It would be natural to think companies run discounts and promotions to attract enough new business to be profitable.
That’s rarely true.
The cost of most discounts and promotions are subsidized by other customers who pay more.
If I taught a hands-on business course, watching Shark Tank would be part of the syllabus, because it offers great real world insight to how business investors with good track records and who put their own money on the line think.
One metric that comes up in nearly every pitch is customer acquisition cost.
Customer acquisition cost is how much it costs to acquire one customer or one unit sold. It’s calculated by dividing all marketing expenses by the number of units sold.
Sharks love products that have close to zero customer acquisition costs. That’s a strong signal that the product sells itself that keeps customers buying and telling others about it through word of mouth.
Products that sell themselves are some of the best, long-standing products around. Coke and Chipotle are two good examples. Chipotle didn’t have to spend much on advertising as it was expanding locations. A line out-the-door would magically form at mealtimes in each new location. A good example of such a product discovered on Shark Tank is Poppi.
Coke does spend a lot of money on advertising, but it doesn’t need to. It does because it can afford to. But, the product sells itself and would whether it spent money on advertising or not.
Sharks are interested, but less so, in products that have acquisition costs that are a small percentage of the margin. This signals that the products sell themselves, but need a little marketing to prime the pump, like maybe to gain awareness.
As customer acquisition cost nears the product margin, the less interested Sharks are in investing. For example, if a product sells for $50 and the business makes $22 on that sell, the closer the acquisition cost gets to $22 the less interested they are.
This is called buying sales. These are products that customers will buy but they aren’t excited about it otherwise. This is common for products competing in already crowded markets where there isn’t loyalty between products.
Sharks don’t like these products because they never truly become profitable. Marketing will always be required to keep them selling. It will always be a fight to sell their product.
Sharks hate products where the cost of acquisition is a lot higher than the product margin. These are products that won’t be in business very long because they burn too much cash.
Over the years, I’ve heard a lot of folks recommend more advertising for mature, saturated businesses.
The first question to ask someone who suggests this is a Shark question: How does the company’s customer acquisition cost compare to the product margin?
It’s surprising how many aren’t even aware of this metric.
At one company, the margin was about $2 and the customer acquisition cost was $3-4. So, every extra dollar spent on advertising lost $1-$2, which is not a good investment.
How long has it been since your company has had an innovation win?
For many companies, the answer is a long time.
Yet, it amazes me that nobody in the company seems to notice or wonder why.
In one company I worked in, each year the innovation group would put forth a big new project, promise it would help the company grow, roll it out with a lot of fanfare and then it would flop.
This went on for years and it never occurred to anyone to ask, is there something wrong with our approach to innovation? Should we expect a win every so often? How often? Why do we believe their current project will work when they last five have not?
It even took me awhile to catch on. It helped that I was in a unique spot to notice. I worked in the company’s pricing group. Every time their big idea missed, leadership asked us to raise prices so they could still hit their financial plan.
After a few years of this, employees started blaming prices for the company’s lackluster performance and saw the pricing group as the evil villains, even though we were just following orders.
Employees in the innovation group were also our critics and asked me to present the case for pricing to them because they wanted to better understand why it had increased so much.
It was in preparing for that presentation where it dawned on me that the lack of innovation success was a primary cause of the rising prices, because price was used to cover those.
I ended up showing a chart of the company’s revenue, earnings and number of HQ staff for the most recent year compared to 10 years before.
I made this point:
Just ten years ago the company’s revenue was much less than it is now and the HQ staff was much smaller because the company could not afford to pay all of these employees on that revenue. Many of the folks who work here now, including you all, are here because revenue has increased enough in the past ten years to afford them.
Unfortunately, the only thing that has increased revenue and enabled the company to hire all of us is that its prices are higher. There has been no growth from increasing market share or new products.
Your jobs exist to find ways to grow from increasing market share and new products. Since you haven’t done that, your jobs are being paid for by the price increases that you are concerned about instead of growth from your initiatives.
Just over the past few years your projects were supposed to deliver X in revenue. When they didn’t deliver that, leadership still wanted to meet their numbers, so they told us to raise prices to cover.
I expected a defensive backlash, but instead, a lot of folks nodded their heads and thought that was a great point.
But, it didn’t change anything. They kept promising big wins, failing and nobody questioned if anything was wrong with their approach.
It did change something for me. I learned that over reliance on price increases is a tell-tale sign that there’s something wrong with a company’s approach to innovation and nobody notices.
I like a lot about this episode of Freakonomics.
One thing I especially liked was this part:
[Roberto] He’s a business professor at Bryant University, formerly of the Harvard Business School. There’s one lecture he likes to start by giving his students this fictional Shark Tank pitch.
ROBERTO: “I’d like to open a new kind of grocery store. We’re not going to have any branded items. It’s all going to be private label. We’re going to have no television advertising and no social media whatsoever. We’re never going to have anything on sale. We’re not going to accept coupons. We’ll have no loyalty card. We won’t have a circular that appears in the Sunday newspaper. We’ll have no self-checkout. We won’t have wide aisles or big parking lots. Would you invest in my company?”
And of course you’re supposed to think, “There is no way I’d invest in that company. That sounds like the stupidest company ever.”
What do I like about it?
He brings up a lot of things that people believe that you just have to do in a business. That not doing them would be crazy and it’s assumed would be bad for business.
Yet, Trade Joe’s provides a real world, living example that you can violate those and still win.
I contend that these things don’t have a positive ROI by the businesses that use them, but they are so generally accepted that questioning them puts you into crackpot conspiracy theory category.
But I think these things tend to live on because of folklore and the elusive idea that someday somehow they might pay off.
I recently read an X post from Bill Ackman listing incentives that are different in the private sector than in the public sector, like shareholders, boards serving shareholders, tracking key metrics and such. These are all subs of the ‘profit motive’ belief in economics that that’s what drives companies to make better decisions.
Two he missed that I think are about 100x more important than the ones he listed are competition and substitutes.
In my experience, all of the ‘profit motive’ incentives of the private sector are not immune to spawning bureaucracies, inefficiency and corruption that rival any government.
I picture that most mature companies are basically bureaucratic oases in the desert that sit on top of wellsprings of nearly automatic cash flow generation.
These are businesses where the products have such strong value propositions that they almost sell themselves no matter what management does.
In these cases, bureaucratic regimes can survive because it’s hard to do enough damage to that underlying value prop to matter much to the customer.
These cash flow wellsprings aren’t too different from government cash flow wellsprings. Once money starts flowing from tax coffers to a group, it usually doesn’t stop, so the same types of bureaucrats play the politics to sit on top of those, too.
In the private sector, the bureaucrats end up gaining control of the management team and filling the Board with buddies then wave their hands doing all the latest trendy business things or bring in top consulting firms to make it look like they are doing all the right things.
Though, a basic review of the company’s financials reveals no discernible change in trajectory since they’ve been in charge.
These corrupt bureaucracies can last a long time, too.
How long they last depends a lot more on the two things Ackman missed — the nature of competition and substitutes for the company’s products — than it does on the ‘profit motive’ incentives taught to Econ 101 students.
Sadly, those bureaucracies will last until competition or new substitutes put them out of business or do enough damage to the value of the business to make them attractive to new investors, like private equity firms, who can come along and buy the company and save enough money in simply cutting out the bureaucracy to increase the value of the business.
I call that Bureaucratic arbitrage.
I think it will be easy for awhile to find expenses to cut. The success from that might lead to others following suit and we may have a good ole efficiency business trend on the way. Prepare to see Departments of Efficiency being ‘standing up’ at other organizations.
But, if I was in charge of anything, I’d be leery about a few things.
First, the efficiency organization can become bureaucracy itself, which is a vested interest that overstays its welcome. An organization that has a say in what other groups in the organization can or can’t do, is powerful, and the power hungry will be attracted to it.
So, I would consider how the efficiency group goes away after the low hanging fruit it picked.
Second, once you cut the obvious waste, cost-benefit evaluations become tougher.
The root cause of bad spending is usually incentives. If those incentives aren’t addressed, the inefficiencies will come back.
A key principle from economics is that incentives matter. Organizations grow inefficiencies because of bad incentives.
One of those is how budgets work in most organizations.
This year’s budget for your group is usually what your group spent last year plus or minus known adjustments like salary increases, expected cost increases from outside suppliers, etc.
What’s missing in that process?
It’s something all of us do every time we decide to put something in the shopping cart, or not, at the store.
It’s evaluating whether the product is worth what you are going to spend on it? Or, in management-ese, a cost-benefit analysis.
When did your group evaluate the expenses from last year to determine if they were worth the benefits?
Chances are, they didn’t. It was just assumed that they were when this year’s budget started off on what was spent last year.
This is the same mental hack subscription services rely on. They want you to subscribe because they know once the fee they collect from you is automated, you won’t evaluate the cost-benefit and they can keep collecting your money even when they aren’t producing value.
Dig deeper, it gets worse.
Who hasn’t been a part of a group that is about to come in under budget for the year, so they go on a spending spree just so they don’t lose those dollars in the budget next year?
Or consider a manager that does the right thing and decides to cut a cost mid-year, then a month later his leaders ask him to cut more from his budget without taking into account the cut he already made.
This just causes managers to hold onto unnecessary expenses until they are asked to cut.
These incentives aren’t even corruption. They are just inherent in how organizations are run.
A common oversight I see when it comes to pricing strategy is to view costs as if they are completely unrelated to the prices charged.
This leads managers to fixate on reducing big costs to improve the bottom line.
The problem is that these costs can be inherent to the value of the product the customers are buying, so reducing the cost also reduces the value of the product and could hurt sales. This approach is effectively a price increase that doesn’t pay off.
Price hack: Instead of asking how much the big cost can be lowered, they should ask what price can they sell the product at that would make them feel better about that big cost?
The next question is, what will happen if we charge that price?
Raising prices enough to make you feel better about the cost might reduce the number of units sold, but will still come out ahead on revenue and make you feel better about every unit that is sold. This is price increase that does pay off.
Managers should also ask, is this cost already priced in? Often it is, as evidenced by the product’s healthy gross margin. I advise against pricing the cost in twice or three times, because that’s when customers start really noticing the disconnect between price and value.
Near the end of his recent People I Mostly Admire podcast, Freakonomics co-author Levitt recalls a speech he gave about why businesses don’t use or appreciate natural experiments.
He describes a talk he gave…
I was talking about something that puzzles me, which is, why is it that natural experiment thinking is almost completely absent in the business world? Natural experiments or accidental experiments, the kind of research that I do, where you can’t run a randomized experiment, so you’ve got to go out and find other ways to get at causality. It’s really just an approach. It doesn’t take a lot of knowledge of statistics, it’s an attitude for finding answers to problems. And I think it would be really useful to businesses if they adopted it. But, I think in part because in high school or college or even in the M.B.A. programs, I don’t think we teach about the idea of what a natural experiment is and how to run it. It just doesn’t happen. So it was sort of a polemic about how business economists should latch onto the idea of analyzing their data through the lens of natural experiments.
I use natural experiments in the business world for my own work to great effect.
I agree that natural experiments are not appreciated.
Professional business managers aren’t interested in accidents. In their minds, business is driven forward by deliberate, smart strategy. Their deliberate, smart strategy. Or, at least, the flavor of the day management strategy that they are trying to emulate.
Natural experiments seems like a cop out to these folks.
They think, I didn’t go to Harvard or Yale just to learn to rely on happy accidents. Anybody can do that.
Bring up the idea of natural experiments with them, and they tend to get defensive and list all the successes they’ve had or heard about that they believe was smart strategy.
After all, some have told me, the iPhone wasn’t a happy accident. Steve Jobs has mythic status for smart strategy and they want to emulate it. They’ve cast themselves as the hero in that same type of story.
Then I start to list all the things that were precursors to the iPhone, including Apple’s first attempt at the personal digital assistant, the Apple Newton about 10 years prior to the first iPod, and then the iPod itself and the other products on the market that influenced the design and direction of the iPhone, including competing music players like Microsoft’s Zune & Blackberry phones.
In hindsight, it’s easy to attribute the the success of the iPhone as a lesson in smart strategy and dismiss the truer story of trial-and-failures and evolutionary processes and a bit of luck that led to it.
The winner always looks smart. And maybe they are.
But, dig a little deeper and you might find that the winners often leveraged natural experimentation to great effect. They may not have realized or it, or make the same attribution mistake when looking at their successes in hindsight.
I worked in a mature company where the leader came from a tech company that was growing while he was there. It was growing before he got there and stayed on the same trajectory until he left.
In hindsight, he attributed its growth during his tenure to things like an open office environment, instead of the company simply being on a natural growth trajectory after stumbling on a good value proposition.
So, he started implementing the open office environment at the mature company, hoping it would change its revenue trajectory to look like the growth company’s.
Spoiler-alert: It didn’t budge. It cost a lot of money and caused lots of strife in the workforce.
He quietly abandoned that about one-third through when it became abundantly clear to him that there wasn’t some magic elixir growth in having everyone be able to watch each other pick their noses all day long.
Our Dinner Table 