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The Myth of Homo Economicus

When I went to school in the Dark Ages, we were taught in Economics that there is such a thing as Homo economicus, a purely rational human who makes all economic decisions based on “What’s in it for me” — sounds a lot like Chicago aldermen, but I digress. In many ways, this short cut made economics much easier.  We didn’t have to worry about things like people’s desire for respect or willingness to impose “fairness” into our negotiations. But it was also a bit like physics, where we were told to ignore the effects of friction in some of our equations – a shortcut than didn’t really help our understanding of the world we live in.

As time moved on, economists and psychologists started to research whether the Homo Economicus was real or a fallacy.  Scholars like Amos Tversky, Daniel Kahneman, Ian Ayres, Dan Ariely and Richard Thaler ran scientific experiments to see if people really did act rationally when it came to economic decisions.  What they all found, in various ways, was that we are not rational at all when it comes to buying, negotiating, selling, responding to advertisements and even going to the movies. In fact, to steal the title from Dan Ariely’s most famous book, we are Predictably Irrational.

I have recently completed reading the book Priceless: The Myth of Fair Value (and How to Take Advantage of It) by William Poundstone. I had read a number of Poundstone’s books before. He wrote books on secrets and puzzlers like How Would You Move Mount Fuji?, but I wasn’t prepared for the level of detail and research that he had completed to write this book.
The book is structured into 53 chapters. Each chapter takes a specific pricing case and talks about the specifics of the deal. There is also a description of a scientific experiment that describes the psychology of the participants. I had read about a lot of the experiments before, but this book allowed you to tie the results of the experiment with the results of a pricing decision in a very real way.

Poundstone opens the book by retelling of the McDonald’s hot coffee lawsuit, where the attorney for the plaintiff in the case employed a simple scheme to raise the amount of the jury award — he simply asked for an astronomical award from the jury.  This raised the anchoring point for the jury so that while they awarded much less than the asked for judgment, they awarded much higher than any rational person would have considered the case to be worth.  Anchoring also works in the grocery aisle.  Not too long ago, the standard size for ice cream was a half-gallon.  Consumers had in their minds what they normally paid for a half-gallon of ice cream.  Manufacturers wanted to raise prices (their costs had increased) but were concerned that if they raised prices, people would notice and either change brands or even more worrisome, consider alternative dessert items.  So, now if you go into the grocery store, most ice cream is sold in 1.5 or 1.75 quart sizes (a reduction of 12-25%), but the pricing is kept in the same familiar range.  The average consumer doesn’t realize that they are getting less for the same price and the market share of ice cream as a portion of the dessert market is safe. Anchoring at its best.

One of the experiments that gets a lot of play in the book is the ultimatum game.  In this game, one person is given $10 and is told that they can give any part of the $10 to another player.  If the other player agrees, then the deal is done.  If the other player does not agree, neither party receives any money.  This simple game uncovers a lot of different outcomes.  Men perform differently from women, Type A’s perform differently from Type B’s, Liberals perform differently from Conservatives, sober people perform differently from those more tipsy.  Is the proposer most rational when he proposes $1 to be given to others while keeping $9 for himself?  Is the receiver rational when rejecting a deal that would make them $1 richer in order to punish the unfairness of the proposer?  The best example in the book of the ultimatum game in real life is the story of Jack Welch’s divorce negotiation.  While we normally think of Neutron Jack as a most savvy businessman, it was fun to read the story how of his former wife turned the tables on him using the precepts of the ultimatum game.

Each of the chapters talks about ways that we as consumers are manipulated to paying more or selling for less than our mythical ancestor Homo Economicus would have been expected to.  This is certainly important to consumers, because a savvy consumer who is aware of the psychological tricks can make smarter purchasing decisions.  As business people, it is helpful to understand how to price your products and services in order to reduce price resistance.

This book was a pretty easy book to get through with enough concrete examples to catch your attention. In the 1-5 star rating category, I would give this book a solid 4 star rating.

New Product, Knowledge and Advice

New Product: I am very excited by the Square credit card processor for the iPhone (and maybe other devices with an audio plug).  This product will revolutionize the way that people can conduct commerce.  Not just businesses, but even person to person.  The device is a small square credit card reader that plugs into the audio jack on the iPhone.  There is software for the iPhone that will process the credit card and transfer money directly to the recipient’s bank account.  Now the founders of Square have done some things right.  They priced the software at $1 and the device is free.  This makes it almost irresistible for anyone who wants to accept credit cards.  Think of craft fairs, your lawn mowing teen or a Craigslist seller. The cost per transaction is reasonable (2.9%) and Square will even donate a penny per transaction to a charity of your choice. More details and a video here.

Knowledge: Steve Schwartz wrote a post on the 3 types of knowledge. While the language is not always appropriate for elementary school, he does explain clearly how these 3 types contribute to our general sense of ourselves.

Advice: Micah writes about giving advice. This one is going to be hard for me to do (given the name of this blog) as I love to give advice almost as much as Micah does, but if he can find a better way, I can try.

Sethx2, The Brain and Microsoft

I haven’t done a recommended links post is a while and so here we go:

Seth: This week Seth Godin directed me to two very cool web resources that I urge you to take time to read and view.

The first is the video Lemonade.  It deals directly with folks in the advertising agency business who have been laid off and how they found their next steps.  Some people feel that it is talking about the need to start a new business, but my take is that it shows that you really can make Lemonade out of lemons if you pursue your dreams.  The video is well made and totally engaging.

The second is a free e-book on pricing.  How exciting can that be, you ask?  Well, the author, Todd Sattersten who has developed the business book review site inbubblewrap, clearly explains the components of pricing, costing and especially margin.  He also delves into the concept of free.  All in all a very quick and information packed presentation.  And the price is right!

The Brain: Harvard Business Review had a nice article on how the middle aged brain (of which I am the proud owner) has some inherent benefits as it relates to businesses.  It is good to hear that while we sometimes can’t remember names, we have built other skills that can help us in the business world.

Microsoft: Microsoft’s perception in the marketplace has changed over the past 25 years. The New York Times has a nice article on what the company has done to put itself in their current market space. This is a good warning to Google as well as any other company that goes through significant growth.

Value and Choice

When I think of all of the businesses that I might want to be involved with, the airline industry is down near the bottom of my list.  Massive government intervention, public ownership, reliance on a wildly fluctuating fuel cost, overcrowded marketplace, customer service nightmares, unionized unhappy employees throughout the organization.  Wow! But it still amazes me that the executives in charge of the majors take their eye off the ball so often.

Doug Parker, president of US Airways, crowed that the carrier was making $400 million per year on ancillary fees.  Never mind that the industry continues to lose money.  Never mind that US Airways lost $100 million in a recent quarter and saw its revenue drop over 13%. United Airlines makes $14 per passenger in ancillary charges, but lost $382 million in Q1 2009.

Never mind that the average consumer is tired of being nickled and dimed – window seat, head set, cut in front of the line, extra 5 inches of legroom, snack, soda, more miles, checked bag, overweight bag, travel on a busy day, talk to a ticket agent, redeem a frequent flyer award – all of these cost extra on at least one major airline (excepting Southwest). The whole travel experience is now so convoluted that some people have decided that the hassle of air travel is just not worth it.  I have had 4 opportunities this year to travel that in years past I would have chosen to fly. Not this year… my rule has become only fly if necessary.

From a customer service perspective it is a disaster.  Every time you need to talk to the company, they want your credit card.  Their eagle eyed bean counters (and remember that I usually love bean counters) are crowing about the new revenue, but aren’t looking at how many people have stopped flying.  That seems to be to be a bigger issue.

I mentioned earlier that Southwest has not moved to a la carte pricing.  They haven’t had a losing quarter this year.  Maybe that should tell the bean counters something.

Even in areas outside of the airlines, we see the same “logic”.  I tried to buy college football tickets online last week.  The website gave me two options for delivery. Print them out at home for $6 or pick them up at Will Call for $3.  In neither case, did the college incur any significant additional cost, but there was that ancillary charge.  Guess what, I didn’t purchase the tickets over the internet.  Oh well.

For those of you out there looking to break down your pricing to provide a more a la carte menu solution, I would recommend really investigating whether you will achieve the goals that you hoped by doing so.  You may be much better off by playing the Southwest to the majors.

Banking Etiquette

Banks have gotten a bad rap over the past year or so.  But in truth, they are the linchpin of our financial livelihood as entrepreneurs.  If you accept credit cards, you need a bank.  If you pay payroll taxes, you need a bank.  If you want to pay your employees using direct deposit (or even the quaint paycheck), you need a bank.  Most vendors still require that you pay them using a check.

Banks also can provide loans for businesses.  These can be asset based loans, lines of credit, mortgages, long and short term.  And this is where businesses can get into trouble.

While most business owners think of their checking accounts and loan accounts as separate entities, the banks do not.  So if you have missed a couple of payments or have just exceeded your loan covenants, the bank can, without warning, clear out your accounts to fulfill the terms of your loan agreements.  And if you have a personal guarantee, they can tap into any personal accounts you might have at the same institution.  Talk about a kick to the head…

I have a few suggestions to try to make this less of a potential issue for you:

  1. Build a good relationship with your banker.  Meet quarterly with him or her.  Take them into your business and explain what goes on.  For sure, tell them the good news when you sign a big deal, but just as critically, let them know when things aren’t going so well.  The more you communicate with them the better you will be.
  2. Don’t put all your eggs in one basket.  Keep your personal accounts at a separate bank.  Keep transactional money at the primary bank, but keep other long term cash somewhere else.
  3. Understand your loan covenants.
  4. If you don’t hear from your banker, or they don’t return your calls, don’t consider this a good thing.  The last time I heard about the money transferring process was 2 weeks after hearing “Oh yeah, I haven’t heard from my banker at BigBank in 6 months.  I’m guessing that they have forgotten about us.  They must have bigger fish to fry.”

When this happens, everyone gets upset at the bank.  How could they do this?  In reality, the bank is just trying to forestall the worst outcome for the bank, a complete loss of the capital that they have provided to the customer. They figure something is better than nothing.  And the entrepreneur needs to understand that that is a potential outcome of the deal that they made when they accepted the cash.

Health Care Musings – Insurance Edition

Earlier this week I posted about the health care mess and talked about some of the causes.  In thinking about this a bit more, I feel the need to expand upon one particular group of participants.  Over time I may go over some of the others, but for right now, my ire is with the health insurance industry.

These are presented as separate musings, all related to the same topic.

Insurance is a funny thing.  Many people believe that insurance should cover all medical costs.  In my world view, this is playing with OPM – Other People’s Money.  If the insurance policy will pay for everything, where is my responsibility to evaluate the costs and benefits of my health care needs?  I firmly believe in high deductible medical policies — where the insured pays for the regular charges and uses the insurance to cover the risk of a costly medical event.  In this way, you can determine if you should go to the emergency room with that sprained ankle or whether it is better to wait to go to an urgent care center where the costs are less.  You need to take control of your health care and the best way to do that is through the lens of your wallet.

I read an interesting article from Nate Silver, from fivethirtyeight.com, the statistical blogger who correctly predicted the last presidential race.  He talks about a George Will opinion article that describes the President’s wish to include a public insurance option as a folly.  Nate (and I) believe that the addition of a public option will provide some competition to the ingrained insurance cabals.

One of George’s thoughts is that the government can undercut the insurance companies because it does not need to make a profit.  Nate brought a good point to the discussion – the fact that profits are not earned by providing better service, just by adding additional people to the pool.  Therefore, the government can provide serious competition to the insurance companies.  Last year, Aetna earned $1.3B in profits, UnitedHealthCare returned $2.977B and CIGNA had a bad year, only $297M in profits down from $1.1B the prior year.  We should not cry for these companies; we need to ask how they are going to help us address the health care crisis in our country.

In any case, the logic that the insurance companies use is flawed.  For example, let’s say that someone has an insurance policy through an employer.  No problem, the insurance company takes a history but, in general, accepts everyone in the group. All is fine until the employee loses his job.  Not a big deal, because there is COBRA, which allows the employee to continue coverage, by paying the entire premium.  Now, this is only the law for companies that have 20 or more employees, but let’s not pick on details.  So, the former employee is now paying the full premium, but is covered under the same terms and conditions as when he was employed.  But COBRA runs out 18 months (yes, there are some exceptions and temporary extensions, but bear with me…).  At this point, former employee needs to get other insurance.  Hopefully he will have gotten a new job that include health insurance benefits.  But let’s take the story one more step.  He is unable to get a new job.  He tries to get an individual policy that will cover his insurance needs.  So, he goes back to the company that provided his insurance coverage while he was employed and during his COBRA period.  Note that nothing has changed:  same company, same person, same health experience, no health changes. The company denies him insurance because of a medical issue.  They claim that his risk is too high.  But nothing has changed!  The risk is the same as when he was employed.  The insurance company claims that because the group is now small (1), they have different underwriting standards.  Instead of looking at their entire pool of policyholders, they focus on the risks associated with a single participant, which negates all of the reasons for having insurance in the first place.

There are many problems with the insurance system today.  George Will elaborated on some of them.  OPM even raises its head here because a significant portion of the employee’s insurance premium is paid for by the company with tax deductable dollars.  But as Nate Silver so adeptly points out, you can’t just start up a health insurance company anymore.  The only entity that has the ability to do so is the Federal Government and I sure would like to see some innovation that might be spurred on by new competition.

The one thing that the general public doesn’t have that all of the other constituencies have is a lobbyist.  The doctors and the AMA have one.  The insurance companies have one.  Big Pharma has one.  The hospitals have them.  Right now, the President has the responsibility for lobbying for the general public.  He has claimed that he wants bipartisan support for health care reform, but it is clear that the only way to get both parties to agree is to have no real change.  President Obama needs to use his bully pulpit and put together a program that will work to reform healthcare, despite the opposition party and the lobbyists.  This is his opportunity to put his stamp on ensuring the future of the American health care system.

The thing about this health care crisis is that no one is going to come out of this with the status quo.  Each constituent is going to have to make a change: it could be to their process, procedures, reimbursement, staffing, equipment, expectations etc. The insurance companies need to take the initiative to strive for new ways of doing business so that they have some say in how it all comes out.  Otherwise, they might just be forced by competition from the government and by force of law to react to a very different world view.

Magic Numbers

I get really jazzed up at this time of year.  Some of it is the magic of springtime, green grass, cycling again, robins chirping.  But mostly it is because baseball is back.  Baseball conjures up in me many things.  Partly it is the memory of “having a catch” with my dad (and continuing the custom with my kids).  Some is the love of the teams and the rivalries (Red Sox vs. Yankees and Cubs vs. Cardinals).

A lot of what we love is related to the ways that we can follow baseball.  Sure, a day at Fenway or Wrigley can be a memorable event. Following the box scores in the paper or watching SportsCenter can stoke the habit.  But in the end, baseball is a complicated game, full of arcane rules and strange rituals.  One way to make it easier to understand is to break it down into numbers.  Everyone knows about batting averages and ERA.  If you are really into baseball, you might know PECOTA, OPS and SLG. These stats help us to visualize, compare and project a team’s future.

In business, as well, we can use stats to help us understand where things are going.  I like to talk about these as Magic Numbers.  Everyone is familiar with the biggies — Net Profit Percent, Average Ticket for a restaurant, Return on Investment, Debt to Equity ratio, P/E Ratio.  But every business has (or should have) some specific measures that are important to its health.  These should be easy to calculate, presented on a regular basis (daily or weekly) and help the manager to forecast where the business is going.

For example, when I was running my consulting company, we had a few numbers that we tracked weekly.  They included Cash in Bank, Average A/R Days, Utilization %, Sales Pipeline and Backlog $.  Some of these were trailing stats; that is, they told us of what had already happened — Cash, Avg. A/R Days and Utilization fell into this category.  Pipeline and Backlog were leading indicators.  Pipeline told us how many deals we had in play for how much and when they were expected to close. We used an expected value (Expected % of Close * Dollar Value) as a tracking mechanism. Backlog told us how much work we had on our books that was signed by the client, but was not performed yet.  We needed to keep backlog increasing through sales at a reasonable rate.  The working off of the backlog would take care of itself; every week people were decreasing it.

Norm Brodsky, an entrepreneur and columnist at Inc. Magazine wrote about his use of Magic Numbers and how the practice allowed him to forecast a downturn in his business.

Sometimes Magic Numbers can be developed that will help you understand your market, while measuring things totally outside of your sphere of control. There are stories about people who count the number of cars in a mall parking lot to determine if their restaurant’s prognosis is up or down.

So, the question is do you employ magic numbers in your management process and if so, what types help you to forecast the health of your business?

Unemployment Ideas

You just never know.  I happened to be at a family gathering recently and was seated next to a woman who I did not know.  She mentioned that she worked for her state’s Department of Labor and was an unemployment counselor.  We got to talking and I found out a bunch of neat things that I didn’t know about unemployment.

(Disclaimer: I am not an attorney or unemployment counselor, so you should check out what I say with your state’s Department of Labor or a real labor attorney.)

  • Depending on your situation, you may be able to shop your unemployment claim to a different state.  If you have worked for employers in different states or even, sometimes, if your corporation has its headquarters in a state, you may be able to file there.  Why is this important?  Unemployment is handled as a state matter.  Therefore, each state has its own limit on weekly benefits. A list of 2008 maximums by state can be found here. The differences can be staggering.  Florida was at $275, but if there is some chance that you can collect from Massachusetts, your weekly maximum could be $900.
  • You can file for non-contiguous time frames.  Say that your boss lays you off, but then offers to pay you half your salary for half time.  You are better off working one week on and one week off.  In this case, you can file for unemployment on your off weeks until you get a job.  Do not work half days because any day that you show up for work cannot be counted towards unemployment.
  • If you do get laid off, look for opportunities to go back to school. Unemployment compensation can sometimes extend throughout your academic program, even if it exceeds the normal time frames.  In addition, there are often state grants for retraining that can be applied for to pay for tuition.
  • There have been many changes to unemployment law and practice in the past year due to the economic conditions.  Make sure to do your homework or talk to an employment counselor at your  Department of Labor to see about the $25 Federal increase and the extension of unemployment benefits.

Certainly, no one wants to be on unemployment, but if you or someone you know has been affected by this economy, it pays to know the rules at the Department of Labor.

Measuring and Rewarding Customer Service

Most of my career has been in managing services businesses. You know, the kind where people actually work on some sort of problem for a client for a fee. I have been blessed to work with really great teams of folks who care about their clients, understand the products and environments and are willing to go the extra mile (actually lots of airline miles) for their project teams.

One of the difficult management issues that arise is how to evaluate these folks and provide an incentive compensation program that works.  Sure, you can measure billable hours, profitability, utilization or professional growth.  Those are relatively easy to track, but are not always under the consultant’s control. As my friend and incentive guru David Kelly says, there are lots of ways to demotivate your staff.

But, you say, the real measure of what your staff is doing is Customer Satisfaction, right? Just measure Customer Satisfaction and then reward people on that. Of course, why didn’t I think of that?  Oh yes, it’s because there is really no good way to measure it in a service business.  In a product business, you can look at returns, customer complaints, help desk issues etc.  But in a pure services business, you need to look at project progress plans, client politics, change orders, working conditions, rework, team dynamics, systems —lots of interrelated pieces that can’t be readily quantified. Wait, I know… What if we were to give the client a survey that asked how we were doing?  That would solve the problem, right?

Not so fast. Sure, you could give the client a survey.  Now the consultant or project manager needs to get the client to fill it out.  Many times the client will not fill it out — legal won’t let them, no time, not on the critical path.  How do we rate the consultant then?  Other times it is either all 1’s or all 5’s (it doesn’t matter for this discussion whether 1 is best or 5 is best).  And much of that is related to the client’s demeanor and general angst at the time that the consultant does the asking.  And that is not even bringing up the subject of the “you scratch my back and I’ll scratch yours” type of discussion between the project leader and the client.

I have recently been involved with two transactions that furthered my discomfort over the use of client surveys.  Over the December holidays, my family took a cruise with Holland America. Our cruise was good in many areas, but not overwhelming.  On the last day of the cruise we were handed Cruise Surveys and the Cruise Director explained how the surveys should be filled out.  Everything on the form was ranked 1 to 9, where 9 was outstanding.  Our instructions included: “The highest score is 9 because, of course, 10 is perfect and we don’t pretend to be perfect.  However, if you enjoyed your cruise you should mark 9’s on the survey.  The crew gets paid based upon your filling out 9’s.  Feel free to add comments, but if you were happy, remember to give us all 9’s.” You get the picture.

If I was the COO of Holland America, that Cruise Director would have been history at the conclusion of his speech.  What is the point of a customer survey if you embarrass or cajole your customers into giving you the scores you want? How can Holland America Corporate understand how satisfied their clients are with the service they receive?  As you might guess, my survey was not all 9’s and had plenty of comments.  I don’t know how the surveys were evaluated, but I never received a call from Holland America (the surveys were coded to indicate the cabin), so I can only assume that they were happy with the way that their crew performed according to my survey.

Lest you think that I am only taking aim at Holland America, it happens in other places too. Last time I brought my car in for service, the service manager delivered the fixed car to me and said that I should expect a call from “Corporate” asking about my service experience.  If there was any reason that I could not give them a 5 down the board, to please call the service director at the dealership.  Now this was a little more benign.  Sure the service manager would have an opportunity to fix my problem, but he was predicating this on getting all 5’s on the survey.

There are too many ways that a Customer Survey that is used for incentive compensation can be misused.  Remember that the behavior that you get is the behavior that you incent.  If you want all 9’s on a survey, you will get them.  Perhaps not the underlying business behaviors that cause 9’s, however. David expounds on this topic as well in Commission Plans – Let the Games Begin.

If you have some good ideas on how to incent Service Providers or how to measure Customer Service in a services environment, please let me know in the comments.

Retail, Entrepreneurship, Financial and Politics

Retail: Microsoft has announced plans to open up retail stores and have hired their first VP of Retail.  Robert Scoble takes an opportunity to give Microsoft some pointers on what they should do to differentiate themselves from Apple and Best Buy.

Entrepreneurship: I just love it when I can uncover a new blog (to me) that takes a different look at things that I am interested in.  So, I found Micah who talks about entrepreneurship.  However, he looks at it at a little bit of an angle.  For example, here are three of his latest essays, “What is an Entrepreneur?“, “The Economics of Stripping” and “Cauldron of Friction“.

Financial: On Friday, I asked about what the big banks were doing with their taxpayer funds.  Apparantly, nothing, according to their testimony on Capitol Hill.

Politics: So, the Democrats handed President Obama the stimulus package that he asked for.  How are the Republicans taking this?  Frank Rich of the New York Times  talks about the win, while Andrew Sullivan of the The Daily Dish castigates the Republicans for getting us into this mess and then whining about fiscal responsibility.

Technology: Ever wonder about how the phone company figures out the charges for text messaging?  So, did Senator Kohl from Wisconsin.  He couldn’t get much further than you or I.

Fun: For a fortune cookie style blog, Amy Flanagan runs theshortestblogintheworld.  Today was a classic Amy: What if Snopes is a hoax?