Industry Analysis: Feature Film Production

The motion picture industry produces and distributes films for theatrical release, home entertainment, and various other markets. The product of this industry is passive entertainment, typically viewed as a leisure activity. Various genres target all market segments, the largest of which is in the 18-35 year old age group. The same product is released via two main distribution channels, theatrical and home video. Theatrical release offers the benefits of large screens, immersive sound, and a social environment. Home video and streaming releases offer convenience and repeat viewing at no extra cost. The basic structure of the industry is broken into three segments: Production (creation of films from concept to finished product), Distribution (advertising and selling films), and Exhibition (screening films).

Industry regulations involve the acquisition of permits and releases to use land and people in the production of films. More famously, the motion picture industry features strict guidelines for censorship. In order to avoid government censorship, the industry created the Motion Picture Association of America (MPAA) to monitor and rate films for public release. Most of these regulations are not detrimental to the production and release of films. Other regulations that limit distribution can be problematic. For example, China will only show 40 or so foreign films a year, limiting penetration for American studios in that market. Regardless, the industry commands roughly $38 billion in worldwide revenue. Revenues can be sizable, but expenses are so high that returns are typically moderate, and often negative. Only through a given studio’s few massive successes are they able to stay on their feet in this expensive industry.

A Brief History of the Motion Picture Industry

Less than 15 years after the invention of film, the studio industry began to take form. Thomas Edison, patent-holder for most American motion picture cameras, formed a trust with the major motion picture companies in order to decimate competition from independent producers and exhibitors. The mergers of the larger companies in this era would lead to the creation of the dominant studios that reigned throughout the “Golden Age” of cinema (1928-1949).

At this point, there were 8 “major” studios, 5 of which had established vertically integrated channels featuring production studios, distribution branches, and sizable theater chains. Creative talent was secured by multi-picture contracts, adding ongoing value to the various organizations. In the 30s and 40s, between 250 and 350 films were produced per year by the 8 major studios alone, commanding 96% of the market. The major studio system was established during this era, and remains to this day, although it has removed theater ownership from its structure.

Decades of mergers, takeover, and closures followed, but the same basic structure remains: a handful of large studios (now 6 instead of 8), and a sea of independent companies with little market share. Major studios had become part of larger conglomerates in the 80s and 90s, affording them unprecedented funding. Filmmakers shifted their efforts to creating big returns through “blockbuster” films that featured heavy national release. The “Big 6” (the top 6 studios) now create roughly 130 films a year, but they are bigger releases, creating higher costs and greater risk.

Key Success Factors

The industry serves domestic markets and foreign, the latter making up the bulk of revenue in many cases. Major motion pictures have become so expensive that studios typically don’t see profit in domestic box office returns, forcing them to rely on supplementary income from China, Russia, Brazil, and the like. These foreign markets have become so important to US
studios that big-budget movies won’t be made without first considering how they will play abroad. For example, franchises play well overseas, often with increasing returns for each installment (unlike the US market which provides smaller returns for each sequel), so studios continue to make Pirates of the Caribbean sequels.

Success can be elusive due to changing audience tastes, external environmental factors (ex: recession), and the fact that each film is a unique artistic product, hence success is judged separately for each release. For example, the success of Batman does not necessarily affect the success of Godzilla, even though both movies were produced by the same studio, and probably share a fair amount of crossover audience. Each film has a limited window to make an impression on an audience that will determine its success. Franchises can build up brand equity, but typically this doesn’t last for more than three films before an audience becomes tired of the same material. Market research, test screenings, and historical performance of films can offer insight into optimal artistic characteristics to be utilized, but the sum of this data often proves to have little predictive efficacy due to the ever-changing interests of audiences.

Every film requires considerable cost, and hence considerable risk. Most studios understand that not every film will be a hit, so they limit their risk by releasing 10-20 films per year, providing a better chance that one or two will hit, making up for the losses of those that inevitably miss. Financial losses can be devastating. A single movie can ruin an entire studio if it does poorly enough. Ancillary markets (home video, VOD, merchandising) provide opportunities to recoup some of the costs of production, but it can take years to recover in some cases.

The trend in the industry is to create blockbuster films that will hopefully generate huge returns. This strategy of high cost products creates dependency on big releases, which puts constant pressure on studios to come up with a hit. Often times the studio relies on these “tent pole” movies to make up for the losses of their other releases. A crucial success factor is to open with big returns. Opening weekend performance can increase or
decrease an audience’s willingness to see a film. Studios have to be careful to time the release of their movies to not compete with strong competitor offerings, or their own releases. Additionally, the industry is seasonal, with the biggest releases arriving in the summer, when audiences have the most leisure time. Winter often sees additional big budget films (albeit fewer) for the same reason. The end of the year also sees an influx of movies vying for Oscar nominations, since the cutoff for submission ends with the calendar year, and they all want to be most recent entry in a judge’s mind.

Most major studios have moved from vertical integration to a mostly disintegrated model. It is ridiculous to imagine a production company manufacturing cameras and film, of course, but even crucial creative processes like color timing are typically brought to other facilities (with close supervision of the studio’s creative team). Some aspects of production remain largely integrated, such as marketing and advertising, which studios invest in heavily with each release. The six top studios maintain their own distribution channels, but smaller studios cannot afford to integrate this process so they must create deals with the majors to distribute their films.

Porter’s Five Forces

Threat of Entry
The film industry has always been dominated by a handful of large companies. Smaller players exist, but they are in a different league altogether. New entrants may find it possible to become another small player, but taking on the big six is too expensive. Producing a single film is capital intensive, let alone starting a new studio and producing several. Movies make back a good deal of their costs in ancillary markets (home video, merchandising), delaying returns for months or even years. New entrants must be prepared to survive long stretches without profit.

Along with a great deal of start up capital (for both the production company and the films it intends to make), young companies also need large teams of talented people (creative, managerial, administrative), various expensive
resources (equipment, studio space, office space), and access to industry-specific services (film developing, permits, etc). Assuming a new company can handle these costs, they must then worry about distribution. No new company can afford to set up its own theatrical distribution channels, so they must establish deals with existing firms. Distributors want to limit their risk, so they prefer companies with a good track record of successful films, brand name recognition, and big name talent. Most new entrants will not have these bargaining chips.

Threat of Substitutes
It is arguable that the movie-going experience has unique value due to its social nature, but in terms of content delivery, its has several rivals, such as streaming media channels like Netflix, Hulu, and Amazon Prime. It is easier and cheaper to use these services than to go to a theater. Other forms of entertainment, such as concerts, video games, and museums, are readily available as well. The internet provides an open and affordable method of distribution, but it cannot be monetized as effectively as the century-old movie industry due to its own abundance of substitutes. This is not to say that it is incapable of competing for consumer attention.

Although current and consistent figures are difficult to come by, a 2006 study, funded by the MPAA, states that internet piracy cost the industry $6.1 billion dollars in the year ended 2005. Roughly 2/3 of this number represents “hard goods” piracy (DVDs), while the remaining third took place on the internet. Surveys with industry professionals reveal that the main sectors that believe they have been affected by piracy are Sales & Distribution, and Marketing. Many other sectors do not feel that it has had a noticeable effect. This is due to the fact that demand has remained constant for content, even though revenue has decreased. Filmmakers still make films and get paid, but the distributors see less profit.

Power of Buyers
The industry has two classes of buyers: exhibitors, and audiences. Exhibitors represent channels for theatrical distribution, non-theatrical distribution (airlines, film societies), and home video. Exhibitors are weak since they
are reliant on the output of studios. Studios reap roughly 50% of theater ticket sales (up to 80% on opening weekends). Since studios could theoretically distribute their films over other channels (digital, home video), but theaters can only be used for showing movies, the theater is dependent on the studio’s product.

Audience reactions can make or break a movie. Aside from the obvious effects on ticket sales, customers communicate quickly, swaying other customers’ opinions through word of mouth, and reviews on various internet sites. Weak audience reaction to a movie might have more lasting effects, as it could be used as data to determine the potential success or failure of upcoming projects in a studio’s pipeline. Fear of audience disapproval has led more studios to take fewer risks by increasing market research efforts, which do not always yield better results. Audience buyer power is strong.

Power of Suppliers
Supplier power is strong in the film industry. Professional film equipment is produced by only a handful of companies. It is unique to the industry and it carries a heavy cost. Film itself is produced almost exclusively for motion pictures at this point. Digital equipment is gaining acceptance steadily, which may lead to a shift in a few years, but at this point film still remains in high demand for the industry.

Suppliers of labor are also powerful. A-list actors, directors, writers, and producers can wield significant bargaining power because they add a tremendous deal of value to a project. Not only do they add artistic merit, but they also bring their personal brand name recognition to a movie, which can attract audiences regardless of the quality of the film. Additionally, there is a strong union presence in the workforce at the major studio level. In the last 15 years, strikes have been held by writers, actors, and even stuntmen. Production halts can create a great deal of trouble for studios due to the amount of money on the line, and the high pressure to create profitable projects. Scabs are readily available for manual labor, but not for creative positions.

Popular opinion is that technological advances have made the movie industry less expensive. In some instances this is true, but there are also heavy costs associated with technology. For example, a post production facility might have to spend tens or even hundreds of thousands of dollars to upgrade their machines and servers. New equipment may require new talent if a qualified operator is not on hand. Training existing staff can take a great deal of time. Digital workflows offer tremendous flexibility for filmmakers, but this also encourages more tweaks in picture and sound editing, coloring, etc. All these tweaks result in extended rentals of editing bays and labor costs for skilled operators, which can quickly add up. Again, suppliers have power in terms of products and services supplied.

Competitive Rivalry
The top six companies in the film industry provide heavy competition for each other. The six companies together make up 80-85% of American and Canadian box office revenues. These companies are Warner Bros., Universal, Disney, Paramount, 20th Century Fox, and Sony/Columbia. Market share is determined by successes and losses for each company, which change from year to year, shuffling the companies around in the six top rankings for market share. Spot 6 is usually around 10% market share, and spot 1 is usually around 18%. The remaining studios, some of them subsidies of the big six (Sony Classics, Fox Searchlight, Focus), each make up 2% or less of market share.

All of these studios are located in the Los Angeles area, as they have been since their respective openings in the 1920s and 1930s. This provides equal access to the industry-related goods and services offered in LA. Smaller studios exist in other major cities, such as New York and Chicago, but these are typically independent firms that compete on a much smaller level. Exhibitors are spread out over the entire globe, though most of them operate on a regional level. Significant tax breaks are offered for filming in other states and other countries, offering studios a chance to gain a production advantage via cost reduction.

Conclusion

High costs of production and distribution have led the movie industry to pursue large returns from a fraction of their releases. While one or two tent pole films a year might garner satisfying returns, these are usually making up for losses elsewhere, which reduces profitability. Production costs are sufficiently high to create financial stress for the lukewarm and poor performers, which outnumber the hits. It should be noted that flops often have budgets equal to hit movies, so a hit has to make up its own cost, as well as some of the cost of a flop. As long as the industry continues to pursue the blockbuster strategy, it will see weak returns. If a studio wants to attempt to break out of the big budget cycle of loss and recovery, they may lose their competitive advantage of scale entirely, and become just another minor production company.

Domestic revenues have been floating around the $10-$11 billion dollar mark for the last 8 years, indicating slow growth. Perhaps in this mature industry it is difficult to communicate new value to consumers, and continued efforts to do so only translate to more cash outflows for marketing and advertising. Seeking revenues in overseas markets steers American studios to produce films that translate well to foreign audiences. In this way, gaining stronger footholds in developing global markets effectively doubles down on the strategy to stay with high spectacle, big budget films. The profitability conundrum is a constant: in order to make more money, studios have to spend more money.