The big idea: When are customer communities critical for the success of subscription-based business models?

The scenario: In 1997, Reed Hastings founded Netflix in Los Gatos, Calif., after paying his local video store $40 in late fees for “Apollo 13.” He asked, “How come movie rentals don’t work like a health club, where whether you use it a lot or a little, you get the same charge?” The key was to let people watch movies whenever they wanted. Hastings once called his business a “goose-bump delivery service.” In that vein, he positioned his company to deliver as many goose bumps as possible, as quickly as possible. After going public in 2002, he surpassed his goal of 10 million subscribers by 2012. As of September 2010, there were more than 16 million.

Netflix’s first innovation, in December 1999, was to eliminate late fees. The key to not charging late fees was a subscription model. Customers who paid a fixed monthly fee of about $16 kept films as long as they wanted and rented as many as four movies in a single order. In fact, the longer they kept films, the lesser the shipping cost per rental for Netflix. This implied that customers who did not use their service were the most profitable. The business model did not make sense!

Netflix quickly realized that the key to a subscription model is higher customer retention — that is, customers keeping their subscription for longer periods. Netflix based its customer retention strategy on two principles: (a) customers who rent more movies keep their subscriptions longer, and (b) customers value recommendations from others in the community. Netflix invested in the now famous “recommender systems” to deliver on the two principles behind customer retention.

The resolution: The Netflix recommender systems suggest movies to customers that are expected to match their preferences. Effective recommender systems can encourage customers to watch more movies, leading to higher customer retention. The quality of Netflix’s recommendations improves with the volume of movie ratings obtained from customers. The customer community was critical in encouraging customers to rate the movies they watched. In these communities, Netflix allowed customers to post their own reviews in addition to rating movies. Everyone had a chance to be a movie critic. Once the number of customers providing reviews and ratings crossed a threshold, the community had a life of its own. Netflix has also had very high customer retention rates and sales growth. Amazon and Apple’s iTunes also have effective recommender systems and customer communities.

The lesson: Businesses need to carefully assess the role of customer communities. Communities that are critically aligned with a specific business objective, such as customer retention, are more likely to survive. Business objectives need to drive the design of the communities.

— Rajkumar Venkatesan

Venkatesan is the Bank of America research associate professor of business administration at the University of Virginia’s Darden School of Business.