Strategic Planning Analogy #508: Profiting from Free

THE STORY
When I was in college, I was desperate to find a job to help pay my college expenses. I ended up taking a job at a call center. The job consisted of calling people to tell them they had won three “free” magazine subscriptions. All they had to do to get their free magazines was pay a small “processing fee.”

As it turns out, that small “processing fee” just so happened to equal the cost of subscribing to those magazines. So the magazines were not free at all. It was a deception. I could not stand deceiving people that way, so I quit after three days.

THE ANALOGY
“Free” is an effective marketing tool. People love to get things for free. And if you cannot do “free” then selling below cost is the next best tool. The problem is that it is hard to make a profit if you give everything away for free or sell well below cost.

Therefore, if you price something as free, you need to get income in another way. That can be a difficult problem to solve. In the story, they solved the problem through deception. That is not usually the best long-term strategy, since the deceptions eventually tend to come out in the open—and people don’t like finding out they were deceived.

In this blog we will look at a list of other ways to bridge the gap so that you can hit a price the market loves and still make money.     

THE PRINCIPLE
The principle here is that the choice of one’s pricing strategy can be one of the most important strategic decisions one can make. And that decision should not be seen as an add-on at the end. In other words, don’t build your strategy first and then decide where to set the price. Pricing needs to be integral to the entire strategy formation—from beginning to end…Why?

1) Free Only Works If the Business Model is Designed to Make it Work

First, in order to support free or below cost pricing, you need a business model which pinpoints other sources of income. If you don’t predetermine those other sources when designing the business model, they will not magically appear later. You need a justification in the business model for why additional money should flow into company (and where it comes from), so that enough money will show up to cover the losses on the core product.

The entire revenue stream needs to be looked at simultaneously, to ensure that total inflows cover your outflows and produce a profit. In this holistic approach, you may find that the model needs adjustments in order to make it all work. For example, you may need:

1.     An additional type of sales force (like people to sell advertising in addition to people to give away the product); or

2.     An additional appeal to an additional customer base (like finding a way to appeal to both premium paying customers and free customers); or

3.      A different production or product design (like a stripped down free model so that you can sell upgrades or perhaps a version more appealing to advertisers).

4.     A broader portfolio of products in the mix (like adding highly profitable french fries to the menu in order to compensate for the loss on selling the hamburger)

Unless you look at all the pieces together, there is a good chance you won’t get enough pieces right to make the whole business work.

2) Subsidies Are Becoming the Norm

The second reason why pricing concerns need to be up-front and integral to the business model development is because the idea of selling free or below cost is becoming the norm. This is no longer just a problem for people selling low cost hamburgers. It is impacting nearly every industry. For example, almost the entire social-based economy has a free element to it. The younger generation who grew up with social media have an expectation that a whole host of items should be free (or highly subsidized), like information and entertainment.

You even see it now in portions of the large durable goods and business-to-business spaces. And if it isn’t there now, it will get there eventually.

The competitive pressure is too great. To create a strategic position which stands out in a hyper-competitive, hyper-saturated environment where consumers are bombarded with too many messages and too little time, you have to exaggerate. To own quality, you need to offer ultra-high quality to get noticed and get credit for it. Similarly, to own service, you need to offer ultra-high service. To own price, you need to offer ultra-low prices. These exaggerations make it difficult to price the core products at a level to cover what it takes to achieve “ultra” status.

Therefore, one cannot count on always being to sell everything one offers at a price which covers all of its costs. It is safer to say that one should count on at least a portion of one’s business to always need some kind of subsidy in order to price at market levels.

Strategies to Win With Free or Below Cost Pricing

So how do we create strategic business models so that below cost pricing is covered? Here are some suggestions:

1)     Bundling. This is epitomized by the fast food combo meal. To sell the below cost burger, they bundle it with a high margin drink and fries, so that the whole bundle becomes profitable, even if the burger is still priced below cost. This is why salespeople try to sell below-cost computers in a bundle with cables, extended warranties, software, etc.

2)     Fees: To make money on low airfares, airlines add all sorts of fees for baggage, preferred seating, meals and anything else they can think of. Offers for products on TV add “postage and handling” fees to the low price. My telemarketing story added fees.

3)     Freemium Model: Common with social media sites are free basic sites, with others paying a premium price for premium features found in the premium version. The idea is that the more users there are on a site, more valuable it is to premium members (network effect). Therefore, it is worth it to sites like Linkedin to build a large free base in order to increase its value to recruiters (who are more willing to pay to access a large base).

4)     Subsidy (Advertising): If you can get a lot of people interested in something due to being free, then there are often advertisers (or others) who will pay to access those people you’ve gathered. This is common in entertainment (like magazines or web sites). Also, check out a doctor’s office to see how many items have ads from pharmaceutical firms. There are ads everywhere! If you can advertise there, why not anywhere else?

5)     Addiction: In the illegal drug trade there is a saying that “the first dose is always free.” The idea is that it is worth it to give away the first dose of the drug, because it will create addictive behavior that will get them coming back to pay for additional doses for many years. This can work for free chips at a casino. Also, I know of a company that gave away free bags of premium dog food. They knew that if they got the dogs hooked on the premium brands, they would refuse to eat the cheap brands anymore.

6)     3rd Party Payers:  If you cannot get customers to pay, get someone else to pay on their behalf. Lots of firms advertise “free” products or services which are subsidized by the government (through programs like Medicare). Convince children to beg their grandparents to buy something for them. Sell “free” benefits to employees by getting their employers to buy it for them (like health club memberships or pet insurance).

7)     Add-ons: Put a low price on a stripped-down basic automobile and then charge a fortune for all the deluxe add-on features.

8)     Refills: Charge a low price for the razor and charge a fortune for the razor blades. Or charge a low price for the printer and a fortune for the ink refills. Or sell the Barbie doll cheaply and charge a bundle for all of the outfits. The idea is to establish your base cheaply and then get a high margin on replacing the items that go with the base.

9)     Delayed Timing: Make it free now, but get paid later. This is the idea of extending credit so that customers pay nothing at time of purchase. This works for automobiles (just sign and drive). There has been a leap in demand for solar panels since going from an upfront purchase model to more of a pay-as-you-go model.

And the list can go on.

SUMMARY
In the hyper-competitive world of today, about the only way to create a position which stands out is by exaggerating features to the extreme. And often, it is difficult to charge a high enough price to cover the cost of that exaggeration. Therefore, one needs a business model which finds other ways to get adequately compensated. And the only way to ensure that occurs is to design it into the core business model from the very beginning. So address your pricing and income strategy at the beginning and all the way through the business model development. It is too important to try to just tack pricing on at the very end.

FINAL THOUGHTS

The whole world is becoming more like those telemarketers or the fast food combo meals. Therefore you need to think more like them and look for ways to subsidize below cost pricing.

Strategic Planning Analogy #507: Hammers Are Lousy As Saws

THE STORY

Joe the carpenter wanted to be as efficient as possible, so he decided to only carry around only one tool—a hammer.

Joe had three tasks that day: hammer some nails, screw some screws and cut some boards. Joe decided to do all three tasks with his hammer. Hammering the nails went quite well with the use of the hammer.

Getting the screws into the wood with the hammer, however, was far more difficult. By the time Joe could bang the screw into the wood with the hammer, the screw was all bent, the wood was a bit shattered, and the screw was doing a lousy job of holding the wood together.

Finally, Joe discovered that if you whack at a board long enough with a hammer, you can break it into two pieces. But when compared to cutting a board with a saw, whacking it with a hammer was less accurate in getting the cut in the right place, and the edges where it was “cut” with the hammer were all distorted and ragged. This made the board less useful than if a saw had been used.

But in spite of all the problems with the results, Joe the carpenter was still proud of his work. After all, as Joe put it, “I simplified my work by having to carry only one tool.”

THE ANALOGY

Joe’s approach to his work was rather misguided. What good does it do to simplify the number of tools you carry if the end results are awful? Replacing the screwdriver and saw with a hammer lead to a rather useless outcome. Not only would the results have been better if Joe had used a different tool for each task, it would have taken less time and been easier.

Business leaders wouldn’t be as misguided at Joe, would they? In one way, I think many are. There is this tool that businesses use, called a “budget.” The budget is a good business tool, just as a hammer is a good carpentry tool. But just as a hammer cannot effectively do all the work of carpentry, a budget cannot effectively do all the work of business.

Three of the key tasks of business management are to:

1. Effectively manage the treasury function;
2. Make sure the business operating divisions are doing the right things; and
3. Provide incentives for employees to act in the best interests of the company.

Many companies rely primarily on the budget process to do all three tasks. But as we will see in this blog, that is like using a hammer to tighten screws and cut boards. The budget is an effective tool to help the treasury function, just as the hammer is effective in hammering nails. But for the other two tasks, there are better tools than budgets. By trying to use a single budgeting process to do all three, one ends up with a mess. There are better tools for monitoring the operating functions and providing employee incentives, and they should be used instead of the “hammer” of budgets.

THE PRINCIPLE

The principle here is that companies are not doing themselves any favors by using budgets as a tool where it doesn’t belong. It is great for the treasury function, but inappropriate for many of the additional places where it is used.

1. The Budget “Hammer” Works Well on the Treasury “Nail”

The key function of treasury is to ensure that the cash of the business is properly managed. It looks for efficient (and cost effective) sources of cash when internal cash flows fall short of need and looks for efficient uses of excess cash produced internally. Timing of these actions is very important, so that the proper level of funding is available to match the fluctuating cash flow needs.

The budgeting process is a rather good tool to help in this treasury function. It provides a broad overview of cash flows over time. This helps the treasury function plan in advance so that the right amount of money is in the right place at the right time at the best price. The budget is also a good tool to share with the debt and equity community, so that they will cooperate more favorably with your cash needs. It helps build trust, so that they will provide cash at a favorable rate. Treasury should be the primary goal of the budget.

2. The Budget “Hammer” is a Poor Choice for the Employee Incentive “Screw”

However, when budgets are also used as the primary tool to incentivize employees, it destroys the integrity of the budget. Employees will try to “game the budget system” in order to insure easier and higher bonuses. This creates a budget which no longer reflects best estimate of cash flows, because the numbers are padded to improve the likelihood of a bonus. As a result, it damages not only the ability of the budget to get employees to work harder but it damages the ability of the budget to accurately help the treasury plan accurate cash flow estimates.

In addition, employees understand that there is usually more than one way to hit a budget number—and not all of these ways are equally good for the long term health of the business. For example, this quarter’s budgeted profit number can be hit by doing lots of actions harmful to long term prosperity, like improperly cutting investment in the future, cutting research, cutting maintenance, cutting quality, cutting service, overcharging customers, and so on. Since both good and bad behaviors can be used to hit a budget number, the budget is not very effective as an incentive for ensuring right behavior. It is like trying to secure a screw by banging at it with a hammer.

3. The Budget “Hammer” is a Poor Choice for the Operational “Board”

Similarly, the budget is a poor choice as the primary means of determining the specific actions of the operating divisions. The main problem is that budgets are frozen well in advance, before the year begins. As we all know, the marketplace is a dynamic, rapidly changing environment. It is impossible to fully anticipate all of these potential changes. It makes no sense to tie up your operations into budgeting straightjackets, unable to adjust to the changing business environment just because the best guess estimate put into the budget nearly a year earlier has proven to be off.

Does it make sense to not exploit a great opportunity merely because that opportunity was not in the budget? That would be like a miner refusing to take advantage of a huge find of gold in the mountain because they only budgeted to take a meager amount of silver out of the mountain. And the opposite is also true…why continue a particular action merely because it is in the budget if the changing situation makes that action no longer viable?

Budgets are typically broad-based numeric documents. They are not good at understanding strategic nuances, competitive dynamics or the actions behind the numbers.  To expect that out of budgets is like expecting a hammer to effectively cut a board.

Recommendations

To get around these problems, I suggest the following:

a) Get A Screwdriver. Get a tool specifically designed for incenting employees. To insure people are incented to do the right things, specifically outline what right things those are and reward achieving behaviors instead of numbers. For example, if you want an employee to master a skill, make skill mastery the criterion for bonus. Or if you want an employee to successfully roll out a new product or enter the Brazilian market or reduce the time to convert a plant to a new production run, then spell it out IN WORDS (specific enough to be difficult to game).  In the old days, we called that Management by Objectives which then morphed into Balanced Scorecards and now Key Performance Indicators (KPI). I think the migration may be going in the wrong direction towards fewer behavior-based words and more game-able numbers, but at least it is better than bonuses based almost exclusively on budgets. In fact, I might suggest doing the “screwdriver” in the spring and the “hammer” in the fall in order to keep budgets from creeping too deeply into the incentive process.

b) Get A Saw. Get a tool specifically designed for directing operations on what is an acceptable approach to their sphere of influence. This tool would tend to set up measures using a more strategic language. It would explain the strategic role that operational unit has within the organization. It would explain what “winning” would look like for that group. It would explain what the proper trade-offs are on attributes and outcomes. It would point the direction in which the operations are to migrate to in order to reach future strategic goals. Then the company delegates the specifics, to free up the operating unit to bob and weave with the changing environment in order to exploit the moment, provided the actions remain within the strategic boundaries.

c) Improve the Hammer. Budgets can be more dynamic. Draw up some contingency budgets in advance (based on different scenarios) so that you are ready if situations drastically change. Consider rolling budgets that adjust quarterly or semi-annually (depending on your business). Note: this becomes easier to do when the budget is freed by no longer having to also work as a screwdriver and saw. Also, consider doing the screwdriver and saw work PRIOR to finalizing the budget. That way, the budget more accurately reflects what will actually be done, instead of being just a wish list. Remember, the budget shows financial outcomes which are determined by action inputs. So get the inputs figured out before declaring the outcomes.

This is not to say that budgets are totally ignored outside of treasury. The budget provides discipline for the more routine aspects of business. The budget can help to determine if the desired strategy is achievable under current cash constraints. And if the budget has no connection to actions, it ceases to accurately reflect what the future cash situation will really be. So a little bit of the strategy needs to permeate the other areas. But it shouldn’t be the primary driver.

SUMMARY

Budgets are very useful, but they should not be the master tool to drive all of your management concerns. Budgets are most effective when centered primarily on the needs of the treasury function. A second, more action-related tool would be used to incent employees and a third, more strategic tool would be used to manage operational units.

FINAL THOUGHTS

Efficiency is not the same as effectiveness. Having a single tool may appear efficient, but it may be so ineffective that it destroys your ability to properly run your business.

Strategic Planning Analogy #506: Perspective

THE STORY

Let’s assume that a government transportation committee examined whether to add more lanes to an urban highway. 

The conclusion of their study went something like this:

Yes, we concede that during a brief period of the day (rush hour), the highway becomes highly congested and traffic stops moving. However, outside of rush hour, the highway is operating well below capacity and flows very smoothly. Since the highway is well below capacity for approximately 85% of the day, we see no reason to add any lanes. After all, 85% efficiency for a highway is quite acceptable.

The response from a consumer group advocating extra lanes went something like this:

The reason why the highway flows well outside of rush hour is because that is not the time when the highway is most used and most needed. According to our research, 85% of the cars using the highway use it during the congested rush hour period when cars greatly outnumber the current highway capacity. Since the highway is well above capacity when 85% of the drivers are on it, we see a clear justification for adding more lanes to the highway. After all, 85% inefficiency for a highway is quite unacceptable.

So is the current highway 85% efficient or 85% inefficient?

THE ANALOGY

Strategy creation involves making decisions. Facts are a key input for making those decisions. In fact, I had a boss once who on a daily basis would say that he would not make any decisions unless they were “fact-based.”

But how reliable is the “fact-based” approach? In the story above, two groups used facts to reach a conclusion. The transportation committee used facts to “prove” that the highway was 85% efficient. The consumer group used facts to “prove” that the highway was 85% inefficient. These facts lead each group to come to a different conclusion about adding lanes to the highway.

Was one group’s facts right and the other group’s wrong?  No, both groups had equally true facts:

a)     85% of the TIME OF DAY the highway had excess capacity.

b)     85% of the TIME OF DRIVERS using the highway was during times of inadequate capacity.

So what is the right “fact-based” decision? Obviously, we need more than just these facts to reach an acceptable decision. And when it comes to strategy we need more than just facts as well.

THE PRINCIPLE

The principle here has to do with perspective. Facts alone do not automatically lead to the proper conclusion. It is only when we place those facts within the context of the proper perspective that we see what is the right thing to do. Therefore as much care and effort should be given to developing the proper perspective as is given to acquiring the right facts.

Perspective depends on two items: Where one is looking from and what one is looking at. In strategic analysis there are usually multiple places to look from and multiple items to look at. If you miss out on examining some of these options, you may come to the wrong conclusion.

Perspective #1: Where One Is Looking From

From the eyes of the transportation officials looking at the highway from afar, what they saw was smooth operations nearly all day long. From the eyes of the drivers on the highway, nearly all of them saw congestion nearly every moment they were on the highway. Their different perspectives cause them to see the situation very differently.

A similar situation can occur in developing your strategy. From the eyes of the executives inside your organization, you may see a particular strategic option as ideal for your bottom line. But how does that option look from the perspective of other eyes?

Perhaps your decision places added burdens on your suppliers, causing them to no longer want to supply you or only supply you if they get added compensation for those added burdens. That added compensation might wipe out a lot of the original advantages you saw from the internal executive eyes. A similar situation could also occur with your distributors.

Or perhaps your decision triggers an adverse reaction from your customers when they see it. This problem could not be seen with the internal executive eyes, but was quickly apparent to the customers’ eyes.  The unperceived adverse consumer reaction could make that original strategic option no longer as viable as first seen.

Or perhaps when your competition sees the strategy, they perceive it as a bigger threat than you thought and they react far more aggressively than anticipated. This aggressive reaction wipes out your perceived benefit.

Or maybe when those ideas from headquarters get down to the factory floor, they cannot be operationalized as smoothly as one thought. Something gets lost in the implementation on the factory floor which hurts the strategy’s effectiveness.

Therefore, before making a decision, step away from the pile of facts and look at the situation through other sets of eyes. How will the decision be seen by all the other relevant parties (suppliers, distributors, customers, competition, front line employees, the government, etc.)? How will their perspective affect their behavior, and how will that behavior impact your strategy?

You may find a need to modify your strategy in order to get all of the players see the situation in a manner which moves them all in a favorable direction for your business.

In addition, consider how you communicate your decisions, so that you can help influence how others see it. How the decision is communicatted may be just as important as the decision itself when it comes to implementation.

Perspective #2: What One Is Looking At

In the story, everyone was looking at the same issue: what is the proper number of lanes to have on the highway.  It assumes that the only way to address congestion is by looking at lane-count for the highway. Is this a fair assumption?

Perhaps there are other solutions one could look at, like:

a)     Increasing use of public transportation;

b)     Convincing more people to use alternate routes;

c)     Getting businesses to stagger the hours employees work;

d)     Reallocation of traffic direction for the current lanes depending upon time of day (e.g., more inbound lanes in the morning and more outbound lanes in the evening).

e)     Financial incentives for carpooling.

f)      Building a separate road nearby.

How do you know you are making the right decision if you have not fully explored all potential options? All those facts you’ve gathered may only be applicable to examining one particular option. If you look at the problem in a different way, you may find that you need a different set of facts altogether.

Remember, business success usually depends on offering a superior solution to your customers’ problems. There may be many distinctively different ways to solve that problem. Unless you examine many alternatives, you may not offer the right solution.

Perfecting the obsolete is not a path to success. After all, even a mediocre smart phone is far superior to the best Morse code telegraph solution, no matter how much time you spend trying to perfect it.

So don’t frame your strategic discussion too narrowly. Before deciding on the best way to do something, first make sure it is something worth doing. First frame the discussion around finding the best solution rather than just finding ways to improve the status quo.

SUMMARY

Facts are useful, but facts alone are incomplete. Facts are only useful if seen from the proper perspectives. Therefore, before deciding a course of action, improve your perspective by:

a)     Looking at the problem through all the eyes of the various people who have an influence on the successfulness of the strategy (suppliers, distributors, customers, competition, front line employees, the government, etc.).

b)     Looking at multiple ways to solve the problem. Creative, superior solutions may look nothing like the status quo.

FINAL THOUGHTS

Great strategic solutions may take you into uncharted territory—doing things in a way they have never been done before. There won’t be a big pile of facts to help you in uncharted territory. And if you wait to act until you can get a big pile of facts, someone else will have already captured that strategic space. Perspective helps fill in the holes when facts are hard to come by.