Businomics Blog

Marriage Is Good For Your Heart (and other Valentine's Day Statistics)

Listen to yesterday's Prairie Home Companion song on romantic statistics: scroll down to "Statistics" after clicking here.

Happy Valentine's Day, readers.

Bill

What Corporate CEOs Need To Know About Big Data

Steve Levitt, author of Freakonomics, gave a presentation on big data in corporations. It should be watched by all CEOs and wanna-be CEOs. It's discouraging in that it shows many companies' unwillingness to use the data they have, but it's encouraging. You don't need to be perfect to beat your competition, just have a willingness to make decisions with data, and spend a little in resources to make it happen. It's also a fun presentation with lots of chuckles.

 

The Trial and Error Economy

For years I have been writing about the Trial and Error Economy. Now there's a great TED talk on the subject by Tim Harford:

 

To read my articles on the subject, scroll down on the right column for the category list and click Trial and Error Economy. The most popular on the series is, of course, The Economics of Dying Pubic Hair.

Starbucks Strategy: Time and Motion Studies Now

Starbucks is trying to help its staff members be more efficient.  According to a recent Wall Street Journal article, they are using old fashioned time and motion studies.  A barista makes a latte, while someone watches with a stopwatch.  Early results are positive, but some baristas worry that this push for efficiency will take away from the coffee-crafting experience.

The Starbucks experience is a part of the charm of the chain, but don't forget the coffee, or that many of us don't want to wait in line.  The Starbucks experience is not about watching someone fumble to find the whipped cream. If the barista can save five seconds by having ingredients located in the right place, then burn off one or two of those seconds with a smile or flourish, then efficiency and the Starbucks experience are both served.

I had the pleasure of spending two hours with one of the top Internet marketing experts.  He says that everyone who survives that business is continually doing "A B testing."  That is, they have their "A" ad, which has proved successful.  But they are also showing a "B" ad, trying out new ideas.  The B ad may only get 5 percent of the impressions, but it keeps the A ad on its toes.  When a B ad surpasses the old A ad, then it gets promoted.  Do the marketers slap each others' butts and call it a day?  Of course not--they have to write a new "B" ad.

If there's anything weird about Starbucks jumping into this efficiency thing it's this: haven't they been doing this continuously for years?  Jeez, it's basic Total Quality Management. This is a basic element of the trial and error economy:  continually test your procedures, looking for room for improvement.

When I was young, I thought that a boss should tell employees what is expected of them, then leave them alone to work out the details themselves.  Boy, was I ever stupid. I learned the error of my ways racing my boat.  I sail a small boat with two other people, and I used to explain the desired results and wait for my crew to figure it out.  And waited.  And waited.  The new, hard ass me is different.  I specify exactly how each step is to be done.  No changes, no suggestions, no variation.  We always do the jibe this way.  After a crew member has mastered the task and gotten some experience, I am very open to suggestion.  When we're out practicing, we can try another way and see how it works.  We watch our competitors, read articles, and try to improve.  But first, we master the old ways.

One final thought, as I'm writing this in a Starbucks at the O'Hare airport.  I walked up at a slack time, and there were four employees without a customer.  Talk about a bad environment for customer service.  They didn't want to stop their conversation for me.  True, it was only five seconds or so before they greeted me, but to be a customer who is ignored for any length of time is insulting.    Every business needs to keep their  employees busy.  "My" Starbucks often has a line in the morning, but every employee is focused on getting the orders in, made, and served.  I'd rather wait in line and see the staff hustling to get to me, than to have no line and be ignored.

Advertising and Quantitative Analysis: The Trial and Error Economy Comes to Madison Avenue

The New York Times has an article about quantitative analysis coming to the advertising industry.  In the old days, ad agencies labored for months to create the perfect ad--perfect being totally subjective.  They only had the vaguest idea of whether an ad sold products.  Maybe the cute VW commercials helped bug sales, or maybe the stunning Apple ad help sell Macs--but maybe customer buzz drove sales and the ads were basically worthless.  Philadelphia's department store baron John Wanamaker said, "Half the money I spend on advertising is wasted; the trouble is I don't know which half."

Now advertisers have embraced the Trial and Error Economy.  It began with Google's AdSense campaigns.  Savvy advertisers would create two different ads, then test one against the other in terms of results.  The revolution was not the two-ad test, but the ability to use analytics to tell which ad was better.  First you looked at how many ads were being clicked on.  Second, you looked at how many of these who went to your web site actually bought a product.  After you determined which ad was better, you discarded the poor ad and created a new ad to test against the better ad.  You kept tweaking ads, looking for better and better results.  Now the top dogs in AdSense are pretty good, indeed, at using actual trial and error methods to improve their advertising.  Madison Avenue: get with the program.

Financial Regulation: Paulson Misses the Trial and Error Economy

This new regulatory proposal from Treasury Secretary Paulson reminds me of the Patriot Act.  The department has a laundry list of changes it wants.  Then there's a crisis.  At which point the department pulls out its laundry list and says, "This is the solution to our crisis."  In reality, it's just the plan that they had on the shelf for a year.  If it really would have prevented the crisis, then the Treasury Secretary should be fired for failing to push harder to get that plan passed earlier.  But of course, that's not the case.

The Wall Street Journal editorial has the key insight into financial regulations:  the market is doing its job.  People say to me, don't we need some regulation to prevent lending to people who cannot afford the loans?  Here's what happened.

1. Lenders experimented with loans to people of lesser credit quality.
2. It worked in the initial stages, so the experiments were expanded into programs.
3. The large-scale programs failed miserably, causing billions of dollars of losses to the people who invested in the loan program.

Now, do we need laws to keep these investors from lending money to subprime borrowers?  I don't think so.  It will be years before those investors will touch that stove again.

If investors won't participate in large subprime lending schemes again, what would be wrong with some regulations?  After all, a regulation that prohibited me from hitting myself in the head with a hammer would not really crimp my recreational choices.  Here's the rub:  entrepreneurs need to experiment.  Some folks who are subprime may really, truly, be good credits.  If we regulate that loans can only be made to people with good credit, then lenders cannot experiment to find out if maybe they should change their lending guidelines.

A key element of our trial and error economy is that good business practices cannot be fixed in stone.  Companies experiment, try tightening a little, try easing a little, look for under-served markets.  For example, take "stated income" loans, in which the lender took the borrowers stated income at face value, without verifying the facts.  Sounds pretty stupid in retrospect.  So let's make a law that income has to be verified.  However, you've just redlined those folks with income that is inherently unverifiable: strippers, street performers, flea market vendors, etc.  We should allow lenders to test the waters with these people.

(If you are not a regular reader of the blog, take a look at some of the articles in the "trial and error economy" theme.)

Insurance regulation?  Part of the plan is a new federal insurance regulator.  What's the problem here?  My car insurer, home insurer, life insurer, are now regulated by my state.  I have not heard of any crisis, scandal or problem here.  This is another case of a "crisis" being used to justify totally unrelated regulatory changes.

Secretary Paulson says the plan will "reestablish the federal government's role in regulating the insurance industry by reclaiming a portion of its delegation of insurance regulation to the states..."  Whoa.  I'm not a lawyer, but I'm stunned that the Treasury Secretary thinks this way.  The constitution does not grant to the federal government authority to regulate insurers, aside from the federal government's authority over interstate commerce.  There has been no delegation of power from the federal government to the states, because the federal government never had it.

Incentive Systems: Markets, Medicare, and Your Business

"Markets and Medicare" is a great article in today's Wall Street Journal by my good friend John Goodman, president of the National Center for Policy Analysis.  The article has value beyond the Medicare debate, but let's first key in on those issues.  Dr. Goodman explains how medical costs can be lowered and health outcomes improved by freeing doctors, freeing patients, and freeing entrepreneurs.  Our rigid compensation system often will not pay for the most cost-effective treatment methods, so we get locked into expensive and less effective treatments.  Not good, of course.

If you're not interested in Medicare, here's how you should read the article:  your current relationships with employees, vendors, joint venture partners, and customers may also be too rigid.  If someone in the network of relationships around your company has a new idea, will the compensation structure allow that idea to flourish?  Do cost savings techniques get rewarded, especially if they increase customer satisfaction?  It may be time to take a fresh eye to your contractual arrangements.

The essence of economic progress is the Trial and Error economy (described in a series of articles listed here, my favorite of which is this one.)  Successful companies set up systems to encourage lots of little experiments in cost savings and customer satisfaction.  The experiments measure results, so that the winners are pursued, the failures are dropped, and progress is continuous.

Nike Strategy: The Trial and Error Economy

Nike has implemented a major change in strategy, according to an interesting article in Forbes Magazine.

The company had previously advertised with a mass market focus.  Its "swoosh" logo was everywhere, as was it's great motto, "Just do it."

The new approach focuses on specific sports markets: running, golf, soccer, etc.  Rather than having a footwear division and an apparel division, the company is now organized around specific sports and activities.  Is this another ho-hum moment in corporate strategy?  I've seen companies centralize to reduce costs, then decentralize to reduce costs, then re-centralize to reduce costs, each time taking a one-time special expense to pay for the reorganization.  I've become skeptical of corporate changes, but I like this one.

When the marketing focus is mass market, it's hard to say what's working.  If you are selling more Air Jordans, is it because of great design or the ubiquitous advertising?  Nobody knows.  And thus, nobody cares.  That is, without specific data, there is no specific accountability.

By working at the sport/activity level, the segment manager becomes responsible.  There's no passing the buck to the advertising manager; the segment manager has her own subordinate responsible for segment advertising.  If the skateboard segment is doing poorly, the VP of skates cannot blame the central design department, but only his own senior designer.

Trial and error does not work well at the amorphous global corporate level, which means the key method of improving products, production, and thus profits, is lost.  However, trial and error works wonderfully in a single business line, even if the corporate honchos don't understand exactly what they are doing.

Good work, Nike.

Starbucks Strategy vs. McDonald's: 10 Possible Competitive Responses

I've used Starbucks business strategy as a way to discuss the Trial and Error Economy (here and here).  I'm not, by any means, the world's greatest expert on the company, but it provides a great vehicle for teaching about corporate strategy.  Now, according to the Wall Street Journal, McDonald's will sell premium coffee drinks made by baristas at most of their 14,000 stores.

How should Starbucks react to the McDonald's threat?  Here are some ways:

1.  Do nothing.  Best implemented with one's nose high in the air, saying that Starbucks customers would never buy coffee at McDonald's.  Would work very well for three to six months.  Ignores the reality that Starbucks' recent growth has come not from Volvo-driving college grads, but from lower-income, less educated people than they originally served.  These are people comfortable at McDonald's.
2.  Cut prices.  This is the time-honored method of competition.  As an economist, I love price cutting.  As a business consultant, I almost always advise clients to avoid a price war.  In the case of Starbucks, I'd ask the company, "Who do you think has the lower cost structure?"  Not only should we look at labor costs, but consider this: at 9:00 am, McDonald's has lots of excess capacity.  Serving an additional customer is very cheap.  At the same time, Starbucks' chairs are full and there's a line at the order counter.  Serving additional customers means real estate expansion and hiring more staff.
3.  Differentiate the product.  In the classic form, the existing customer begins to differentiate, highlighting their product superiority.  Of course, Starbucks is already selling a product that it has successfully differentiated.  The practical way to do that now, in the face of McDonald's, is a "nobody makes a latte like Starbucks" campaign (using a catchier slogan that I just suggested, but pushing that theme.)
4.  Move upmarket.  In conjunction with more product differentiation, maybe Starbucks should raise its prices, ceding the price sensitive customers to Mickey D, but pulling more profit from the loyal customers.
5.  Lock up the resources needed to make the product. Starbucks is not going to corner the market on coffee, but in many cities they have cornered the market on corners.  That is, they have leased the top spots for urban coffee locations.  McDonald's, though, is known for great real estate.  (Not great buildings, but great locations.)  They are not optimized for the morning crowd, though.  Starbucks, for example, favors locations that are on the right hand side of the street for inbound morning commuters.  In rush-hour traffic, customers don't like to make left hand turns.  I'll bet that McDonald's has ignored this.  However, using existing resources instead of building new locations is a huge cost saver.  Bottom line: I don't think Starbucks can lock up a critical resource.
6.  Build customer loyalty.  Airlines, beginning with Western Airlines but quickly followed by American, built frequent flier programs.  Now a traveler has a big incentive to travel on one airline as much as possible.  But the potential rewards from buying all my coffee at one chain rather than another?  OK, Starbucks has their prepaid card which is really convenient; I use mine a lot.  They could add a rewards element to it; like prepay $20 and get $21 worth of sales.  But if I wanted coffee and I saw a McDonald's, with no Starbucks in sight, I would not keep driving just because I had some incentive card.
7.  Go head to head.  Imagine Starbucks looking for a location across the street or next door to every McDonald's.  Some of them might not be profitable locations, but it's a way to try to get McDonald's to drop the idea of specialty coffee.  Drive them out of that line of business.  I'm guessing that Starbucks already has plenty of locations near the competition,a but it would certainly be expensive to target all, or most, of the McDonald's locations.
8.  Merge.  One of them acquires the other.  They announce the Wall Street great synergies and economies of scale.   It would be really hard to make this work, but it's tried fairly often in other industries. Investment advice: sell short the merged entity.
9. Cut costs to maintain profits while sales are falling.  This is a pretty stupid plan, but common.  In Starbucks case, either the quality of the coffee would fall, or the best employees would leave.  The company would end up a shell of its former self.
10.  Ask for government regulation.  Probably won't happen here, but it's a standard response by plenty of corporations facing competition.  They might propose licensing baristas for the protection of customers, enforcement of antitrust laws against the competitor, product safety rules that would be hard for McD's to comply with (no meat preparation in the same location that coffee is prepared, to protect against mad cow).

There's the list of choices.  (Readers, feel free to suggest additional choices in Comments.)  How should Starbucks choose?  I recommend that they narrow the list to those that could be tried in a single market, rather than company-wide.  That would be 1 through 7.  (Maybe number 9, but that has really big potential impacts on company-wide reputation.)  Then Starbucks should its manager of each metropolitan area what they want to do.  Monitor sales data carefully.  Watch McDonald's, perhaps by hiring observers to count cars in the parking lots and going through the drive throughs.  Evaluate which response works best.  And of course, let metro area managers try other strategies I haven't thought of.

By trial and error, Starbucks should be able to identify the most successful response to the McDonald's threat.  The same process can be used in most cases of competition.

Starbucks Strategy: Trial and Error at the Beginning

Starbucks began with a willingness to experiment, according to Taylor Clark's new book, Starbucked: A Double Tall Tale of Caffeine, Commerce, and Culture.  The book begins with a story from when the company had only eleven stores.  The Vancouver BC store was at capacity, and another location in the city was hard to find.  Howard Schultz saw a failing restaurant across the intersection from the Starbucks location and rented it--not to replace the existing store, but in addition to it.  So the bit about Starbucks opening a store across the street from another store dates back to the beginnings.

They weren't sure it would work, but they tried it and monitored the results.  Actually, the monitoring did not require a sophisticated statistical analysis: both the old and the new store did a great business.

We learn from this story the value of the experiment.  It sounded stupid to me.  No amount of head office analysis would have justified the new location.  Some things you have to learn by doing.

What will you get if you try this approach?  A lot of failures.  Later in Clark's book there are plenty of stories of early plans that needed adjustments.  I'm certainly not endorsing bet-the-company risks every day.  But the businesses that succeed best are continually testing the waters with new ideas, new products, and new markets.  Even if the new market is just across the street.

(Want to read that story?  Go to Amazon's Starbucked page, click the "Search Inside" page, and search for "Experiment."  Look for the entry in Front Matter (where the introduction is).  It's one of several items; what you're looking for is the book's Introduction.  That will give you the first few pages.  The first real chapter of the book is available on the publisher's web site.)