I’ll Have Another Order of the Escalade, Please

My wife recently relayed to me an odd story told to her by a car rental agent. This agent told my wife about a woman who for months has rented the same Escalade over and over, renewing her rental agreement for a few weeks at a time. Escalades are considered premium/luxury rentals, so the bill has mounted quite rapidly. At this point, she could have easily taken all that money she spent and bought herself a new, albeit modest, car.

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
A Cadillac Escalade

Why Is the Middle Seat So Valuable On AirTran?

AirTran Airways provides multi-tiered pricing for advance reservation of seating in its coach class. AirTran differentiates its pricing by positioning vertically in the plane, but not horizontally. That is, for some reason, AirTran charges the same price for a middle seat in the same row as an aisle and middle seat. AirTran does not charge passengers when the airline assigns the seating.

Exit row seats are the most expensive at $20 per reservation. Exit row seating provides extra leg room. Zone 1 seats are located toward the front of the coach section and offer priority boarding privileges. The first rows in this section cost $15 while the remaining rows in Zone 1 cost $13. All remaining coach seats cost $6 to reserve in advance.

Most travelers consider the middle seat of plane the equivalent of hell in the sky. However, on AirTran middle seats actually get reserved BEFORE the supply of aisle and window seats run dry! I would expect such behavior only if middle seats actually cost (a lot?) less to reserve than aisle and window seats AND passengers are charged even when the airline assigns the seat.

The graphic below shows a sample grid for selecting a seat on an AirTran flight. The text bubble provides basic information about any seat of interest. Note that numerous middle seats are reserved even though windows and aisle seats are available on either side. That is, these seats are most likely reserved by solo travelers who are free to choose any seat in coach. (It is possible that AirTran has blocked these seats, but I am at a loss to provide a rational explanation for such a policy).


Grid for reserving a seat on a typical AirTran flight
Grid for reserving a seat on a typical AirTran flight

Source: AirTran
(Click for a larger view)

I have not been able to figure out why a solo passenger would pay $6 to reserve a middle seat when it is flanked by available aisle and window seats for the same price. However, I do know that under such conditions a person who prefers aisle and window seats to middle seats should consider saving money and taking his/her chances with the random assignment process.

For example, in the case above, there are only five middle seats available outside of Zone 1 and the exit row. There are 23 aisle and window seats available (the text bubble covers a few of them). Thus, assuming a purely random process and assuming that AirTran sells no more tickets, a passenger has an 82% chance of getting the (presumed) higher quality seating for free. Otherwise, a passenger could pay $6 to avoid the 18% chance of getting the dreaded middle seat. The “expected value” of this choice is a mere $1.08, well below the $6 the airline charges. (Conceptually, if you are unlucky enough to draw the middle seat, you could pay $6 to switch to an aisle or window). Personally, I am willing to take my chances with the random assignment with these odds and costs!

Only passengers who are trying to keep a party seated together should be willing to pay a non-zero price for the middle seat. If there are enough people who think like I do, AirTran will increase revenues in the above situation by reducing the price of the seats in relative over-supply, in this case, the window and aisle seats. Otherwise, most passengers reviewing their options will choose to wait what for a seat assignment at the time of boarding.

Having said all that, my choice might change for a red-eye flight or after flying four times in a row in a middle seat!

Waste Management Collects Its Dirty Data in the Field

{Spoiler alert! This post reveals the story of a previously aired episode of “Undercover Boss“}

After watching this year’s Superbowl, I left the television remain turned on and discovered a CBS show called “Undercover Boss.” On this show, top executives disguise themselves as lower level employees to review company operations from the perspective of the average employee. The executives are essentially conducting field studies and collecting data to get the real “dirt” on their respective companies.

The particular episode I watched featured Waste Management (WM):

“Larry O’Donnell, President and C.O.O. of Waste Management, works alongside his employees, cleaning porta-potties, sorting waste, collecting garbage from a landfill and even being fired for the first time in his life.” (aired February 7, 2010)

O’Donnell visits five locations. He discovers not only is he incapable of doing most of the jobs his employee do on a routine basis, but also some of his efforts to increase efficiency are having the exact opposite impact and lowering employee morale. His path of discovery demonstrates the power of collecting data firsthand, the limitations of creating corporate strategy in the abstract or using numbers bereft of direct experience, and the importance of directly monitoring results from the bottom to the top. Granted, these observations occur in front of a camera, so employees have incentives to put on their best show. However I was convinced that most of the workers used this opportunity to expose the difficulties they face on the job.

I briefly summarize O’Donnell’s experiences by site and follow with some lessons learned:

Recycling Site
The conveyor belt transporting trash through the facility moves extremely fast. As a “trainee”, O’Donnell makes numerous mistakes and is exhausted by the time he retires to his hotel. He is dismayed to learn that employees are docked two minutes for every one minute they report late after lunch. The site manager maintains vigilant watch over the entire facility using a battery of security cameras installed in his office. The strict enforcement and tight surveillance are an on-going source of grief amongst employees.

First Landfill
O’Donnell is tasked with picking up litter blowing across a hill adjacent to the landfill. O’Donnell must fill at least two bags of trash every ten minutes, but, once again, he is not up to the task. His performance is so poor that the supervisor fires him from the job. It is interesting to note that the supervisor does not oblige O’Donnell’s request for guidance on technique because it is “…not rocket science. It’s a very easy job.” It turns out that this supervisor is disabled and ignores his pain to report to work every day. Thus, he has little sympathy for able-bodied employees who cannot perform. O’Donnell is impressed with the supervisor’s will, attitude, and stamina, but he fails to note the opportunity to improve knowledge transfer, even for such a simple task.

Second Landfill
O’Donnell is assigned to assist the office administrator who is doing the work of several employees as office manager, accounts payable/receivable, payroll, executive assistant, and scale operator. Cost-cutting has reduced the workforce, and the site manager has pressed his administrator to wear multiple hats with no promotion or increase in salary. O’Donnell becomes particularly sympathetic upon learning that the administrator is about to lose her house.

Carnival Site
O’Donnell trains to clean outdoor toilets. He encounters a worker who displays a lot of enthusiasm for his work. This employee cheerily teaches O’Donnell the tricks to clean the toilets as efficiently as possible. O’Donnell comes well short of the required cleaning rate of 15 toilets per hour, but his trainer still notes the potential to develop into a good worker.

Trash Collection Route
O’Donnell rides with a trash collector to learn how to load and unload garbage cans into the truck. He is horrified to learn that she must urinate in a can because she does not have time to stop and use a bathroom. His own productivity requirements are producing these time pressures. Constant surveillance from roaming and calling supervisors keeps the trash collector on edge. An example occurs in real time as she points out a white pickup truck that has followed her on her route. She also gets annoyed by a status check from a supervisor who wonders what is taking her so long; it so happens that O’Donnell’s “training” is slowing things down.

Some of the trash collector’s customers come out to show their appreciation and to talk, but O’Donnell notes that his productivity requirements prevent the trash collector from fully engaging with her customers. This limitation is significant given trash collectors are “the face of the company.”

Lessons
This experience with data collection in the field taught O’Donnell that productivity and cost-saving measures can place extreme pressures on employees. Only the most “optimistic” of employees can thrive under such circumstances. Management must balance the drive for efficiency and productivity with employee empowerment. O’Donnell could not have learned this as effectively from verbal or written communications from his direct reports.

Of course, O’Donnell also learned firsthand the level of difficulty associated with the work of his employees. This fresh understanding and heightened appreciation should better inform future company initiatives.

Changes and Results
The trailer at the end of the show indicated that morale and productivity improved at the recycling plant after O’Donnell changed the onerous lunch policy. It was not clear whether surveillance practices were also adjusted.

The landfill administrator was given a promotion, a raise, and two new assistants. O’Donnell created a task force to think of ways to improve the working environment for trash collectors. He also channeled the positive energy of the toilet cleaner into a program on employee motivation. The determined landfill cleaner was given time off to better manage his disability and to help others with similar worklife issues. The show did not provide a status report on the impact of these initiatives.

Interestingly enough, O’Donnell did not mention his experiences during Waste Management’s latest earnings report on February 16. Even more surprising, analysts did not ask any related questions. Hopefully after another quarter or two, we will learn a little more about the quantified impact of O’Donnell’s changes.

In conclusion, here are some key quotes from O’Donnell about Waste Management’s operations from the transcript of the earnings call (from Seeking Alpha).

“Our residential collection line of business provides a very solid foundation because it’s very stable, but it carries the lowest margins of all our collection lines of business. The landfill business carries some of our highest margins, but it is very difficult to flex down costs, especially labor, as this line of business is less labor intensive than our collection line of business.”

“We will continue to work hard at aggressively flexing and eliminating costs. So for the full year 2010 we expect margins to continue to improve, and as many of you are aware, one of our key financial components to our annual incentive plan is expansion of our income operations margin as a percent of revenue.”

“If we don’t expand that margin in 2010 as compared to 2009, we will not receive an incentive payout for that portion of the bonus plan, so you can be assured that everyone will be working hard to find ways to control our costs and improve our margins.”

Amazon’s e-Book Pricing Problem

I intended to write a detailed examination of Amazon’s pricing problem with e-books. However after doing just a little research, I found there are plenty of people who have already provided excellent opinions and recommendations. So, instead of providing my classic unsolicited advice, I am posting links to the two most insightful pieces I found in addition to a general news story if you just want an overview on current events.

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.

Dan Siroker’s Five Keys to Successful Data Analysis

Dan Siroker, former Director of Analytics for the Obama Presidential Campaign, was a keynote speaker at SoCon10. SoCon is an annual conference run by the Center for Sustainable Journalism at Kennesaw State University in the Atlanta, GA area. This year’s theme was “Proven Social Media, Social Network Tactics to Enrich Your Business, Nonprofit and Yourself.”

Siroker described how his team used the power of data analysis to raise an extra $44M or so for the Obama presidential campaign. Here are his five keys to success in getting actionable and profitable results using data analysis:

  1. Define quantifiable success metrics. For Siroker, these were donations and votes.
  2. Question assumptions.
  3. Divide and conquer (segmentation of data).
  4. Take advantage of circumstances – be prepared to leverage unplanned events.
  5. Always be optimizing – continual improvement.

Siroker’s results speak for themselves!

Pricing Program at the UC Berkeley Center for Executive Education

The UC Berkeley Center for Executive Education is offering a 4-day pricing program called “Pricing for Profitability in the Information Age“, April 27-30, 2010 and November 15-18, 2010.

Here is the intro and program description provided by the program’s website:

“Companies leave millions, sometimes billions, of dollars on the table every year through sub-optimal pricing practices. The current abundance of customer data, in the context of increased global competition and the instant information sharing made possible by the internet, requires companies to not only set the right prices, but to continually monitor and refine pricing.

The four-day Pricing program at the UC Berkeley Center for Executive Education equips managers with proven techniques for assessing, formulating, and monitoring pricing strategies. Participants will learn several powerful principles of pricing, and will explore innovative approaches that take full advantage of the rapid changes brought about by the information age. The tools developed in this course will enable participants to fully integrate the 3Cs of pricing (Customers, Competitors, and Costs) into the best price for your products.

At the end of the program, participants will be awarded a certificate of completion by the UC Berkeley Center for Executive Education.”

Tom Davenport Discusses New Book: “Analytics at Work: Smarter Decisions Better Results”

Tom Davenport discusses his new book “Analytics at Work: Smarter Decisions Better Results” in Information Week. Davenport and his co-author, Jeanne Harris, wrote this follow-up to:

  1. Provide a guide for creating and promoting analytical capabilities without making analytics a core business strategy.
  2. Emphasize the importance of data governance.
  3. Introduce a formal framework called the DELTA model: Data, Enterprise, Leadership, Targets, and Analysts.

Here is the intro to the article:

“The business best seller Competing on Analytics made the case that there are big rewards for organizations that embrace data-driven decision-making. Offering a preview of his soon-to-be-released follow-up, Analytics at Work: Smarter Decisions Better Results, co-author Thomas H. Davenport , professor of information technology and management at Babson College, recaps the book’s five-stage “DELTA” model for assessing and improving analytical decision-making.”

Why Can’t I Have the Brownie Instead of the Muffin with My Box Lunch Special?

I maintain a relatively regular lunch rotation that features essentially the same main item at each eating establishment. Today, I was delivered a shock to my comfortable culinary routine: I was told that I could not substitute a brownie for the muffin that comes with the chicken salad sandwich box meal at, what I will call, “Establishment X.” (Note that the woman at the cash register was not the same woman I have seen for all these many months to-date. I can only assume that THIS time, I got the manager/owner!)

As I did my best to conceal my complete and utter shock and dismay, I casually observed that the brownie is the same price as the muffin ($1.99 vs $2.00). I was summarily informed that “the ingredients are different. They just use different ingredients. And the muffin is really good.” My overt protest shut down at that point, but my inner pricing analyst began gnashing away on the logic of this tragic situation.

Eating establishments typically use bundling to entice consumers to buy additional food that they otherwise would not have purchased separately, either because of price or (temporary) appetite constraints “at the moment or at the margin.” This technique is profitable when the complementary product has a high enough margin such that the effective discount applied to the extra food item still results in a positive overall margin.

In the case of the brownie vs. the muffin, I can only assume that the cost of the ingredients of the brownie are higher than those of the muffin (assuming no difference in labor and spoilage costs, etc..). If so, then all my earlier substitutions have caused Establishment X to lose some untold amount of profit (likely very small).

It was not in my interest to provide unsolicited pricing advice in this case since I am the consumer. However, if Establishment X hired Ahan Analytics, LLC for pricing consultations, I would likely recommend increasing the price of the brownie. Let’s assume a 25 cent increase still leaves the muffins with higher margins. This price increase would serve multiple purposes which should lead to higher overall profits:

  1. Drive consumers who are indifferent between muffins and brownies to buy the more profitable muffins.
  2. Extract more money out of consumers who strongly prefer the brownie and are willing to pay accordingly. I am biased on this point because I believe the brownie is at least ten times better than the muffin, and the slightly higher price would not discourage my purchase of the brownie by itself.
  3. Eliminate confusion about the relative value of the brownies vs. the muffins in the sandwich meal.
  4. Provide an opportunity to offer a brownie option for the sandwich meal at a slightly higher price.

Given I have plenty of other eating options in my lunch routine, I will not likely miss the chicken salad sandwich meal. I will just have to find solace in the “satisfaction” that on future visits, I will be purchasing the brownie at some discount to its, let’s say, “true price.”

Dan Siroker – Director of Analytics, Obama Presidential Campaign – Keynote Speaker at SoCon 10

FYI – Dan Siroker, Director of Analytics, Obama Presidential Campaign, will be a keynote speaker at SoCon 10, January 29-30, 2010.

SoCon is a conference on Social Media and Social Networking held in the Atlanta area every year since 2007. I attended in 2008, and I highly recommend it for anyone interested in this space.

Here is how SoCon describes this year’s conference:

“In the first three years, we introduced social media, user-generated content, blogs, podcasts, video logs, social networking, wikis, Twitter… but nothing stands still. Find out what you have to know in 2010 to stay ahead of the learning curve. Find out who is doing great stuff; who has great, innovative ideas. Network and learn — and maybe even partner with — independent content producers, new media pros, academics and people from across the spectrum of marketing, public relations, legal, human resources, and executive ranks.”

Burger King Broiling: Struggling with Global Vs. Local Profit Optimization

On the same day that BusinessWeek lauded Subway for the success of its discount $5 footlong sandwiches, the National Franchise Association (NFA) sued Burger King Corporation over the legality of requiring franchisees to charge no more than $1 for the Double Cheeseburger. The Subway success story features a pricing strategy built from the bottom where the initiative and innovation of a single franchise owner led the way. The local profit optimization of the franchisees directly support the global profit optimization for Subway as a whole. The unfolding drama at Burger King features a pricing strategy commanded from the top against the expressed desires of the majority of franchisees. The global profit optimization that has convinced management to plow ahead appears to violate the local profit optimization of the majority of franchisees. The dispute has now devolved into a lawsuit filed in the U.S. District Court Southern District of Florida on November 10, 2009. The class action complaint starts with the following introduction:

“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.