Amazon may cut itself on ‘razors and blades’ theory

November 21, 2011, 5:06 PM UTC

FORTUNE — A report Friday that the Kindle Fire costs a few dollars more to make than its $199 selling price is drawing renewed attention to Amazon’s adherence on the “razors and blades” theory. That theory has been around for a long time and has been much discussed with the rise of new technologies over the past few decades. Whether it will work for Amazon is an open question, but the odds may be against it.

The theory is, if you give away a razor, you can make up the loss by selling lots of blades. Amazon (AMZN) is “giving away” the Fire tablet so that it can sell lots of other stuff to Fire owners through the Amazon Store.

The founder of Gillette (PG) is often credited with this idea, but that company didn’t start selling razors cheaply until after its patents had run out. Before then, competitors were already doing it. And anyway, the marketing idea behind it had been around for decades, if not centuries, before safety razors were invented. For example, the Standard Oil Company gave away kerosene lamps in order to sell oil to the Chinese.

So what’s the problem? Standard Oil was a monopoly, which is a crucial fact because the razors-and-blades theory works best when only one vendor is selling the blades (or the oil). When other vendors enter the market, prices fall. At the very least, margins have to be high on the blades or the oil — or on the stuff you sell through a tablet computer.

Amazon’s not in quite such an advantageous position. Certainly, it has a monopoly (of sorts) on the highly regarded Amazon Store for which the Fire is optimized, but it certainly does not have monopolies on the movies, books, music, video games and other goods the store makes available. Quite the opposite: The market for those products is highly competitive, keeping margins razor-thin.

Razor-and-blades wouldn’t work if Schick’s blades fit into Gillette’s razors and vice-versa, or if Lexmark’s (LHK) ink cartridges were identical to Hewlett-Packard’s (HPQ).

That’s more or less what Amazon is facing. Consumers can buy the same movies and video games on many tablets — you don’t need the Fire. Amazon has designed the Fire’s Android-based operating system and its Silk browser to be optimized for buying through Amazon. But that’s not the same as creating an “ecosystem” like Apple’s (AAPL). In that case, Apple controls all the components of iTunes and iOS. What’s more, Amazon is losing more than just a few bucks on each Fire it makes. The analysis released Friday counted only hardware costs. Amazon is also licensing software for the Fire, which means it’s actually losing more on each unit sold. How much exactly is unclear.

The only advantage Amazon has is the quality of its store. The Kindle Fire comes loaded with extras competitors like Barnes & Noble can’t hope to compete with, including membership to Amazon Prime, the company’s frequent buyer program. The trouble is that the popularity is driven not only by the vast selection and the high level of customer service, but also — and mainly — by the deep discounts the company regularly offers. That might boost demand, but it also cuts even more deeply into profits.

It would help if the Fire were so good that it approached the quality of the iPad even at hundreds of dollars less. Unfortunately, that’s not anywhere near the case. Investors recently punished Amazon and its chief Bezos for spending too much to gain traction in the tablet market. They might have had a point.