Inelastic part of Demand and Supply Curve

The proposed oil tax holiday does nothing to demand and supply! Other links: Greg Mankiw

Berkeley Business Plan Competition Finalists

The Berkeley Business Plan Competition finals is Thursday May 1st 2008. There are eight finalists, three are in the biotech-biomed area. My bets are on one of these three. Here is the list with my annotations and odds of winning the competition and in the market place.

Gas Tax Vacation Savings per person

The total cost to the Federal Government was estimated to be about $6.6 billion from 18.4 cents per gallon on 400 million gallons sold per day.

The per capita gasoline consumption per year varies from 215.3 gallons in Washington D.C to 615 gallons in Wyoming, for a US average of 464 gallons.

For the 100 day (rounded) holiday period, the savings work out to $11 to $31 with more than 95% of people saving less than $30.

Since this is a direct incentive to an individual, a small amount of $30 over 3 month period has no effect on the consumption. But due to its cumulative effect on the tax revenue has a big impact on infrastructure investment.

Restaurants on a Downward Spiral

I listened to J. Carlo Cannell of Cannell Capital LLC speak about his Investing Strategy, "Selling Short: Controversial Black Magic". He agreed to let me share some of the broad themes from his lecture.

His thesis is,

"it is more difficult to pick a stock and go long than it is to pick an absolute loser. What do any one analyst or stock picker know more than the rest combined? On the other hand there are industries that perpetually weak and all businesses in that segment someday go out of business. Find one such weak industry segment and find the worst loser in that segment and short it. Look for signals like, unknown auditors, bad reps for their C level officers, lawsuits, labor union, dealings with Governments. Do not short a stock based on valuation, the market always will move against the valuation call as the company manages earnings through complicated schemes. Look for the real duds."

Once such industry is Restaurants, Carlo has considerable experience and knowledge about this segment.

"There are no barriers to entry, customers are fickle with no switching costs, employees steal from the business, from money to food carted out through the back door and for a food service business most of its profits come from liquor sales. In the data, from 1983 to 2005, the stocks shrank -8.7% CAGR. Once a restaurant hits the downturn, it is not suddently going to turnaround. People who left for the next cool place are not going to come back. Given enough time every restaurant will go out of fashion and will go out of business."

I asked him specifically about the Ruby Tuesday case and its current investment of $50 million to improve the lights and upholstery. He replied, " people did not leave because of bad lighting, just by changing they are not going to come back. May be they have done some EBIDTA calculations that show a positive outcome". But as I discussed last time, at their projected growth rate of 3%, $50 million investment is not a positive NPV project.

Finally, given this loss making characteristic of restaurants, should anyone open a franchise?
" If you are the first one to get franchise for an geographic area and your plan is to roll it out, make money in 2-3 years and sell it off, then yes". The corollary is, it is not usually a good option to buy a franchise from a previous owner. You have to ask, why are they selling and will you be able to find another buyer who will buy this from you at a higher price.

That said, I am in no hurry to short Ruby Tuesday. I am a simple indexer.

Web2.0 does not obviate Strategy

I attended a two day class on Web2.0 marketing taught by Andreas Weigand. There is nothing new that came about. I do see generalizations of certain concepts, like free is the next business model. One important impact of Web2.0 that gets lost in the hyperboles is the ease, speed and scale of the customer conversations. Customers were always talking to each other, tinkering with the product, and exchanging experiences and their product adaptations. Now all these happens at a much faster rate and across a large audience.

In my conversation with Professor Rashi Glazer, he described Web2.0 world as Marketing Communication, he added "today your customers are having conversations about your product and your decision is whether you want to be part of it or ignore it". In other words, Web2.0 is not a substitution for bad strategy or lack of one, but a tool that companies cannot avoid but use to communicate with their customers. It is an effective marketing communication tool. Having a blog, user participation, social network, a tag cloud etc does not help your firm if it lacks strategy. If the firm ignores these tools in its marketing mix, it stands to be excluded from the conversation.

When a firm decides to enter a market it still has the fundamental questions to answer:

1. Who are the customers and how do they make purchasing decisions?
2. How is the market segmented?
3. What are the holes that we can fill? Why haven't someone else filled it?
4. Who are the current players in the market?
5. What is their strategy? Will they accommodate us or fight on price?
6. What should be our firm's strategy? Go for Profit or Market share?
7. Do we want to stay small and capture one segment or grow to fill other niches?
8. How defensible is our strategy? What is unique about our offering or the activities we perform to deliver these?

Web2.0 is part of the marketing mix tactics, letting you choose your price, channels and communication. It does not obviate strategy!

Corporations and Human Rights

What is a corporation's role in dealing with countries whose Governments have questionable human rights? Should a corporation be singularly focused on generating shareholder value and spend its precious capital on non-core and non profit generating activities?
Is the economy that generates so much of wealth in the developed countries applicable to even countries that have no democracies or rules of law?
Is the argument to not interfere with the market forces a valid one when the former depends on the existence of democracy and rule of law?

John Ruggie answers (PDF) these in his special report to UN on Human rights.

The root cause of the business and human rights predicament today lies in the governance gaps created by globalization - between the scope and impact of economic forces and actors, and the capacity of societies to manage their adverse consequences. These governance gaps provide the permissive environment for wrongful acts by companies of all kinds without adequate sanctioning or reparation. How to narrow and ultimately bridge the gaps in relation to human rights is our fundamental challenge.

Branding and Pricing effects on Consumer Behavior

I regret not doing the Consumer Behavior course this semester. I see a whole bunch of experiments being conducted by my classmates for their final projects. I served as a willing subject for many such experiments, from tasting organic vs. non-organic vegetables and wines to deciding whether or not I will bet on an outcome with same expected payout but different entry costs. There was one study that promised a gift card raffle for participants deciding on Tulley's pricing market entry strategy, now I wonder if the study was really about consumer behavior with respect to raffles.

The New York Times talks about recession diets, people cutting down on brand name goods for cheaper alternatives.

Holly Levitsky, a 56-year-old supermarket cashier in Cleveland, buys a brand of steak sauce called Briargate for 85 cents and surreptitiously pours it into an A1 steak sauce bottle she keeps at home.

“My husband can’t even tell the difference,” she said.

The packaging and the marketing has obviously trained her husband to associate the taste and the experience to the brand name A1 even if there is no clear link (as Ms. Levitsky's experiment demonstrates).

On a more scientific level, Business Week reports a study done by Stanford and CalTech researchers on the same consumer behavior on wine pricing.

"The marketing industry has done a good job convincing people about their free will and that they are making logical, well-thought-out decisions about the things that they buy," Linn said. "Studies like this suggest that, in fact, there are lots of things that influence our responses to marketing and our choices of products that are completely irrational that we might not be aware of."

It's a Text Book case of Market forces

Text books are expensive. I paid about $120 on the average for my new text books and did not have good experience buying used books online. The New York Times wrote an editorial on the high price of college textbooks calling it "outrageous pricing". I do appreciate the Congressional bill that will allow unbundled pricing. But more than this I do not see a need for any actions for setting prices.

Greg Mankiw, the author of my favorite Macroeconomics book that not only helped me do extremely well last semester but also gave me tools to analyze McCain's gas tax vacation, says in his blog that the Times should consider entering the market instead of editorializing sine there are no barriers to entry, t has a strong brand and it already knows how to hire writers. He concludes that Times, "would not view starting a new textbook publisher as an exceptionally profitable business opportunity"

I looked at the Market Research 2007 data on Text book publishing.
Size of new text book business: $3.4 billion, growing ~3%, slower than used book segment
Market share of top 8 players: 95%
Operating margin of top 4 players: 25.6%, 20.2%, 15.7%, 13.0% (a nice margin)
Demographic characteristic: Students buying fewer books as they share or buy more used books.

I think with such strong concentration at the top and high fragmentation at the remaining 5% it is not easy to enter the market. While the students buy the books, marketing is done to the professors who recommend the books. I wonder whether the professors rely on the established brand name publisher than the author of the books. This creates barriers for new entrants despite the latter's established brand name in other areas.

I also think margins like 15% to 25% are extremely attractive and also tells us that the publishers are not doing this just as a service to education. The continued increase in prices despite the technology, marketing strength, outsourcing and experience curve benefits is surprising. It does leads one to wonder if there is tacit price collusion. More analysis is needed to look at specific segments each of the top players specialize in and whether they split the market among themselves to avoid competing with one another.

I would like to see no more recommended textbooks and unbundling at chapter level. Professors should pick and choose separate chapters from a variety of authors (dealing directly with them instead of publishers) and suggest a proposed electronically published course pack. This sure would solve the high price of textbooks by changing the game instead of through legislations.

CO2 Share of Wine and Beer Revisited

In a previous post I calculated the approximate CO2 footprint of a bottle of beer to be 125 grams. The calculation did not look at the CO2 share of raw materials (cultivation, storage, transportation) and used the average CO2 output of the entire brewery (New Belgium Brewery) instead of calculating for individual process steps.

The New York Times has a nice calculation for a bottle of wine, shipped from France and shipped (to New York) California. The respective numbers for France and California are, 1371 and 2514 grams. The breakdown is as follows:



The transportation numbers for California are higher due to coast to coast shipping. If we take the average then it is about 700 grams and for local consumption within California it is about 50-75 grams (guesstimate).

To put this in perspective, a bottle of French wine is equivalent to driving 3 miles and a bottle of California wine is about 3.5 to 5.5 miles. So if you biked to work for an average of 6 miles round trip and finished the evening with a bottle of French wine, your saving from not driving th car is cut in half.


The transportation costs for beer is lower because most breweries are located close to the market they sell. The numbers however may well be an underestimate.

In both the Beer and Wine CO2 per bottle calculations, the numbers are average. That is the total numbers are distributed among the quantities produced. But most of these CO2 costs (manufacturing, transportation, storage) are fixed costs and not marginal costs, producing and consuming one more bottle of beer does not increase CO2 cost by another 125 gram. But the numbers do add up if everyone cuts just one bottle of beer per week.

For driving, the 450 grams per mile is marginal cost, so even if you are the only one who chose not to drive there are savings.

I wonder what is the CO2 impact of drunken driving!

Ideas Marketplace

Eureka Ranch Technology is launching an ideas marketplace, Planet Eureka for brining together individuals with ideas and small businesses and big corporations looking for ideas. As the WSJ says, it is meant to help "small businesses looking to find a hot idea -- or trying to sell a hot idea to big company"

Their site says, "Research indicates Small Business start-ups are 10 times more successful executing innovations than corporations (SBA, Journal of Mkt. Research, Ranch Research)."

I question the premise and the conclusion they draw from the research. The first point is trivial, correlation does not mean causation. The other main argument is that Eureka is only looking at data on successful ideas. What about the unsuccessful ideas? What proportion of the failures come from small businesses?

They do not provide link to the research and the data they looked at. Even if the claim can be taken at face value, what does it say about the ideas themselves? How is a big corporation going to find the needle in the haystack?

I believe ideas are not that difficult to find, especially for businesses that know how to execute profitably. If the idea is to link the patented ideas with executioners, doesn't the patent database already fill that role?

I found some of the research alluded to in their website at SBA.gov, it is in the 2004 report to the president(PDF), page 183. The article has this important caution:

A few preliminary words must also be said to avoid misunderstanding of just what it is that is to be explained. It is not the hypothesis here that a large percentage of entrepreneurs employ innovation in the new firms they create. On the contrary, the evidence, imperfect though it is, suggests that most new firms are virtual replicas of many firms already in existence, and there is nothing innovative about them. Second, there is no suggestion here that even among that relatively uncommon species, the innovative entrepreneur, the preponderant focus is on anything that can reasonably be deemed breakthrough innovations. Here again, casual empiricism indicates the reverse—that the bulk of the novelties they introduce are only slightly better mousetraps.
...
that among the (rare) innovations that can be considered to be radical, a disproportionate share is provided by independent innovators and their affiliated entrepreneurs.

It does not say anything about successful execution of ideas but does say a lot about the quality of ideas.

Ideas marketplace is not a new idea and an unnecessary execution.

Carbon Offsets

One of my classmates started a project LiveClimate.org that lets you offset your CO2 by donating money to specific projects that "remove CO2 from the atmosphere for you".

I am very much impressed with the site's design, flow and integration. They use a shopping cart to add your donations to specific projects, a clever use of shopping cart and have an amazing photos widget. As a great example of user interface design, their footprint calculator links directly to the "Shopping Cart". While they ask you for a donation of $21 per tonne of CO2, they are very accommodative, instead of typing your carbon footprint, you can type in the amount you want to donate.

There is no excuse these days to have a mediocre web design. I really would hire the people who did their website design.

Is Ruby Tuesday solving the right problem?

As the slowing economy eats into restaurant sales, Ruby Tuesday is trying to improve sales with a $50 million investment to spruce up stores. The Wall Street Journal reports:

To boost sales and set the company apart from its casual-dining competitors, Ruby Tuesday is spending at least $50 million on remodeling, with 668 of its 721 company-owned locations getting a new look. It is replacing its decor of Tiffany lamps and roller skates with custom artwork and leatherlike upholstered furniture. Servers are wearing black pants instead of jeans.

The company has changed some of its food suppliers to trim costs. It saved $800,000 on broccoli by using a different supplier, and an additional $500,000 by switching mashed-potato suppliers. Ruby Tuesday is installing a new frying-oil filtration system to reduce the amount of cooking oil the company uses, a move Mr. Beall estimates will save $2 million a year.

Even if we work with their premise that improving the ambiance will steer customers to their restaurants, the numbers do not work well. Suppose, they capitalized the $50 million and depreciated it over 10 years and they are able to keep up with the $3.3 million cost savings. Their 2007 10-K says their current free cash flow is $59 million and one of their goal is to reach a 3% year over year same restaurant sales growth. If we assume that they achieve this and this increase flows to a 3% increase in free cash flow. Let us assume their discount rate (WACC) is 12% and discount the increase in cash flow over the 10 year period. This investment turns out to be a NPV negative one.

Why is Ruby Tuesday and all other places seeing slowing sales? As the restaurants proliferated at a rate faster than population growth, they generated sales by selling more per customer. As people cut their spending, eating out is one of the first to go. Even though the economic slowdown may be short lived the increasing oil prices and grain prices are here to stay. This calls into question their profit growth.

More important than these finance issues, there is a bigger positioning issue here. The customers are not walking away from Ruby Tuesday to their competitors. Hidden in the data is that customers are buying more prepared meals from supermarkets. The market demographics is also shifting with more women staying at home. This indicates that the value proposition to these customers is convenience and not ambiance. Ruby Tuesday is seeing itself in the business of providing a better dining environment than their competitors, the casual dining places.

An alternative to restaurant redesign project would be to aggressively enter prepared meal segment and reach their customers through supermarkets. This requires Ruby Tuesday to see itself in the food service or even convenience business and not in the restaurant business.

Since they are committed to the $50 million spending, I expect their stock to fall further from its current level of $7.35.

Slowing Restaurant Sales

The problem with products like food and drinks and with food service business is scalability. There are only a limited number of people in the market. The current slowdown in restaurant business has its roots in how the market grew at faster rate than the population growth. National Restaurant Association says that the number of restaurants grew at a more than two times the rate of population growth during the period 1990 to 2006. The total market size increased from $239 billion (nominal) to $550 billion (nominal). This implies two stylized facts:

1. The average sales per restaurant has remained constant over this period.
2. An average meals consumed outside the home per person increased as well.

The current economic slowdown will lead to people cutting their additional meals outside home. An average restaurant that saw near zero growth will now see its sales drop. With increase in marginal costs due to food prices increase and the increase in operational costs, restaurants are getting squeezed from revenue side and the cost side.

For franchise owners, there is no relief from the franchise fees despite falling sales and rising costs since the franchisees pay a percentage of the sales.

For family owned and operated restaurants, the impact is going to be worse, since the costs are much higher and the operations are geographically concentrated.

This calls into the question the notion of making a comfortable living by owning a franchise or a family restaurant let alone running a business

CO2 Share of a Bottle of Beer

I wanted to find out how much impact the beer itself has on the environment. Would it help the environment more if people stopped drinking beer?


I used the data from New Belgium Brewery, it produces 330,000 barrels of beer a year and according to their data this process produces about 5000 metric tonnes of CO2.

(1 beer barrel is 31 gallons, 1 gallon is 128 ounces, and 1 bottle is 12 ounces)

If I can do a simple cost allocation and distribute the 5000 metric tonnes across 109.12 million bottles of beer, it is about 46 grams of CO2 per bottle. This is just manufacturing alone. If we can triple this for refrigeration, shipping and retail sales, it is about 125 grams per bottle.

Compare this to EPA numbers on driving a car. On the average 12,000 miles add 12,100 pounds of CO2, converting to metric units, it is about 450 grams per mile.

If you want to find the CO2 impact of your meals check out the LowCarbon Meals calculator that Siel of LA Times points out.

Older Workers in the Minimum Wage Pool

As the US economy weakens, increasing number of adults are finding themselves in minimum wage jobs that are traditionally done by young adults. The minimum wage jobs do not pay enough for a sustainable living and these are not meant to. For an efficient labor market these wages should be cleared at the market price that matches demand with supply.

WSJ says:

Weakness in the economy is accelerating a structural shift in employment patterns. More adults, including unemployed college grads, older workers, former welfare recipients, immigrants and working adults seeking second jobs, are competing for low-skilled hourly posts.

The increase in supply of labor will place a downward pressure on the wages. The increasing gas and food prices will continue to make to make it difficult for these adults and unemployed college grads to sustain a living.

The problem could get worse during this summer with the June 24th minimum wage hike. Business owners grappling with increasing prices of raw materials and supplies that cannot be passed on fully to their customers cannot let their thin margins erode with a wage increase. Any artificial increase in wages when supply far exceeds the demand will cause the businesses to not hire, aggravating the situation.

The alternative is to reallocate capital from social spending projects to infrastructure projects. May be even adopt a version of McCain's tax holiday plan, except instead of giving the tax holiday to the customers use the $6 billion dollar gas tax collected over the 90 period to fund startups, invest in special education for job training and other job creation projects.

Woz Talk

Some excerpts from Woz.

"If you are persuasive and likable, people will do a lot of things for you"

"It seems wrong to buy something for 6 cents and sell it to someone for $6. Shouldn't you
tell them you bought it for 6 cents?"

"Getting a Job at HP working on Scientific calculator was like you loved Apple computers and found a job at Apple"

"It wasn't software back then, it was hardware!"

" I hardly ever used it, I just wanted to create it" (on his rigged up Video Terminal form TV with Keyboard and modem)

"We were people like yourself, not money people or CEOs, we gave away our code"

"Sometimes we all have dreams that cost a lot of money. Stick with whatever money you have and do what you can."

"We went to the venture capitalists but we could not speak like business people."

" Why didn't the HP spin me off? They couldn't do my product, due to their corporate culture."

"What would it take for a Robot to make a cup of coffee? That Robot has to live a long life to do these things".

"After a while you get old and go into management"

"We did not realize the world was changing, the software was going to be more important"

" I can't understand why you won't let me put a ringtone in the iPhone"

Watch Steve Wozniak Speak

Steve Wozniak, Apple co-founder, is talking at Haas School of Business today at 1930PDT.
Watch the live feed at this link.

Pricing at the Gas Pump

What are the cost components of a Gasoline retailer? How is the $3.50 we pay gets allocated? An amazingly well written article on gasoline retailer pricing models is available at the National Association of Convenience Stores (NCAS) website. The article gives a clear explanation, rooted in economics, of why the prices at the pump reflect the current crude oil prices even though the retailer bought the current inventory at old prices.

A gasoline retailer typically seeks to establish a retail price based on the cost of replacing the gasoline currently at the retail location, not the cost of that product itself. Basing prices on "replacement costs" is especially critical when wholesale prices fluctuate frequently. A retailer must generate sufficient cash from its current retail sales to purchase its next delivery of gasoline; otherwise, the retailer would be constantly using debt to finance wholesale gasoline purchases.

Here is a broad cost structure of retail gasoline (source NPR), and California. Variable Costs (per gallon): Cost of Goods Sold Crude Oil: $2.50 (fluctuates daily, market prices, cost to refineries) Refiner Margin: $0.25 Distribution Margin: $0.07 Credit Card fee: 2% = $0.07 Federal tax: $0.184 State tax: $0.38 (varies state to state) Total: $3.479 The credit card fees are incurred at percentage of dollar amount. Master card charged 2%. Fixed Costs: Since the gas retailers usually have other services including convenience store, the fixed costs are part of the whole operation and not just gasoline sales. The fixed cost components are: Real estate Employees Maintenance So the contribution margin from a gallon of gas priced at $3.50 to the retailer is about less than 5 cents. That does not look like a considerable margin for the business.

Using Pascal's Wager in Supporting Corporate Environmentalism

Is it a corporation's role to invest in the environmental projects and try to reduce the impact on the environment? While there is still confusion around the data on the causation of Global warming how can a manager decide to invest shareholder capital in Green projects?

There is line of argument that justifies the need for sustainability projects that is analogous to Pascal's wager. Pascal's wager defined for faith in god, stated using decision theory, looks like

	God exists (G)	God does not exist (~G)
Living as if God exists (B)	+∞ (heaven)	−N (none)
Living as if God does not exist (~B)	?? not specified perhaps N (limbo/purgatory/spiritual death) or −∞ (hell)	+N (none)

So the dominant strategy is to pick Living as if God exists.

In the environmental context, companies are advised to act now, because it is a dominant strategy to pick "Living as if Global warming is an effect of industrial activities".

However, unlike the religious argument, this assumes that all these environmental friendly initiatives are NPV positive projects. That is investing in them, even if it turned out "God does not exist", has a positive NPV at the discount rate the corporation uses for its investments. That sure is a big if, not supported in the data. In fact there is more data to suggest otherwise.

The bottom line is shareholders trust the corporation and its executives to invest in projects that have a higher return on investment than the investors can find for themselves.

I believe in reducing consumption and waste. These are necessary for operational excellence. But should the strategy be aligned along Green themes?

CO2 Share: Walmart Vs Small Store

I am still not convinced about the impact of CO2 emissions on global climate change. However I decided to do a comparison of CO2 footprint of Walmart vs small stores. Since there are so many discussions around supporting local mom and pop stores vs. big box retailers, I wanted to do a comparison of these two along just this one dimension (commemorating the Earth week). To make it an even comparison I used CO2 tonnes per dollar of sales and per employee.

I assumed that the retail stores are on the average 4000 square feet and owned one car driven for 20,000 miles for business purposes. Since no free calculator for small business is available, I used an estimate that mirrors an household of similar size and people. Hence I underestimated the electricity spent on large refrigerators, continuous lighting, store display signs and the CO2 impact of distribution of goods to the stores.

For Walmart, the published data says $19.2 million tonnes and it includes all their trucks, corporate jets, stores and corporate offices.

The total US retail sales is $4.2 trillion (retailindustry.about.com).
The single stores' share of total retail sales is 50% (same source).
US Census data says, the number of retail stores with less than 10 employees as 796,000. These numbers give a very high annual per-store sales (about $2 million). This should be treated as an overestimate of actual numbers.


Here is the comparison. On a per dollar sales, Walmart looks about 50% as bad. On a per employee basis, Walmart is way better.

Caveats:

1. For small stores, the CO2 footprint is underestimated and the annual sales numbers are overestimated.
   
2. Walmart's numbers include the entire corporation and non retail related activities.
   
3. Walmart has large economies of scale and can ride their experience curve to make large positive impact on their CO2 footprint.
   

Getting your suppiers to pay you to play

Home furnishings retailer Linens N Things is on the brink of filing bankruptcy. The New York Times reports that some of their suppliers are tightening contract conditions and stopping shipments. The question to ask is would the suppliers be better off by helping LnT at this crucial time or by choking it further and hastening its bankruptcy.

Gilbert W. Harrison, Financo’s chairman, said that despite its financial problems, Linens ‘n Things has several attractive assets like its real estate.
...
But suppliers have an incentive to keep Linens ‘n Things afloat, Mr. Harrison said. Without the chain, they will have to deal with only one major customer, Bed, Bath and Beyond.

The questions the suppliers must be grappling with are

1. What are the chances a LnT turnaround or a potential buyer rescuing LnT?
2. What is underneath the problems?
   
3. What is the expected cost of LnT going down, both from lost account receivables and from future pricing squeeze by Bed Bath and Beyond?
4. What is the expected cost of reviving LnT and for how long they have to keep it up?
   
5. Would they be the only vendor stuck with supporting LnT? Would everyone else go with it? What is the critical mass required that improves the changes for turnaround?
6. If they are he first, would everyone else follow? Should they wait for someone else to move first? What if everyone waits for the other to move?

“Vendors want to keep this company alive,” Mr. Harrison said. “The last thing they want to see is for it to die.”

Operations is Child's Play

I spent a fast semester learning Operations.
How do you maximize profit when the inventories have to scrapped at the end of each day?
How can you predict future demand?
How do you know how much to order?

News Vendor model to the rescue, if you know the past demand history.

Kids these days learn this just by watching Cyber Chase on PBS, particularly one specific episode, aptly titled as "Past Perfect Prediction". The kids run a some sort of oil change garage to raise money. They have to order Cryoxide, the raw material that costs $15 a can and expires at the end of the day. They charge $32.5 for the service. They place an order for Cryoxide the previous day and it gets delivered in the morning.

Past Perfect Prediction

Convinced that the last piece he needs to activate his powerful new machine is hidden in Slider's garage, Hacker threatens to evict the teen unless he pays up on an old debt. Enter the kids and Digit. As a way to raise the money, they convince Slider to open the garage for business – just like his dad did. They do, but quickly discover that there's more to it than meets the eye. Can they unlock the past to find the key to saving Slider's future?

On the first day they order 66 cans based on one receipt they find in their father's files. As it turns out they could use only 30 of the cans, wasting the other 36 cans. They figure out that that was just one data point and it was also from a Saturday whereas they started work on Monday. Their initial search gives them one past receipt for each day of the week. Not satisfied with the dataset they search more and find the receipts for the whole month. They find the average demand for each day and place a order for each remaining day of the week.

Perfect. They end up using every can everyday and end up making a wheelbarrow load of money.

Now if only I had seen this.

Questioning Going Local

I wonder if Go Local campaign has any economic merit. I wonder if it is really fair for the very locals the campaign targets to help.

1. Why go local?
2. Why should you pay a higher cost to buy local when the market offers a lower price in places that are "non local" and products that are "non local"?
3. Do we know for sure that the value creation (environment, labor, community impact) are all demonstrably higher with local vs. non local?
4. Why pay for the inefficiencies of a local store or producer? If Wal Mart squeezes out the inefficiencies to provide customers with lower cost, would it simply not be better to take capture the added value?
   
5. Do you stop at goods and services for local? How about ideas? Should you listen to and cultivate only the local thought leaders?
6. What does it mean when a bookstore says Buy Local? Should people only read books written by local authors and printed using paper produced from local trees by local paper companies and sold in local bookstores?
7. What about the locals who work in chains? Is it fair to deny them their right to earn a living by working in a place that offers them the best value?

Business Plan Doctor

Who is a business plan doctor?
Professor Rashi Glazer of UC Berkeley said he has a reputation as a "business plan doctor". When many of the startups whose business plans get rejected turn to Glazer for help. He described how the typical call would go,

Founders: We heard you are the business plan doctor could you help us?
Glazer: Let me ask you something about your business plan.
You say in your plan you have a great product,
you describe the founders as smart people from Berkeley and Stanford,
in the market section you show hockey stick growth,
and in your competitor section you have three words, There is none.

Founders: (very excited that they got the right guy), Yes on all, so would you help?

Glazer: I just told you what the problem is. Your market description and competitor section do not agree. Any market that is growing at the rate you describe is going to have competitors. Saying there is none convinces the VCs that either you did not do your work or that the market isn't really there. If you think it is indeed a new product with no competitors think about the substitutes. No one is going to believe you when you say there are no competitors. When there are no competitors there are no customers too.

Narratives in Marketing

What is narrative in marketing?
According to David Aaker, retired marketing professor from Haas School of Business and now a partner at Prophet, this can be best answered by showing a perfect example of masters of narratives, The Republican Party. Narrative is about having a coherent theme in every communication, repeating the same message over and over. Narrative starts with correctly framing the message and choosing words that reinforce this framing. Take the case of some of the republican causes:

1. Death Tax, Not estate tax!
2. Pro Life
   
3. Tax Relief
   

David Aaker, spent an engaging hour with a small group of students. His favorite answer for a question is, "you know I have written a book on that, have you read it". Which is true, he has written several books which are arguably seminal works on Branding and Marketing strategy.

Gas Tax benefits do not trickle down

Presidential candidate John McCain called for gas tax holiday over the summer months. The idea is that reducing taxes increases the disposable income people have and will lead to higher consumer spending which leads to income growth as a function of Keynesian multiplier. McCain is correct in that this is like a fiscal stimulus which will lead to expansion.

Gas Tax is not a percentage of gas price we pay at the pump. It is fixed at 18.4 cents per gallon. According to 2007 data, US consumes 388.7 million gallons of gas a day. Rounding it to 400, this translates to a lost revenue to the Government over this tax holiday to be, $6.6 billion.

The first question to ask with any fiscal stimulus package is, "How are you doing to fund it?"
One way would be to reduce Government spending. In the election year, even the self described fiscal conservative like McCain would not agree to cut in spending. So this would be deficit funding. Right on the heels of $145 billion fiscal stimulus approved by the Congress, the additional tax reprieve will hurt the deficit.

Another important question McCain should ask is, "What is the source of the gas price increase?". Unlike previous oil price shocks the source of the current shock is the higher demand for oil from China and India. So reducing the gas tax may entice the US consumer to consume more gas, increasing the demand further and hence the price at the pumps, creating effects that are opposite of what McCain wants.

The other source of the gas price increase is the weak dollar. Since US is a net Oil importer, it has to pay more of its weak currency and that gets passed on to the consumer. An increased consumption due to gas tax holiday may funner more US dollars to the oil producing countries, there by decreasing net exports and hence shrinking the economy.

It is very easy to see that McCain and his economic team understand this and know full well this is not going to happen. They also know that the democratic candidates would come out strongly against this tax holiday. This is just a way to get political mileage with more ammunition to describe his opposition as tax happy spenders.

A perfect application for Squidoo lens

I found a perfect application for Squidoo lens, or I should say, Squidoo lens is a perfect tool for the task I had in hand. I created a LinkedIn group called Boulder Net, to bring together professionals in Boulder. I needed a website for this group but I did have the time or resources to buy, design and constantly update one. I wanted the website to be a place holder and dynamically updated with a collection of RSS feeds relating to events, jobs, startups in and around Boulder. The main purpose of this website is to feed users to the LinkedIn group. Nothing more.

Squidoo fit the bill perfectly and more. I created a lens in no time and added several RSS feeds. For something that is not searchable, (you can't even search for groups within LinkedIn, let alone Google) now there is a link from a site that is as good as professionally done and with valid and current content.

There is just absolutely no excuse these days for not having a great website.

Changing Consumer Behavior: Heinz in India

Indians are used to ketchup that flows easily from the bottle. No tapping on the sides or the bottom of the bottle. The well known Indian ketchup brand is Maggi (owned by Nestle). Its viscosity is very low and it almost pours out. Heinz ketchup is much thicker viscous than anything Indians are used to. Heinz could have changed their product to match the expectations, instead they decided to train the consumer, change their behavior to accept Heinz for what it is. Instead of masking the difference they showcase it, trying to get the consumer accept it. See the following Ads. (You may want to lower the volume)




The punch line is, "takes a while to come out".

I wonder how they decided that reducing product variability in different markets is more important than meeting the consumer taste.

From the Web2.0 Class

The first session spent a lot of time on Free. I said my willingness to pay for web services is $0. The new book by Chris Anderson is pushing this idea of Free. You can listen to NPR interview with Chris Anderson, editor-in-chief of Wired magazine, Kevin Rose, founder of the social bookmarking site Digg, and Brad Feld, a venture capitalist, in which they talk about the cost of offering online information to millions of people — free of charge.

The concepts being pushed are, the basic version is free, users pay with their attention, information, or a third party pays.

The General Public

The general public plays in the middle. By definition they show no extreme sentiments, passion nor do they get agitated. They do not complain when someone professes to speak on their behalf. The general public has no original ideas or principles it is willing to stand behind and stamp its name on it. The general public will not set fire to SUVs or bomb abortion clinics. The general public does not think much about Tibet or China and will not come out to protest the Olympic Torch run.

Only the extremists find it preferable to ignore their day to day responsibilities and take on what they consider to be higher goals.

So anyone can describe their feelings and ideas in ways that suit them. Politicians do. Take for instance the Olympic protests and the Chinese Government's response. (from NYTimes)

The news conference was apparently intended to address Sunday’s protests in London. Ms. Wang blamed the disruptions in London on a “few Tibet separatists” and described their actions as the work of saboteurs. She said Beijing’s Olympic organizers “strongly condemned” the Tibetan protesters.

“The general public is very angry at this sabotage by a few separatists,” she said. “During the torch relay, we met with some disturbances, but we believe that all the peace-loving people in the world will support the torch relay.”

Mr. Wang is correct in describing the protesters but he claimed to represent the general public, describing them as "very angry".

The general public does not care.

Death by million posts

How difficult is it to produce that one more blog post?

Could the last post you and I wrote be the last one we would ever write?

Is there a pricing model from Miroeconomics we can apply to blogging?

Is your blog meant for transactional readers or relationship readers?

The New York Times talks about the difficulties in driving users and hence generating revenue from blog posts. With no barriers to entry, infinite supply, zero switching costs and customer loyalty, and limited number of reader-hours blogging is taking its toll on those who blog for money.

The very fact that reader volume is unpredictable and determined by when the post hits the blogosphere relative to other posts points to world of "transactional readers" and not "relationship readers". The latter is also known as subscribers to the RSS feed. Blogging for the transactional readers is unproductive, the marginal cost of producing one more post is way more than the marginal traffic (revenue) from that post. Since the probability that any single post can generate positive revenue is zero, the marginal revenue is zero as well.

If it is anything Microeconomics teaches us worthwhile, it is the concept of marginal costs and revenue. It is unpardonable to produce at marginal cost higher than marginal revenue.

On the other hand, going after relationship readers is a different game. The marginal revenue from one additional post is not the additional traffic and Ad clicks it generates but how much it adds to your credibility as an expert which gives a justification to your current subscribers for subscribing to your feed and for the transactional readers to become your subscribers. Note however that in relationship model, the marginal revenue is sill zero. But you are not producing and selling one post at a time. You are selling your expertise as a whole and it is irrelevant whether or not a single post brings in readers.

Once you realize this, there is no more pressure to produce in volume or beat others to break a news. There is no need for "toiling under great physical and emotional stress created by the around-the-clock Internet economy that demands a constant stream of news and comment" (NYTimes).

The other way to look at relationship blogging is to see it as an output of the work you did to gain and improve your expertise. This means that blogging is all fixed cost and zero marginal costs. Since the marginal cost and the marginal revenue are equal (of course, they are both zero) this is the right profit maximizing point to be.

But how do you recover your fixed cost when marginal revenue is zero? The pricing scheme that models the relationship blogging is Two-Part-Tariff. When the readers subscribe to your blog they pay the one time entry cost. You earned your revenue by gaining a share of their mind, time and space in the RSS reader. By charging this fixed price and a unit price of zero you have captured all you can from any single reader.

It is not difficult to see which model is better to pursue.

Attending a Course on Web2.0 Marketing

For two Sundays in April, (one of which is tomorrow) I will be attending a Web2.0 Marketing class at Haas School of Business, UC Berkeley. This course is taught by Andreas S. Wegend, who had worked for Amazon and as a Assistant Professor at NYU Stern School of Business.

I hope to learn more about the analytics and do some nice cases.

I will write more on these topics in the coming days.

My Willingness to Pay for web services: $0

The concept of Willingness To Pay (WPT) is meant to convey what price a consumer is willing to pay to buy a product and still be left with a positive value. The idea of profit maximization is to price a product in such a way to extract every bit of value from the customer that they will be indifferent between choosing and not choosing the product. In a much broader sense Chris Anderson calls this "Free! Why $0.00 is the future of business".

I have not paid any for any of the web services I have been using. Search, blog, group collaboration, my own social network, surveys, documents, spreadsheets, etc.

Now when a new service that is marginally effective aims to charge me for using it, the choice is easy. Unfortunately the price of web services is now their marginal cost, $0. Anyone thinks otherwise has not got their business model right.

Biased Expectations

Before you make the big decision to quit your job to start your own venture or to move to a different city to start fresh, be aware of the highly biased opinion we have about our abilities. The very trait that defines an entrepreneur, unbridled optimism, works against them preventing them from interpreting the data in an unbiased manner.
Wharton professor Gavin Cassar says,
"It's been shown in many studies that people are overly optimistic. Individuals form an inside view forecast by focusing on the specifics of the case, the details of the plan that exists and obstacles to its completion, and by constructing scenarios of future progress."

Even when the entrepreneurs use metrics and accounting systems to budget and forecast, their self bias make them overestimate the opportunities and diminish the risks. As Cassar says, "it is important to recognize that financial projections of success are merely projections based on beliefs, which are sometimes based on overconfident or optimistic assumptions".

The other aspect that leads one to quit the current job and enter self-employment is due to incorrect estimation of costs, more specifically ignoring the opportunity cost of doing so. Focused on the earning possibilities and the project cost of making those earnings, individuals ignore the income they were leaving behind and whether the new income compares well against what they were letting go. The opportunity cost is not just your pay check, it includes the health insurance,4 01K matching, holidays and vacation pay and other fringe benefits.

The question is, when the startup bug bites you would you recognize the need to do the costing and earnings estimates right?