Review – Nintendo Magic

Nintendo Magic: Winning the Videogame Wars

by Osamu Inoue, published 2009, 2010 (translated from Japanese)

Two Nintendo legends no one seems to know about

The original Nintendo started out as a manufacturer of playing cards and other toys, games and trinkets near the end of the Shogunate era in Japan, but the modern company we know today which gave the world the Nintendo Entertainment System, the Game Boy, the Wii and characters like Mario & Luigi and Pokemon, was primarily shaped by four men: former president Hiroshi Yamauchi, lead designer Gunpei Yokoi, the firm’s first software designer Shigeru Miyamoto and the first “outside hire” executive and former software developer, Satoru Iwata.

A family member of the then privately-held Nintendo, Yamauchi took the presidency in 1949 when his grandfather passed away. He tried adding a number of different businesses (taxis, foodstuffs, copiers) to Nintendo in true conglomerate fashion, managing in one 12 year period to grow sales by a factor of 27 and operating profits by a factor of 37.

But his most influential mark on Nintendo’s business came with his fortuitous hiring of Gunpei Yokoi, an engineer, who would head up hardware development for Nintendo’s game division. It was this strategic decision to concentrate Nintendo’s efforts on game development that would lead to the modern purveyor of hardware and software known around the world today.

Hardware engineer Gunpei Yokoi is not a well-known name outside the world of hardcore Nintendo fandom, which is not altogether surprising because most Nintendo fans alive today were not users of some of his first toy gadgets such as the “Love Detector” and the “Game & Watch” handheld mini-game consoles. On the other hand, it’s a shock that the man’s reputation is not larger than it is because he essentially single-handedly created the company’s hardware development philosophy in the 1960s which has remained with it today and continues to influence Nintendo’s strategic vision within the video game industry.

That hardware philosophy was summed up by Nintendo’s first head of its hardware development section as “Lateral thinking with seasoned technology”. In concrete terms, it is the idea of using widely available, off-the-shelf technology that is unrelated to gaming in new and exciting ways of play, for example:

  • Yokoi’s “Love Detector” game, which used simple circuitry and electrical sensors to create an instrument that could supposedly detect romantic chemistry between two users when they held hands and held the machine
  • A blaster rifle toy that used common light-sensing equipment to deliver accuracy readings of the users target shots to the rifle, registering hits and points
  • More recently, the Nintendo “Wiimote” concept, which was simply the idea of repurposing the common household TV remote into a tool for play

Yokoi’s lasting impact on the hardware (and software) philosophy at Nintendo is best captured by current president Satoru Iwata who once said,

It’s not a matter of whether or not the tech is cutting egde, but whether or not people think it’s fun

Similarly, this focus on repurposing existing technology for fun rather than investing in brand new technology helps to explain why many of Nintendo’s systems have been knocked for their not-so-hardcore hardware (think non-HD Wii vs. HD-enabled Sony PS3 and Microsoft Xbox 360) but nonetheless became massive consumer hits– the focus was on fun, not flash.

The Wii particularly was the response to the failure of two systems which preceded it (Gamecube and N64), which were extremely technologically advanced for their era and which departed as swiftly from Yokoi’s philosophy as they posed monumental development challenges for software developers due to their complex, proprietary nature. Instead of creating yet another whizbang console, Nintendo decided that if Wii’s costs were kept down and developers were free to focus on things like a new, intuitive controller and built-in connectivity functions, fun and market success would follow.

Essentially, the game hardware is a commodity with zero barriers to entry. Anyone can have the latest, greatest technology if they’re willing to pay for it. There is no way to establish a competitive advantage on the basis for hardware sophistication alone. It must come from design, or, as Yokoi put it,

In videogames, these is always an easy way out if you don’t have any good ideas. That’s what the CPU competition and color competition are about

Nintendo’s two leading lights: Satoru Iwata and Shigeru Miyamoto

Rounding out the Fantastic Four are Satoru Iwata, the company’s current president, and Shigeru Miyamoto, the star software developer.

Iwata came from relative privilege and studied computer programming in school. He had a passion for making and playing games from an early age. He joined a software developer, HAL Laboratory, early on. He successfully turned around the flagging HAL Lab before it was acquired by Nintendo.

Meanwhile, Miyamoto first came to fame through development of his Donkey Kong arcade game, which introduced the characters Donkey Kong and Mario and which was originally based off of Popeye until the IP could not be acquired for licensing. As a small boy he spent hours running around the hills, forests and mountains outside his home, which inspired many of his later game creations such as Pikmin, Animal Crossing, The Legend of Zelda, etc. He was the first designer Nintendo had ever hired. Miyamoto often utilizes his “Wife-o-meter” to help him understand how to make games that are more broadly appealing.

Miyamoto’s design ethic is best synthesized as populist-perfectionist:

When creating a game, Miyamoto will occasionally find employees from, say, general affairs who aren’t gamers and put a controller in their hands, looking over their shoulder and watching them play without saying anything

He creates game characters, game designs and immersive environments that appeal to everyone, not just the archetypical “hardcore gamer.” But this desire to serve a mass, unsophisticated audience does not mean that Miyamoto considers quality as an afterthought. Miyamoto will “polish [an idea] for years, if he has to, until it satisfies him” and “shelving an idea does not mean throwing it away. Those huge storehouses are full of precious treasure that will someday see the light of day.”

This is part of the value of Nintendo– they have many unrealized ideas waiting to be turned into hardware and games and the only thing preventing them from seeing the light of day is someone like Miyamoto who wants to make sure that when they eventually emerge into the light, they don’t just shine but sparkle.

And this thinking carries over to the company’s hardware efforts, as well. According to a lead engineer, the DS

had to work consistently after being dropped ten times from a height of 1.5 meters, higher than an adult’s breast pocket

Nintendo is “obsessed about the durability of their systems due to an overriding fear that a customer who gets upset over a broken system might never give them another chance.”

“Nintendo-ness”: how Nintendo competes by not competing

In 1999, then-president Yamauchi saw a crisis brewing for video game developers:

If we continue to pursue this kind of large-scale software development, costs will pile up and it will no longer be a viable business. The true nature of the videogame business is developing new kinds of fun and constantly working to achieve perfection

The solution was to adhere ever more closely to “Nintendo-ness”. Nintendo picks people with a “software orientation.”

“Nintendo-ness” is the company’s DNA, once someone has grasped Nintendo-ness, it is rare for them to leave the company. That tendency protects and strengthens the company’s lineage and makes employees feel at home

Manufacturing companies create hardware which are daily necessities, which compete based on being better, cheaper products. Nintendo is in an industry of fun and games, software, where polished content is the goal. Compare this to rival Sony, where hardware specs are key and the software is to follow.

According to Iwata,

Do something different from the other guy is deeply engrained in our DNA

Similarly, Nintendo-ness means delighting customers through creation of new experiences because

if you’re always following a mission statement, your customers are going to get bored with you

This way of thinking goes back to Hiroshi Yamauchi, president of Nintendo for 50 years, according to Iwata:

He couldn’t stand making the same kind of toy the other guy was making, so whatever you showed him, you knew he was going to ask, ‘How is this different from what everybody else is doing?’

For some reason, Nintendo observers and critics don’t get this– why isn’t the company doing what everyone else is doing? Why are they making a console with a TV remote instead of HD graphics (the Wii)?

To Nintendo, the risk is in not trying these things and trying to do what everyone else does. Iwata sums it up nicely:

Creators only improve themselves by taking risks

Of course, not all risks are worth taking. Iwata as a representative of Nintendo’s strategic mind makes it clear that the company is keenly aware of its strategic and financial risks:

The things Nintendo does should be limited to the areas where we can display our greatest strengths. It’s because we’re good at throwing things away that we can fight these large battles using so few people. We can’t afford to diversify. We have overwhelmingly more ideas than we have people to implement them

For example, Nintendo considers the manufacturing of game consoles to be outside its purview, a “fabless” company.

Then there’s the reason for the huge amount of cash on the balance sheet:

The game platform business runs on momentum. When you fail, you can take serious damage. The risks are very high. And in that domain, Nintendo is making products that are totally unprecedented. Nobody can guarantee they won’t fail. One big failure and boom– you’re out two hundred, three hundred billion yen. In a business where a single flop can bankrupt you, you don’t want to be set up like that… To be completely honest, I don’t think that even now we have enough [savings]… That’s why IBM, or NEC, or any number of other companies are willing to go along with us. We’d never be able to do what we do without being cash-rich

That being said, Iwata has not been shy about his policy toward dividends and acquisitions. He has stated that assuming Nintendo’s savings continue to accumulate, passing 1.5T or 2T yen, a large merger or acquisition may become a possibility. Otherwise, excess capital will be distributed as dividends.

The next level

Nintendo’s philosophy is to avoid competition. It sees the hardware arms race as an irrelevant dead-end. The key is to create new ways to interact with game consoles and software that keeps game players on their toes and brings smiles to their faces. According to Iwata,

We’d like to avoid having players think they’ve gotten a game completely figured out

Thus, for Nintendo the next level logically is integration of  User-Generated Content into their software environments, which would have inexhaustible longevity. First they sought to increase the gaming population, now they’re looking at how to increase the game-creating population.

The company’s true enemy is boredom. Whatever surprise you create today becomes your enemy tomorrow.

In the end, Iwata says,

Our goal is always to make our customers glad. We’re a manufacturer of smiles

This is what the company calls “amusement fundamentalism” and it’s what sets them apart from their perceived competition, especially comparisons or criticisms aimed at the company in terms of how it stacks up against a company like Apple. To Iwata, this just doesn’t make sense:

We’re an amusement company and Apple’s a tech company

Review – Scientific Advertising

Scientific Advertising

by Claude C. Hopkins, published 1923

The “Benjamin Graham of advertising”?

Claude C. Hopkins was not only a contemporary of Benjamin Graham’s, but apparently a man after his own heart, for if the essence of “Scientific Advertising” were to be boiled down to one phrase it would be:

Advertising is most successful when it is most business-like

Anyone who follows the writings of Benjamin Graham should immediately understand what that means. For those who are unfamiliar with Graham, the idea is that advertising has its biggest impact when its goals and results are examined as to their practical effect– your advertising is a sales person for your organization and it should earn its keep; advertising is not about being witty, creative or memorable, it’s about buying customers at the lowest cost possible.

This has much in common with Graham’s concept of value investing, whereby the objective is to buy future investment returns potential at the lowest cost possible. Just as Graham would advise us not to overpay for anticipated business growth and the eagerness of the investment crowd, Hopkins advises us to study our costs and profits from our advertising campaigns scientifically, to ensure we’re getting the most bang for the buck without wasting money on entertaining and amusing those who never intended to buy from us in the first place.

Advertising as sales force multiplier

The role of advertising within a business organization is best thought of as a sales force multiplier. Accordingly, Hopkins stresses that,

The only purpose of advertising is to make sales… treat it as a salesman

This line of reasoning anticipates some self-check questions when considering an advertising campaign, namely:

  • Would this help a salesman sell the goods?
  • Would it help me sell them if I met the buyer in person?

When crafting an ad campaign, it’s important to think of an individual buyer of your product, what they look like, what they need and want, how they like to be communicated with, etc. You should consider how you would entice them if you were selling them face-to-face. Ultimately, it may be “the masses” who create volume markets for your products, but it is individual buyers who will read your ads and actually place orders.

The making of a great ad

The best ads:

  • based on the service rendered by the product in question
  • offer wanted information
  • cite advantages to users
  • often do not quote a price

They play to the ego of the individual buyer, because “whatever they do, they do to please themselves.”

Headlines are about grabbing the attention of people who are interested in your product. Not everyone is going to be a buyer of your product. You only have to get the attention of people who actually might buy.

The use of psychology is critical to ad programming. Human psychology is mostly constant and has been “since the time of Caeser”:

  • “Americans are extravagant. They want bargains, but not cheapness”
  • create a feeling of possession, ownership of property; when people feel something belongs to them, they’ll go out of their way to obtain it, even if it’s a trifle
  • limited offers applicable to restricted classes are more appealing than general offers available to anyone; “those seemingly entitled to an advantage will go a long way not to lose that advantage”
  • invite comparisons to your rivals, which demonstrates you do not fear them

Specificity is also another powerful tool in the advertiser’s arsenal– whereas an advertisement is a sales force multiplier, specificity is an authority multiplier for an individual ad.

Platitudes and generalities roll off the human understanding like water from a duck

Specific claims imply engagement with truth; something which is precise and “tested” demonstrates accuracy and experience which is usually accepted. To make a specific claim, one must have made tests and comparisons. This is why they have more force in the buyer’s mind. Further, standard, essential ingredients or functions of a product’s make or capabilities can be addressed in a specific way which creates a sense of differentiation (eg., two beer makers use the same pure, filtered water but one advertises that he “drilled 4,000 feet into the earth” to obtain the proper purity for his product).

Another principle of good advertising is “telling your full story”:

When you once get a person’s attention, then is the time to accomplish all you ever hope with him. Bring all your good arguments to bear

Think of the readers of your ad as new customers. Those who use your product don’t read your ads and you don’t care if they do anyway as they’re already happy customers.

The use of art in advertising should be made according to similar guidelines as those followed for writing headlines. Art, like headlines, use critical and costly advertisement real estate; they should be used in such a way, if at all, that they pay for their cost. Art should only be used to attract those who can profitably be sold to, and then only when the same message could not be conveyed as efficiently through a similar-sized amount of text.

Information, strategy, samples and more

It’s important to know your market, how big it is and what it’s worth. You never want to make the mistake of spending more than you could ever hope to earn because you were ignorant of the market you were advertising into.

You must also keep in mind your competitors: what do they have to offer? What kind of price, quality or claims can they weigh against your own? How can you win trade from them, and how can you hold it once you’ve got it?

We cannot go after thousands of men until we learn how to win one

Further, never forget that people don’t change their habits without a reason. And that it’s costly to create a non-specific market through your advertising that can be served by others than just yourself– then you make the mistake of advertising for your competition.

As far as samples are concerned, they are ineffective if wasted on people who have no intention or no ability to purchase your product. Give them only to those who show and interest, and then, make them exhibit that interest by exerting some effort.

Test campaigns can be used to establish the effectiveness of particular strategies on a small scale (say, thousands versus millions); then, using the law of averages, we can expect the results to hold at greater scale if the campaign is to be expanded or incorporated into the standard strategy set.

Whenever possible, introduce a personality into your ads and then, stick to it. If you change the personality, you’ll force people to continually refamiliarize themselves with your product and you’ll give up all past prestige you’ve managed to build up.

Negative advertising is not a good strategy:

  • never attack the competition
  • show the bright side, happy side, attractive side
  • beauty, not homeliness; health, not sickness; envied people, not the envious; tell people what to do, not what to avoid

Unless you have a catchy name that has become a household replacement word (like Kleenex, Vaseline, etc.), remember you’re advertising the service of the product, not the name.

Conclusion

When you think of your advertising efforts, imagine a rapid stream passing by in front of you. Without scientifically testing the results of your advertising efforts, the potential power of your advertising effort is wasted like the water rushing past. Scientific measurement and testing of your ad campaign is akin to placing a water wheel in the middle of the stream and channeling all that potential energy into actual energy which can be useful as a multiplier to the efforts of your sales force and your business organization as a whole.

Review – Death By Meeting

Death by Meeting: A Leadership Fable About Solving The Most Painful Problem In Business

by Patrick Lencioni, published 2004

The Model

Meetings are boring because they lack drama. Leaders must look for legitimate reasons to provoke and uncover relevant, constructive ideological conflict.

Meetings are ineffective because they lack contextual structure. We need to have multiple types of meetings and clearly distinguish between the various purposes, formats and timing of those meetings.

Meetings should start with the injection of drama in the first ten minutes so participants appreciate what is at stake. For example, illustrate the dangers of making a bad decision, highlight a looming competitive threat or appeal to commitment to a higher mission or vision for the organization.

Then, the meeting leader should mine for conflict whenever disagreement is present. It is better to hash the issue out and let everyone say what is on their mind then to let resentment and personal politics build. And it will require “real-time permission” from the meeting leader to make it work. Conflict must be affirmed as normal and desirable to increase the likelihood it occurs.

The Four Meeting Types

There are four different meeting types to be used based on content:

  1. The Daily Check-In, aka the “huddle”, a standing meeting no more than 5 mins in length; each participant reports on what they’re working on or need help with that day
  2. The Weekly Tactical, weekly/bi-weekly, 45-90 mins in length; Lightning Round, go around the table and report on 2-3 priorities for the week in 60 secs or less per person; move to Progress Review, including a report of KPIs, 4-6 per person, 5 mins total; Real-Time Agenda, this grows out of the Lighting Round and Progress Review portions, an agenda for discussion should focus on critical issues raised in these first 15 minutes; the overall goal is to resolve issues and reinforce clarity
  3. The Monthly Strategic, every 2-4 weeks, minimum of 2 hours per topic; discuss a few critical issues that affect the business fundamentally; need to occur regularly to serve as a timely “parking lot” for critical issues raised in the Weekly Tactical
  4. The Quarterly Off-Site Review, meets quarterly and offsite to focus on big picture strategic issues; 1-2 days; includes time for a team assessment; personnel review, identifying stars and poor performers; competitive and industry review to spot trends; most important objective is to build team unity

Sneaker Time

“Sneaker Time” is what is created by a lack of effective meetings and structure. Anything that can not be communicated (or is not communicated) in a group meeting means walking around the office for one-on-one visits. Given there are multiple people on the average team, this time burden involved in communicating can quickly zap teams of their vitality and effectiveness. A great organization can not afford sneaker time and therefore it can not afford to not make its meetings great.

Conclusion

This isn’t a super meaty book, but that’s a virtue– it’s short and sweet and to the point. The delivery of the concept via an interesting and relatable narrative story is also an enjoyable touch.

Notes – The Art Of Profitability

Notes from The Art of Profitability, by Adrian Slywotzky

Chapter 1, Customer Solution Profit

The Customer Solution Profit (CSP) model encapsulates the idea of understanding the customers problems and then providing them with a solution to their problems.

In the narrow sense, the CSP model captures the idea of having an intense, personal and detailed understanding of the challenges a customer faces and then providing them with a unique, custom-tailored solution that meets their needs. Such a relationship requires upfront investment of time and resources from both parties (the business and the customer) and it entails high switching costs because finding a competing business who can offer that same level of personalized service would require the loss of previous investments made in the existing relationship. This helps to create a “moat” around a CSP model business. Some examples of a narrow-CSP business would be a software solutions firm (a company producing custom back-end software that an operating company runs off of), a consultancy business, the professional relationship of a trusted lawyer or doctor, or a manufacturer of custom fabrications. The recent rise of information analytics engendered in data mining through web browsing activity also represents a form of narrow-CSP business modeling– think about the way Google can track your browsing habits to serve up targeted ads, or the way Amazon tracks your browsing and purchasing history to suggest items you may be interested in purchasing from them.

In the broad sense, the CSP model actually applies to ALL businesses. Every business seeks to create customers, and the way businesses create customers is by finding problems customers have that the business can solve. In Chapter 1, the guru David Zhao asks the protagonist, Steve, “Can you be profitable without knowing the customer?” It’s possible to think of semantic games you could play to answer this question in the positive, and surely there are some businesses which know their customers better than others, but in a general sense the answer is clearly “No.” To provide someone with a solution, you have to know them enough to know their problem.

The context of this question is partly related to Chapter 1’s exploration of the company Steve works for, Delmore, which by Steve’s judgment is a business which has seen growth in the past but seems to be stumbling and may even be heading for a downfall. Steve believes Delmore has lost its way and is not focused on serving the customer. Zhao’s question resonates even more in this regard because Delmore’s management seems more focused on administering the business rather than knowing its customers. In the present, Delmore still appears to be profitable (though much less profitable than its heyday), which seems to suggest that even a company that doesn’t know its customer can be profitable. But the implication of Zhao’s questioning is that over the long-run, Delmore will not be profitable if it can not find a way to focus on understanding its customers better.

Another idea explored in Chapter 1 is the role of company culture. Zhao talks about consulting for a company after learning the secret sauce of their competitor. He says he hand delivered the total solution to the business he was advising and they only ended up implementing part of it– they saw a pick-up in their business as a result, but it was not as dramatic as it could have been if they had implemented his ideas wholesale. Why, Steve asks, do some businesses behave this way?

To succeed in business you need to have a genuine, honest-to-goodness interest in profitability.

This suggests that differences in margin structure and net profitability for companies in the same industry could come down to the “profit culture” of the business, likely established by the original founders and permutated by succeeding hires and executives. They could have the “technology” or strategic know-how to earn a profit, but simply be disinclined to work hard enough or with a unified purpose or without the ego necessary to fully capture the opportunity available to them. This idea also introduces additional context for why much M&A activity rarely seems to bring the “synergy” promised by combining two companies into one– if they have wildly disparate cultures, getting the same performance out of the new company as was available in the two separate companies may be impossible, and cultures may clash so wildly that the overall profitability is in fact harmed by corporate unification.

The subtext to the entire chapter on Customer Solution Profit models is that to really understand the value of a business, you must look at what customer problems the business solves, and how. By studying what is unique about the customer solutions the business offers, you are able to have a better analytical window into the durability of its competitive position, the source of its profitability and profit potential, its opportunities for growth and the stability of its margin structure.

Chapter 2, Pyramid Profit

The Pyramid Profit model consists of multiple quality and price tiers for products, targeted at multiple types of customers (and customer preference), which creates two powerful dynamics for the business:

  1. Protects them from competition from market entrants below (commodity market)
  2. Creates profitable “customer migration” opportunities as loyal customers move up the steps of the pyramid (franchise market)

Why is this model so powerful?

As guru David Zhao teaches,

Your pyramid has to be more than just a collection of different products at different price points. A true pyramid is a system in which the lower-priced products are manufactured and sold with so much efficiency that it’s virtually impossible for a competitor to steal market share by underpricing you. That’s why I call the lowest tier of the pyramid the firewall. But the most important factor is the nature of your customer set. The customers themselves form a hierarchy, with different expectations and different attitudes toward price.

The competitive environment all businesses would prefer to have is that of a franchise, where their product is deemed uniquely valuable and essential such that the business can capture a franchise premium in its margin structure, a premium which is enduring and protected from competition over time by the proverbial “moat.”

Simultaneously, the competitive environment all businesses fear is that of a commodity market, where the only way to distinguish your product from someone else’s and incite the customer to buy is by offering the lowest price. It is a true race to the bottom and the turnover for businesses in commodity markets can be quite high.

As discussed in Clayton Christensen’s classic, The Innovator’s Dilemma, most innovators arrive in a market as low-cost entrants. Incumbent firms see no problem in giving the low-margin business dregs to them as they’re happy to play in the higher-margin markets upstream. The hungry commodity firms are constantly looking above them at the juicy margins available in this other market– can they apply their innovative, low-cost practices to this higher-margin space and move in for the kill? As Christensen details, so often they try and succeed.

This is the genius of the Pyramid Profit model. Incumbent firms are protected from innovative, low-cost competition by offering a low-to-no margin product that creates a competitive “firewall” at the most vulnerable place in the market, the violently dynamic commodity space. Then, they are free to play in the middle and higher margin markets without stress.

There is an additional benefit, as well. By capturing new customers even at the low-margin end of the market, the firm is able to increase customer loyalty and brand familiarity over the customer’s lifecycle. Over time. these (presumably) younger, poorer customers turn into older, richer customers following the circumstances of life.

The value of a Pyramid Profit model depends on the shape of the pyramid. A pyramid with a wide base and a narrow top is relatively inefficient and less valuable as most of the business volume is captured in the low/no-margin mass market whereas the high-margin premium market remains under-promoted. An ideal shape would resemble something more like a skyscraper tower– the same width for all tiers, all the way up, with enough segmentation via price/quality tier to progressively move customers up the pyramid at a rapid pace. The more business that is concentrated at the upper levels of the pyramid, the better the margins and the more profit the firm can earn.

The Pyramid Profit model can be found in many well known businesses, even though it is a rarer circumstance than that of the Customer Solution Profit model discussed in chapter 1. A good example is the automobile industry with its “economy” and “premium” brands (for example, Honda and Acura, or Chevy and Cadillac). Even within each brand, many manufacturers have managed to create a “pyramid” of quality, price and even features/capabilities (for example, Honda has the LX base model, EX, EX with leather and EX-L with navigation; it also has the Civic for the entry buyer, the Accord for the more sophisticated, the Odyssey for the family buyer, etc.). Another example would be the airline industry, such as Virgin Atlantic’s “Economy”, “Premium Economy” and “First Class” seating and service tiers. However, no airline seems to have created separate brands/carriers that focus on one tier of the pyramid over another, instead this segmentation always occurs per aircraft (contrast this to a “single class” carrier such as JetBlue or Southwest Airlines, though notice that even these firms have begun to offer new passenger tiers for additional money such as early boarding, extra luggage capacity, etc.)

Speaking of the auto industry again, one of the most prodigious Pyramid Profit employers has been Toyota. Toyota offers three brands in the United States: Scion, Toyota and Lexus. Scion was a brand developed specifically for the young car buyer, initially offering lower price points, simpler model choices and a “no bargaining” purchase experience that was supposed to capture a first-time buyer and put them into the “Toyota system” for the rest of their automobile-buying lives. Then, there was the mass market, multi-trimmed and multi-segmented Toyota brand, offering cars, vans, SUVs and light trucks to the everyman. And finally, there was Lexus, the flagship brand for wealthy, older, image-conscious and highly-demanding customers.

Toyota’s pyramid is awkwardly shaped, however. It’s base, Scion, is minuscule and definitely low/no-margin. The middle step is enormous and fairly profitable relative to the rest of the industry. And the top is much wider than one would expect it to be, being both relatively high-volume for a luxury market and quite profitable despite ongoing margin erosion in the industry overall. Indeed, Lexus auto dealership franchises are consistently one of the most valuable and sought-after brands in the industry alongside BMW and Audi, commanding high market multiples reflective of their premium value.

The key to a successful and highly profitable pyramid is twofold. First, you must be lucky enough to operate in a market that is conducive to segmentation of customers (especially self-segmentation). Second, you must know your customers well– the Customer Solution Profit at work again! The better you understand your customers and their specific needs, the better you will be able to create custom quality and pricing tiers in your pyramid that will meet their subjective needs.

Chapter 3, Multi-Component Profit

The central idea to the Multi-Component Profit is “same product, several businesses,” in contrast to the Pyramid Profit which targets distinct customer sets with distinct product offerings (differentiated in terms of quality and price). The example given in the book is Coca-Cola, which may be offered at several prices in several different venues ranging from a 6-pack at a gas station to a 2-liter bottle at the grocery store to a glass at a restaurant. The price per unit is different in each case,  meaning variable margin structure, but the customer is captured nonetheless at each consumption opportunity.

While each of these margin structures and business opportunities combine to average out to one margin for the controlling firm, Coca-Cola, each product represents a unique business opportunity from the standpoint of marketing and advertising, competitive dynamics and ultimately, profitability. And this is where the secret of the Multi-Component Profit lies– just as an entire economy can benefit from the division of labor by breaking large tasks into smaller ones that individuals can specialize in, an individual firm can benefit from identifying ways to segment its large business into several smaller, distinct components, managing each one uniquely.

How is this possible? If the price of a firm’s good is set at one price regardless of the volume, and marketed in a uniform way, the firm can miss opportunities to sell their product to a.) people who don’t see value in marketing not aimed at their needs and tastes and b.) people who would be willing to buy the product at a different price and in different quantities than how it is normally offered. By catering to these preferences as distinct markets, the business is able to offer optimum combinations of price and quantity that meet each markets needs better, thus increasing total volume and profit.

Another example of a Multi-Component Profit model at work would be a software operating system company, such as Microsoft, which has different business units for Business/Enterprise, Government/Education and Retail and Wholesale channels. Each user buys a different amount of software licenses and pays a different price for them. This would also be a principle at work in a computer manufacturer’s business, such as Dell (same business lines), or a networking component company like Cisco.

Would an oil producer qualify, such as Exxon Mobil? An oil producer actually produces a number of slightly differentiated products depending on source and quality of the oil sold (West Texas Intermediate, Brent, etc.) which would seem to put it more into a Pyramid Profit model, though even that relationship is tenuous because oil is a nearly ideal commodity product in the sense that it is hard to create a “firewall” product as well as to move customers up a pyramid structure, especially with the fact that oil tends to trade at a uniform price across world markets no matter where it is produced (if it is of the same type). An oil firm probably does not give significant discounts to “different customers” based on quantity ordered, either.

Similarly, an oil refiner would seem to be a Multi-Component Profit model with its different kinds of refined products marketed in different ways (kerosene for lamps, or kerosene for jet engines) but again, these markets are so commoditized and regularized across world markets that it is hard to imagine these businesses creating separate marketing and pricing initiatives for differing customer demand, instead just dumping their product into various wholesale markets that then re-sell the products to end users (though perhaps these businesses are in the Multi-Component Profit model).

Over time if I think of other examples, which there undoubtedly are, I’ll post them but for now I will close out these notes with this summary from the book’s protagonist:

Different parts of a business can have wildly different profitability. The customer behaves very differently on different purchase occasions. Different degrees of price sensitivity.

The value of this lesson, as the book’s guru says, is that constant innovation is a key ingredient to maintaining and growing the profitability of any business, and one way to innovate is to find ways to break your existing business into smaller and smaller components which can be separately managed with unique marketing, growth and profit trajectories.

Chapter 4, Switchboard Profit

The Switchboard Profit model combines three essential elements to generate outstanding profit:

  1. Packaging; the provision of necessary component resources for a task in one place/package that can be hired together instead of separately
  2. Monopolization; control of a critical resource that all users need to hire
  3. Market share; control of a critical mass of the total market (approximately 15-20% minimum in practice) which gives the perception of dominance and incentivizes economic actors to utilize the switchboard firm, thereby creating a multiplicative network effect that enhances the value of the switchboard with every additional increase in market share

Those are the essential ingredients. The way they work together to create outstanding profit opportunities is like so: limiting competition and reducing transaction costs. Those are the primary principles at work. By putting together various resources which would normally be hired separately (and thus, would be exchanged each in their own competitive markets), the Switchboard Profit model brings these resources under one roof where they can be hired together (packaging), where they can be hired no place else (monopolization) and where other similar resources, typically skilled labor, are thus attracted to because they see the probability of being hired at advantageous rates themselves to be much higher by participating in the network effect of the Switchboard Profit model firm (market share).

The result is a constrained supply which can negotiate for a higher total hire price. It is valuable for those hiring the products of the Switchboard Profit model firm to pay this higher price because they save on search costs and they also face the alternative option of hiring lower quality substitutes. The more that the resources in question come under the control of the Switchboard Profit model firm, the greater profit the firm can generate from being the central hub for hiring the resource out.

One company that sounds like a Switchboard Profit model on its face is Amazon, a logistics giant that aggregates numerous consumer goods in one place. This satisfies the packaging criteria, and it almost satisfies the market share criteria as suppliers of goods want to participate in Amazon’s marketplace because it can increase their market exposure and thus the chance that the product will be purchased. But Amazon does not maintain anything close to a monopoly on these goods because they’re widely available “commodities” rather than unique or limited supply products carried only by Amazon.

The example given in the book was the Hollywood talent agency of Michael Ovitz. Ovitz combined top star power with “total production resources” (writers, actors, directors, etc., all in one place) and he commanded a large share of the market such that additional writers, actors, directors, etc., had a strong incentive to join his firm and thus increase his profitability as his market share grew. An obvious additional example would be any other large, dominant talent agency such as for sports stars, musicians or other celebrities who each represent unique products that can be easily “controlled” and “constrained” by one firm.

The network effect seems to be a key aspect to the profitability of the Switchboard Profit model. Google’s dominance in search means it is largely the central hub by which people conduct their internet searches, meaning a person buying ad space in the Google network is getting a better package deal than other search network ad buyers.

A television network might also qualify as a Switchboard Profit model: if you have the best shows on TV and a large market share with all the kinds of shows in one place that people might want to watch, advertisers will be more attracted to you and so will TV show producers and so, too, will TV viewers. And the more people who utilize your TV network, the more valuable it is to everyone involved.

Other examples might include a health insurance network which includes top medical professionals under the insurance plan; a legal association with the best legal minds in a market in one place; or even a top university or research institution known to have the brightest minds.

Something interesting about the Switchboard Profit model is that most of these businesses seem to revolve around human resources, rather than non-human resources (commodities which are common or rare alike).

Chapter 5, Time Profit

Many of guru David Zhao’s profit models come with simple illustrations which capture the essential ingredient of the profit model. The image of the Time Profit model is an X-Y axis with “$/unit” on the Y-axis and “time” on the X-axis. Plotted across this chart is one line, which runs from the top left corner toward the bottom right corner at a 45-degree angle reading “Price”, and another line below that labeled “Cost” at a more mild angle, eventually intersecting with the “Price” line near the right side of the chart and then overtaking it.

The concept is simple: Time Profit is generated by being the first to market a new product or service because over time imitators will compete and eventually drive price toward cost. Time, therefore, is of the essence.

In TAOP, Zhao and Steve discuss Time Profit models in the context of firms without special legal protections (such as patents or copyrights) on their works which serve to shield them from competition. However, whether such legal protections are permanent or limited in duration, the Time Profit model principle is the same– only by being first to market would you even be afforded such legal protections in the first place, so there is an incentive to be first else you finish last.

Zhao and Steve discuss the Time Profit model within the context of an investment bank constantly innovating with new financial products. But this model could also easily apply to pharmaceutical and software development companies (which enjoy legal protections on their products), as well as a tech product manufacturer, such as a smartphone manufacturer, whose core product features are likely not subject to legal protections. Here, the Time Profit model is essential as the first firm to get a product to market with a valuable innovation that creates a consumer craze can capture a premium for their products while competing firms figure out how to duplicate this technology and make it standard in their follow-up product offerings. These “second place” firms are doomed to earn commodity returns on their products, only the first-mover gets to enjoy a profit premium.

Like the Customer Solution Profit model, the Time Profit model is more than just a specific business model, it is something of an essential feature to the competitive conditions of any firm in any industry facing innovative development which, practically speaking, is all firms in all industries. Whether a new product, a new service or a new internal or customer-facing process, all businesses seek to adopt one another’s best practices to save costs and increase profitability. The first firm to innovate something that is eventually imitable by others gets a profit advantage during the period of time between innovation and imitation by others. Time Profit models can be thought of as temporary competitive advantages due to periodic innovation.

As David Zhao teaches, a key component of the Time Profit model that is often overlooked is the role diligence in the innovative process plays:

Tedium is the single greatest challenge for a business that’s built on innovation

The first act of innovation is thinking, the arriving at of a brilliant new idea. The second act, and far more important, is the doing, the translation of an innovative idea into an innovative product, service or process. This part requires the same rigmarole of standard business practice: making phone calls, sending emails, training people, holding meetings, crunching numbers, keeping people on task and pulling in the same direction, etc.

Innovating, idea-making, is sexy and fun. But turning innovative ideas into real profit is often boring, common and time-consuming. The people and firms that are able to apply energy and determination to this part of the process are the ones who can most consistently capture the Time Profit. As innovator Paul Cook says, “What separates the winners and losers in innovation is who can master the drudgery.”

Ancillary Notes

Chapter 5 had a few other points worth mentioning, some of which were connected to carryover discussions from earlier chapters.

The first point concerns the power of critical numerical thinking. When working through a number problem, Zhao advises,

Getting the order of magnitude right is what matters, not the details

This is similar to Buffett and Munger’s “approximately right versus precisely wrong” dictum. Zhao also talks about using the numbers to ask and answer critical questions; the numbers of business (assumptions, projections, actual results, etc.) can tell us a story, but we have to be curious about the numbers. It’s not enough to wonder, “Why are the numbers what they are?” we have to be able to put forth some effort to attempt to answer such questions ourselves. As Zhao says,

Being able to take the measure of the world is one of the most crucial skills we can develop

The second point, which is arrived at in a discussion of business innovation, is the “paradox” Zhao observes in the semiconductor industry, which is that the firms involved “copy each other’s chips, but not each other’s business models.” It is the business model which is responsible for mastering the Time Profit concept and other models discussed in TAOP– why don’t more managements focus on copying successful business models rather than imitating successful products and services?

It brings to mind a question for potential investors, too. Which businesses could see their value dramatically improved by focusing the company’s efforts on copying the leading business model in the industry rather than engaging in the rat race of perpetual product innovation/imitation?

The final point has to do with the nature of learning. Steve the student asks Zhao for a copy of his notes from a previous meeting. Steve wants to see how Zhao solved a problem they both worked on. Zhao suggests,

you’ve got to learn how to solve these problems in your own way

the idea being that true knowledge means being able to solve a problem in your own way, not by imitating somebody else. This is why some firms are innovators while the rest are imitators. Innovators are capable of solving problems their own way; imitators just copy the innovator’s solution. But it’s a lesson that’s important to the budding business analyst, as well. How will you solve problems when there is no guru there to teach you? You have to find your own path and do your own thinking.

Until you can do that, though, as Steve says, copying a few “Picassos” to practice a known master technique can be helpful.

How Does Amazon Avoid Creating It’s Own Mini-Depression?

According to a new article at Slate, Amazon will soon (within the next 12 months) be offering it’s Kindle e-reader device for “free.” Here’s the part of the story that interested me the most:

Every time Amazon drops the price of the Kindle, sales of the device and sales of Kindle books increase dramatically.

This is curious. According to conventional economic views of the business-cycle, depressions occur when nominal price shocks occur in the economy which reduce the amount of aggregate spending, promoting further price decreases by businesses, which lead to even more reductions in spending as consumers become convinced that if they just wait a little bit longer, they can buy what they need at a lower price.

Next thing you know, spending has collapsed into the notorious and much-feared “death spiral” and the economy grinds to a halt. Mass unemployment, the fall of social morality and Huns impaling the babies of screaming mothers on top of their bayonets. The yooj.

But at Amazon, every time they lower prices, people spend more.

How come when Amazon does it, it creates more business and an environment where everyone (consumers and Amazon as a business) prospers, but when it happens in the economy at large, we get a death spiral and impaled babies?

Somewhere, there’s a disconnect between micro and macro. The secret (that the Keynesians never share and refuse to explain) is how and why this necessarily happens. Good luck figuring it out, I still haven’t!

How Businesses Grow: The Five Guys Story

What does America’s fastest growing restaurant chain look like on the inside and how was the growth accomplished? For the answers to those questions and many others I read a recent Forbes article entitled “Five Guys Burgers: America’s Fastest Growing Restaurant Chain“.

First, “Five Guys” growth in numbers:

  • Doubled number of stores since 2009
  • Started in 1986; since then, has grown to 1,039 stores in the US and Canada with commitments to open another 1,500
  • Grew 792% since 2006, nearest competitor Jimmy John’s grew 241% over the same period and now has 1,329 stores
  • Company-owned franchises 200; franchised 839
  • Projected sales of $1B+ in 2012; corp revenues of $275M with cash flow of $50M
  • Current value of the company estimated at $500M, $375M of which belongs to the founders, on an initial investment of $70,000

Founder Jerry Murrell and his sons came up with the idea in 1986 when Murrell offered his older sons nearing high school graduation a deal– they could go to college, or they could use their tuition money to start a restaurant.

Like many rapid growth successes stories, early growth was slow and hard to come by. Persevering through employee theft, customer service shortcomings and inter-family squabbles behind the scenes, the group opened their second store in 1989 after being turned down for business loans by numerous local banks. Instead, they raised money $10,000 to $30,000 at a time from 100 friends and acquaintances and committed to always paying on time.

Even early on Murrell received suggestions that he stray from the company’s “core competency” of high quality burgers and fries– coffee, chicken sandwiches, milkshakes and more were all brought up and some even tried but every time Murrell found it to be a disaster. Eventually, Murrell and company gave up, and his disciplined reasoning is instructive in demonstrating his understanding of his own brand:

My fear was that we’d add something new and not be good at it, then some reviewer would write about how bad our coffee was and not how good our burgers and fries are… [The demise of other restaurant chains involves one constant.] They all started to offer too many items and got away from their core.

By 2002, they had 5 stores in Northern Virginia and began thinking about franchising. Murrell received a copy of Franchising For Dummies from his son which he read and that, combined with a fortuitous meeting with former Washington Redskins-kicker and burger joint owner Mark Mosley and consultation with Fransmart the Five Guys team moved ahead, selling out all franchise rights to Virginia within three weeks.

The standard franchisee must have a minimum net worth of $1.5M and liquidity of $500,000. He pays an upfront fee of $75,000 per store, the average store costing $350,000-$500,000 to open and generates an average of $1.2M in revenues each year. Five Guys corporate charges 6% of gross revenues and another 1.5% which is collected for “audits” which are used to pay $1,000 weekly bonuses to stores that score will after being visited by independent examiners. According to Five Guys largest franchisee, stores break even within two and a half years and have operating margins in the mid-teens.

There are other entrants in the “better burger” category such as Smash Burger and Shake Shack (note: I’ve had both and I don’t think they offer much competition) and because of the rapid franchising, Five Guys has occasionally run into the problem of overlapping markets where franchise owners cannibalize one another’s sales. Murrell occasionally buys back franchises when he can and the company is currently working on an overseas expansion which will begin in the UK. There’s talk of expanding to the Middle East and private equity and investment bankers have been on the company’s case for years.

Who knows what lies ahead but so far, through all the ups and downs, the company has remained a thoroughly family affair.

How Businesses Grow: “The LEGO Story”

I found this video on the Laissez-Faire Books blog after Jeff Tucker posted it recently.

It’s an entertaining and educational video that provides anecdotes about how and why small businesses grow. In the case of LEGO, because they had to– the owner-operator of the company had no golden parachute to fall back on if he failed. This kept him thinking creatively about how to solve the many challenges he and his business faced. It was “find a way” or else he and his children would starve.

It’s a story of entrepreneurialism, the essence of which is experimentation, vision and constant change.

As you watch the video, it’s hard to imagine a story like this being told about anything other than an initially small, local, privately-owned business. It perfectly captures the idea of the “benevolent dictatorship” style of business and capital management. We also get a look at the innovative process that leads to the creation of a whole new industry (or sub-industry, much like the iPhone was an emergent sub-industry within the industry of smartphones).