THE STORY
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 PRINCIPLE
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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