to introduce you to a concept called “breakage.”

Before I explain the concept, I want you to think of how most businesses operate.

The customers want a particular product or service. They buy it. They use it. The transaction is done.

You’re hungry and you want a sandwich.

You go to the deli and buy a sandwich.

You eat the sandwich.

You’re happy because you’re no longer hungry.

The deli owner is happy because she generated a sale.

This is how most businesses work.

The “breakage” business model works the exact opposite way.

In this scenario, the company makes money when you do NOT use the product or service you purchased.

Let’s look at the business of gift cards.

You go to Walmart and, on your way to check out, you buy a $25 gift card to Starbucks.

You give the gift card to your friend for his birthday.

How does Walmart make any money doing this?

Well, it turns out that for every $100 spent on buying a gift card, only $75 is actually ever redeemed. People who receive the gift card either lose the card, forget about the card, or don’t use up the entire value of the card.

This is breakage.

Another example is health clubs or gyms.

Most fitness centers work on a monthly membership fee model.

I pay $75 a month to have access to the facility.

Whether I show up every day or never show up, I still pay the health club the same $75.

In the health club business, by far the most profitable customers in the industry are people who sign up as members but don’t actually show up to the gym.

This is also breakage.

Breakage-based business models can be very profitable.

(Imagine a health club with 10,000 paying members where nobody actually shows up.)

The problem with breakage business models is that you’re receiving value from customers without customers actually receiving value in return.

In essence, you’re betting that customers are too dumb or lazy to change their minds.

Before Netflix and video streaming of movies became the norm, a company called Blockbuster used to rent DVD movies to entertainment seekers. You would rent a movie for two nights for something like $5. If you forgot to return the movie on time, they would charge you a $3/day late fee.

Imagine renting five movies for the weekend and forgetting to return the movies for an entire week. Instead of spending $25, you end up spending $100.

This is a form of breakage too.

It turns out that, in its prime, Blockbuster was generating 70% of their net income from late fees.

Their profits came from customers who were too lazy or forgetful to return the DVD sitting in their car.

Another problem with breakage is that customers don’t like it.

When Netflix first started, they had a subscription-based DVD rental by mail business. For a flat fee each month, you could keep the movies you rented for as long as you wanted.

Netflix targeted Blockbuster’s most profitable customers — those that pay late fees — and ultimately bankrupted Blockbuster.

Personally, I sleep better at night in a business where sales and profits come from happy customers, instead of unhappy ones that wish your way of business didn’t exist.

I don’t see the gift card and health club businesses changing dramatically anytime soon. At the same time, I like the idea of customers receiving good value for what they pay. It’s a good thing to profit from really happy customers that are thrilled to do business with you.