Tuesday, June 4, 2013

Strategic Planning Analogy #503: Unbundled Subsidies


When I used to eat at a fast food restaurant, I’d order a burger and fries. But then I realized that the low price menu would have burgers for about the same price as those french fries. After that, I skipped the fries and ordered a second burger.

My logic went like this: Fries are merely grease sponges—just empty calories filled with fat and covered with too much sodium. By contrast, at least with the cheap burger I was getting some protein. They cost about the same and filled me up about the same and were equally tasty. Therefore, instead of getting a burger and fries, I started getting two burgers.

That was all fine by me. But I don’t think the fast food restaurants enjoyed my new decision. After all, they made a good profit on the fries but were losing money on that low-cost second burger.


No matter what business you are in, your customer has choices. Even in a monopoly situation, the customer has choices. They can choose a substitute from another industry or choose not to purchase at all.

Many of the decisions businesses make affect those choices, such as product assortment and pricing. When the fast food industry added low-price value items to their menu, they changed the way I made choices about how I eat.

Unfortunately, my change was to the detriment of the fast food restaurants. I switched from high-margin fries to a negative margin value burger. And it was THEIR decision which caused my changed behavior to work against them. Their actions made me a less profitable customer.

So don’t limit your discussions about what is strategic only to big issues like positioning and productivity. Even smaller issues, like the pricing of a burger, can have a huge impact on performance for years to come.

Think of it like making a small decision about whether or not to bring a woodpecker on board your boat. It’s just a little bird. But one day the woodpecker pecks a hole in the boat. Even then, one little hole is not a big deal—it can be repaired. Over time, however, the woodpecker pecks a great many holes in the boat and it sinks. It is the accumulation of many small, bad consequences from that one little decision about birds which sank the boat.

This is also true for business. It is usually not the big decisions which bring a company down. After all, executives spend a lot of time making sure they get the big decisions right—that’s why they’re called “Big Decisions.” No, it’s the accumulation of many small daily decisions (decided poorly) which sink a company.

Little decisions start chain reactions in how customers make choices. Any one of them may not hurt you, but in total they can create a disaster. If those daily decisions are not made within a strategic context or are not thought through thoroughly, they can destroy the grand design or your larger strategy. After all, your strategy is not what you say, but what you do. And what you do is determined every day with those small decisions. So strategy needs to “sweat the small stuff.”


The underlying principle behind the fast food mess is “unbundled subsidies.” And if you are not careful, unbundled subsidies can ruin business models for a lot more industries than just fast food.

1) The Origin Of Subsidies
Many industries are highly competitive. This creates severe downward pressure on prices (competition won’t let you raise prices). And to top it off, we’ve trained consumers to not have to pay full price for anything. Just ask the customers of JCPenney. When JCPenney eliminated sales, they lost over one quarter of their business. It turns out that people expect deals and won’t willingly pay full price.

Therefore, highly desired items are often sold at little to no margin (or even a negative margin). So how do you make money when your key items are sold at or near a loss? The answer is subsidies. You get customers to buy additional items that have a high enough margin to offset the loss on the core.

In fast food, the high margin drinks and fries subsidize the low margin burgers. On big-ticket electronic items, high margin extended warranties traditionally subsidized the low margin device. The base sticker price on a car is kept low, but they get you with high margin upgrades, accessories, financing and repair work. Low margin industrial goods are often subsidized with service contracts. Low margin printers are subsidized with high margin ink.

It has become the way of the world. In order to compete on price versus competitors and satisfy customers who want a deal, core items are becoming like loss leaders, forcing businesses to surround them with subsidies in order to survive.

2) Unbundling of Loss Leaders and Subsidies
Originally, the idea was to try to bundle the loss leaders and subsidies as tightly as possible. That way, every purchase could still remain profitable because the loss leaders and subsidies were sold together. In the fast food world, they were called “Combo Meals”—you had to buy the whole bundle of food to get the deal.

Other industries followed with their own version of the bundle. Cable and telecom companies bundled phone/internet/TV. HP used patents so that you could only use their high margin ink on their printers.

But the hypercompetitive world started causing the bundle to fall apart. Between 2000 and 2002, McDonald’s rolled out the Dollar Menu in the US. Now you could buy the cheap items without also buying the subsidies.

In the telecommunications industry, companies started turning subsidies into additional loss leaders. For example, charges for texting used to be the subsidy for voice calls. Then texting became free and had to be subsidized by data downloads. I was talking to someone in the industry who said it is a constant race to find the next subsidy, because someone in the industry is always trying to turn the current subsidy into a loss to get an edge.

And then the dotcom world came up with the “Freemium” model. In this model, most people pay absolutely nothing for the service (it’s free) while a small minority pay for a premium version. This is how linkedin works. I pay nothing for the basic service because it is subsidized by a totally different customer, usually a recruiter, who buys a premium version. Or Zynga had most people playing Farmville for free while a small minority subsidized the whole system by purchasing virtual farm equipment.

This all starts to become dangerous territory when loss leaders and subsidies are unbundled. In fast food, you get people like me who now load up on the loss leaders and avoid the subsidies. In telecommunications, there is the risk of running out of new sources for subsidies to support the ever expanding list of loss leaders.

The price of loss leader consumer electronics got so low that it became “disposable pricing.” If something went wrong, you could afford to just replace it, erasing the need to buy the extended warranty subsidy.

The freemium model runs the risk of the two audiences getting out of balance, with not enough payers to subsidize the freeloaders. Zynga just announced huge layoffs because they are having trouble with their business model.

And it is hard to go backwards on these trends. The telecommunication folks want to dial back the unlimited data plans but are meeting strong resistance. When the fast food people try to dial back the value menus, the customers revolt. Newspapers have been trying to get people to pay for the online version (which used to be free) with only varying levels of success.

Once you set up a subsidy system, you redefine the expected cost for the loss leader. “Regular” price becomes the loss leader price. Consumers see anything higher as outrageously high pricing. This makes it very difficult to reverse the pricing once the loss leader position has been made.

But now that the subsidies are becoming ever more unbundled from the loss leader, it is more difficult to ensure that enough subsidies are sold to offset the loss leader prices. Profits become more elusive. Risk of failure is increased.

3. Lessons Learned
What can we learn from this? First, small actions today have consequences well into the future. And it may not be initially obvious today what those consequences may be. Therefore, before making some of these small actions, we need to take time to consider their impact on the larger picture. Otherwise, we may unintentionally be dismantling our grand strategy one brick at a time.

Second, if strategists (or strategic thoughts) are only limited to an annual offsite meeting, they will be unable to adequately impact all those little day to day decisions. We need to get strategic context around a larger proportion of our decision making.


Strategy should be more than just big thoughts around big decisions. It needs to permeate the organization more regularly and further down the organization, where many of the more mundane decisions are made. After all, these more “mundane” decisions can accumulate to the point to where they threaten the entire strategy.


How many decisions are made in your business without asking the question “How can this decision impact the long-term viability of our strategy or company?”

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