The question is why is she “wasting” so much money?

Given my past training in economics, I could not accept that this woman (let’s call her “Elaine”) is behaving irrationally – I searched the deepest corners of economic logic to explain Elaine’s behavior. One saving grace is that she has not spent so much that she could have purchased an Escalade outright. This condition allows me to create two key assumptions (every economic theory needs convenient, simplifying assumptions):

1. Elaine’s, uh, business cannot be conducted without an Escalade. The style, the comfort, etc… is an absolute necessity to demonstrate to her customers that she is one of them, rich and powerful and ready to deal.
2. Elaine’s business is very uncertain. She lives from deal to deal. She works hard to close every deal, but she cannot afford to count her chickens more than a few weeks out. (Maybe she sells real estate to high-end clientele?!?)

These rationalizations mean that Elaine cannot risk committing to a $60,000+ purchase or even a less expensive lease, but each deal earns her enough to generate the $500-1000/week it costs to rent the Escalade she requires for her business. When she closes another substantial deal, she happily skips to the rental car agency to ask for another extension.

So is there a point at which Elaine is better off purchasing the Escalade? Not at all. As long as she is never “sure enough” about a $60,000+ income stream, she is better off buying what she can afford and still conduct her business. (Not to mention few banks, if any, especially these days, would even consider loaning money to Elaine for buying the car or for funding the business given the looming uncertainties!) At some point, she may save enough money to buy the Escalade outright, but it is also possible she has other expenses that prevent her from saving enough Escalade-money.

In other words, Elaine may be doing what so many people do NOT do – buying what she can afford now and not burdening herself with debt she can only aspire to afford.

This parable reminds me of something Nassim Taleb – the famous author of “The Black Swan: The Impact of the Highly Improbable” – said about confidence and debt:

“…overconfidence translates 1-1 into accumulation of debt…I know I’m going to make an 8% return, and if I underestimate my error rate I will know with certainty I’m going to make an 8% return, so if I borrow at 5% I can leverage up the wazoo. (“Taleb on Black Swans, Fragility, and Mistakes“, interview with Russ Roberts on EconTalk, May 3, 2010).

Go Elaine! And happy deal-making!

A Cadillac Escalade

General news
ChannelWeb: “Amazon Gives In To Publisher’s Demands For Higher E-Book Prices”
BusinessWeek: “Amazon’s E-Book Price Reversal: A Mixed Blessing” – considers the impact of pricing on demand for e-readers and e-books.

Opinion
The Big Money (Marion Maneker): “Amazon’s Self-Defeating War on Publishers”
Tobias Buckell: “Why my books are no longer for sale via Amazon”

Maneker recognizes that sales of e-books will inevitably dominate sales of physical books and recommends the following:

“There is…a compromise that might benefit all parties. Amazon has been pushing the Kindle to heavy users of frontlist books. But the agency terms offer an opportunity for backlist books that gives everybody a win. With the agency model, a backlist book becomes a goldmine for publishers, authors, Amazon and Apple. Priced at $9.99, the publisher receives pretty much the same amount of money under agency terms as it would have for the wholesale book. Still protecting their preferred terms for electronic books, the publishers could maintain their 20-25% of net receipts formula for author royalties because the author would be getting more money ($1.75 vs. $1.05 in paperback royalties on a $13.95 physical paperback). Leaving the publisher with $5.25 in margin, more than they’d get from the physical paperback. When you include the savings in paper, printing and binding, freight and warehousing, the margin jumps even more.

This detente would flood the book market with titles that have stood the test of time where demand remains strong–a good incentive for Kindle and iPad buyers–while protecting the physical book distribution business. It would also buy publishers some time to divest the distribution assets that will inevitably erode as e-book selling takes off.”

Buckell write an extremely long piece, but it is worth the read given it comes from a concerned author. He laments that Amazon is attempting to abuse its market power to fix prices and thwart publishers’ ability to implement dynamic pricing. Buckell also describes process of making books in extraordinary detail. He explains his interest in writing this piece in personal terms:

“I’m not trying to exhort anyone to do anything, but to explain the situation I’m in, and to educate. I’m seeing a lot of people state things with certainty (points I try to knock down above) who have no involvement in the trade.

A lot of readers are going to take this out on authors, and I wanted to basically show my homework to explain things that people may not be aware of. People toss out prices of what eBooks ‘should be’ who’ve never even stopped to understand how the math of something like this works. They demand things they’d never demand of a jacket salesman, just because they think economics and supply and demand and volume don’t apply to eBooks. They do.

Seriously. I’ve thought about these things a lot. Mostly because I have a novel series that has not been renewed, and I keep running the numbers to see if I could write it as an eBook, and when I run these numbers, I come up looking at making a few thousand dollars for half a year’s worth of work based on how eBook sell now. Yes, there are a few J.A. Konrath’s selling well on Amazon, but as I’ve linked, other authors aren’t automagically selling thousands of eBooks there. Most who follow these footsteps sell hundreds. Not everyone becomes JK Rowling.”

The last point reminds me of Nassim Taleb’s “The Roots of Unfairness: the Black Swan in Arts and Literature“. Taleb notes that artists and writers work in a field where a few successful people take the majority of the rewards in the industry. He attributes this situation to largely unrecognized random events (luck!) that are highly improbably but have large impact (“Black Swans”). Moreover, he observes:

“The occurrence of the Winner-Take-All effect in any form of intellectual production has been accelerating along with the speed of reproduction and communications.”

So, ironically, e-books will continue the democratization of publishing and reading (through convenience, easy access, and low costs), but the percentage of winners may narrow further even while providing those winners more wealth than ever.

“This action arises out of a dispute between NFA, on behalf of all owners of franchised Burger King restaurants in the United States (the Franchisees), and Burger King Corporation (BKC) concerning BKC’s actions in compelling the Franchisees to sell a food product known as the BK Double Cheese Burger (DCB) at no more than the maximum price of $1.00, and BKC’s claim that it has the legal right to dictate price points under the respective Franchise Agreements (the Franchise Agreements) previously entered into with the Franchisees – even if those prices are below the Franchisees’ cost and cause them to incur a loss on sale of the product.”

The core of the complaint is as follows:

“The provision of the Franchise Agreement at issue is Section 5, addressing ‘Standards of Uniformity of Operation.’ It provides that ‘BKC shall establish, and cause approved suppliers to the BKC System to reasonably comply with, product, service and equipment specifications.’

While these provisions address standards of uniformity for various operational issues, including menu items, hours, and uniforms, nothing states that BKC has the right to impose mandatory price points for product sold by the Franchisees. The dispute between the parties is triggered by the position recently taken by BKC, contrary to decades of practice, that the general language of Section 5 gives it the power to set prices for its independently owned franchises…Since at least the 1960′s (if not back to the beginning of the BKC franchise system itself), BKC never attempted to unilaterally impose or require a price point for products sold by Franchisees, and did not take the position it had the right to do so under the Franchise Agreements.

After the formation of [the NFA] and a Marketing Advisory Committee in 1989 and shortly thereafter, BKC did not attempt to set, much less enforce, mandatory price points for its franchisees without the agreement of a supermajority of the franchisees.”

Burger King has responded that “the litigation is ‘without merit,’ particularly after an earlier appeals court ruling this year showing the company had a right to require franchise owners to participate in its value menu promotions.”

The legal issues will likely get resolved by determining which contracts are legally binding and what are the conditions for enforcement. I am much more concerned with the strategic and economic issues.

The price cut on the DCB is dramatic; the drop from $2 to $1 positions the DCB below McDonald’s DCB priced at $1.19. The gross margin loss of -10% is significant; the DCB costs on average $1.10 to make. The complaint notes that no other item on the BKC value menu loses money. Based on this loss, franchisees rejected the first proposal in 2008 and rejected it twice by vote this year.

In “$1 deal may boost profits,” the Miami Herald describes an analysis generated by a franchisee that concludes that the $1 DCB is a money-loser:

“…financial models run by one Illinois franchisee and circulated among franchisees across the country suggest that [the $1 DCB] won’t drive enough sales to offset the margin pressure. The franchisee models suggest that the bottom line impact for restaurants would be a loss of between $489 and $930 depending on the percentage of total sales generated by the value menu.”

However, management has its own analysis (and assumptions) showing the $1 DCB is a winner. Again, from the Miami Herald:

“Based on numbers Burger King provided to franchisees, the company projects that the double cheeseburger will lead to a 5-percent increase in restaurant sales. That will translate into an increased bottom line profit of $365 per restaurant based on $105,000 in sales, according to the analysis.”

How could the franchisees and management come to completely different conclusions on the merits of this pricing strategy? Soda and fries make the difference. Soda and fries are higher-margin items. If the cheap DCBs generate extra sales traffic that buys soda and fries, then it is possible to make up the loss in profit from the DCB. In fact, BKC management is relying exactly on this dynamic. The McClatchy-Tribune reported on Nov 13, 2009:

“During an 18-month test, the $1 double cheeseburger had a negative impact on gross profit margin, Burger King said, but restaurants increased gross profit because consumers added high profit items like sodas and fries.”

In “Burger King’s battle cry: $1 burger,” the Chicago Tribune reports how the local optimization can invalidate the attractiveness of a mandatory $1 DCB promotion:

“John McNelis, president of the real estate division of Mirabile Investment Corp., owner of more than 40 Burger Kings in the Memphis, Tenn., area [states]: “…in some price-sensitive markets, you are just selling a bunch of double cheeseburgers…”

The cheap DCB pricing strategy works if soda and fries are “complementary products” to the DCB. However, if these products are truly complementary, then the more profitable pricing strategy is to make sure that DCB-buyers purchase soda and/or fries by bundling the products into one offering. In other words, customers can only buy the DCB for $1 if they also buy soda and/or fries for a price that generates a profit for the entire bundle. Without this bundle, BKC is using a loss-leader strategy in the hopes that the extra foot traffic will behave in a profitable way.

I suspect that BKC is not bundling the $1 DCB with soda and fries because the bundle would work counter to its efforts to attract increasingly price sensitive customers (high demand elasticity) and would obscure its price positioning versus McDonald’s. Putting the reported analyses aside, I suspect that when BKC runs its global optimization, it finds that it has enough markets with customers who will buy the bundle on its own merits. Absent profits, BKC could still justify the program based on customer retention in the hopes that customers stay loyal to the brand even after the money-losing promotion ends (a much shakier proposition in the highly competitive fast-food category). The franchisees run a series of local optimizations and find too many individual franchisees who lose money to make the program worthwhile as a mandatory offering. Apparently, there are enough of these profit-losing franchises to motivate the lawsuit (according to the class action complaint, about 75% of franchisees belong to the NFA). Indeed, the diversity of markets explains why most discount promotions amongst franchises include the caveat “at participating locations only.” The local optimization typically dominates the global optimization.

Burger King’s August 25th conference call to discuss fiscal fourth quarter 2009 earnings provides additional clues into management’s rationale for implementing a mandatory $1 price point for the DCB (quotes from the transcript provided by Seeking Alpha).

Management describes how it used controlled experiments to measure the potential success of a $1 DCB:

“…we have probably now well over 40 markets in the country that are on $1 Double Cheeseburger and we’ve actually seen a pretty steady check performance…And we’ve really been pleased with what our plans were for check dilution versus what’s really happening in those markets.

…there’s no question that the $1 Double Cheeseburger through its adoption in increasing amounts of markets in the U.S. has helped to improve traffic. So we have seen month-to-month-to-month improvements, a narrowing if you will on our traffic losses nationally and we have certainly seen the markets that have adopted the $1 Double Cheeseburger move into some very strong performance as it relates to traffic.”

Burger King management is eager to reduce losses in traffic. It is probably no surprise to anyone that discounting a burger by 50% will drive increased traffic. There is no indication here that the promotion is actually making money, only that it is losing less money than expected.

Again:

“…we modeled for some GPM [gross profit margin] dilution in the business case for $1 Double Cheeseburger but so far all the test markets have been outperforming in terms of GPM dilution. In other words it has not been as deep as we originally thought. What you really kind of see happening is the effect of this discounting is sort of offsetting the price increases that we’ve taken in the past which would kind of cause for the level check if you will that you’re seeing.”

There is no explanation here that sales of sodas and fries are specifically making up for the profit loss on DCBs. Instead, it seems that price increases on a variety menu items have given BKC the extra cushion it needs to justify using the DCB as a loss-leader. Management does not provide details on these price increases, but, in general, they seem odd given the existing competitive environment and sluggish economy. All together, it seems that traffic is the prime motivator for the promotion – with the assumption that short-term profit-losses will somehow give way to longer-term profit gains.

Finally, it seems competitive pressures are forcing Burger King to take extreme measures:

“…we have to be aggressive on value for the money. There’s no way you can turn on a television set and look at any retail brand in any space and not hear language that talks about price points and value. And we’re no different. Now our value for the money equation also includes talking about a superior tasting product with flame-fresh taste. It includes featuring our superior size versus McDonald’s on our Double Cheeseburger. And yes it’ll continue to pound on the $1 access.”

In the end, BKC’s global optimization is apparently not convincing enough for the franchisees who are presumably more concerned with their individual local optimizations. Certainly, the NFA should not have filed its class action complaint if BKC’s market tests demonstrated comprehensive profit gains from a preponderance of successful local optimizations. A global optimization that delivers average profit gains across the system is insufficient to justify a franchise-wide, mandatory pricing strategy. If this averaging is indeed the true source of the conflict, it is akin to averaging the net worth of Bill Gates and your home town and concluding that your home town would be filled with millionaires if Mr. Gates moved in.

This lawsuit will be fascinating to follow as it could provide additional insights and clarity into BKC’s pricing strategy and the actual data used to justify it.

Demand Elasticity
Subway’s $5 footlong promotion was so popular, so fast, that it caused inventory shortages throughout the company. This surge in sales volume generated more revenue AND profits starting with the pioneering franchise: “…food costs did rise as a percentage of sales, but that was offset by the overall boost in volume and the increased productivity of …employees, who had less down time. Even after adding two new staffers, [franchisee] Frankel made money on each $5 sandwich.”

In other words, the footlong sandwich used relatively more expensive food than the typical sandwich, but sales volumes increased the proportion of time employees spent making sandwiches versus standing idle. The biggest bonus likely came from the incremental demand created by the promotion. The new demand created by the promotion directly added to revenues and profits. The lower pricing brought new customers to stores and (presumably) encouraged existing customers to buy more sandwiches. Subway discovered that these sandwiches have very high demand elasticity (for reasons described in the article), meaning that the percentage increase in demand was very high relative to the percentage change in price. The menu of higher pricing had prevented Subway from tapping into a hidden reservoir of demand. (Note that food service consultant Dean Dirks speculates that Subway’s promotion is actually a money-loser).

Controlled Experiments
Subway managed to execute this powerful pricing concept without analyzing past transaction data. Instead, Subway used the more direct approach of controlled experimentation.

Controlled experimentation allows a business to try out an idea in a well-defined place and time. This setup facilitates convenient data collection and fast analysis of the data. If the idea works in the controlled setting, then expand the trial into a slightly larger controlled setting. Repeat the process until the recipe for success (or failure) appears sufficiently confirmed and understood.

In Subway’s case, the numbers spoke loud and clear. Profits and revenues soared for Frankel soon after launching the promotion at his two franchises in Miami. It ran for a year before it was tried at another Florida location, this time in Ft. Lauderdale: “On the first day of the promotion, the store nearly ran out of bread and meat. Sales doubled.” Next, the promotion expanded throughout South Florida and met more success. Despite this winning record, Subway’s franchisee marketing board still voted down a proposal to expand the promotion nationwide. Additional successes from “Washington to Chicago” finally convinced the board to approve nationwide expansion.

Key Lessons
The article does not count how many controlled experiments Subway has run in the past that began successfully and yet ended in failure. We also do not know how many “bad” ideas the board must endure at every meeting. (Many stories about success in business suffer from “survivorship bias” where only proven winners make it to the front page and the losers of the past are long forgotten). However, a key lesson in this story is that ideas for change are strengthened when backed by evidence and data. Subway was fortunate to own an infrastructure conducive to running and maintaining controlled experiments and fortunate to stumble upon an idea whose success was so undeniable. Even if your business is not similarly fortunate, applying the lessons of pricing to demand and of generating evidence through experimentation will certainly drive measurable improvement in your business.

Without data, we can have no impact. How can anyone really know whether or not a tax holiday not only works or is even worth its cost to the state budget? Certainly, everyone enjoys tax-free shopping, but the cost may outweigh the benefits if, for example, the state is not able to fund other important projects or increases taxes somewhere else to make up for the revenue gap.

These lessons apply in business as well as government. Without data to measure performance, business plans and strategies are subject to the whims of “gut instinct” or personal biases and subjectivity. One person’s success can easily be another person’s failure and power relationships may win the day instead of what actually improves profits.

How could the state of Georgia attack this problem? The first step is the collection of the retail data. This data needs to be daily so seasonal and cyclical patterns can be accounted for. The second step is to consider controlled experiments. For example, run the state holiday on different dates in different counties, skip a year, or change the dates around from year-to-year. In other words, establish a set of data than can be used as the control for comparison of performance. If the quantity of data or the number of stores present large obstacles, establish the data points for select stores that have an established record of sales in the local community. At this level, every effort should be made to track the specific items that consumers purchase as well.

I strongly suspect that if the state of Georgia applied some simple analysis to this program, the results will surprise them!