Understanding How Data Is Organized: Key Terms and Technologies

A databaseA single table or a collection of related tables. is simply a list (or more likely, several related lists) of data. Most organizations have several databases—perhaps even hundreds or thousands. And these various databases might be focused on any combination of functional areas (sales, product returns, inventory, payroll), geographical regions, or business units. Firms often create specialized databases for recording transactions, as well as databases that aggregate data from multiple sources in order to support reporting and analysis.

Databases are created, maintained, and manipulated using programs called database management systems (DBMS)Sometimes called “databade software”; software for creating, maintaining, and manipulating data., sometimes referred to as database software. DBMS products vary widely in scale and capabilities. They include the single-user, desktop versions of Microsoft Access or Filemaker Pro, Web-based offerings like Intuit QuickBase, and industrial strength products from Oracle, IBM (DB2), Sybase, Microsoft (SQL Server), and others. Oracle is the world’s largest database software vendor, and database software has meant big bucks for Oracle cofounder and CEO Larry Ellison. Ellison perennially ranks in the Top 10 of the Forbes 400 list of wealthiest Americans.

The acronym SQL (often pronounced sequel) also shows up a lot when talking about databases. Structured query language (SQL)A language used to create and manipulate databases. is by far the most common language for creating and manipulating databases. You’ll find variants of SQL inhabiting everything from lowly desktop software, to high-powered enterprise products. Microsoft’s high-end database is even called SQL Server. And of course there’s also the open source MySQL (whose stewardship now sits with Oracle as part of the firm’s purchase of Sun Microsystems). Given this popularity, if you’re going to learn one language for database use, SQL’s a pretty good choice. And for a little inspiration, visit Monster.com or another job site and search for jobs mentioning SQL. You’ll find page after page of listings, suggesting that while database systems have been good for Ellison, learning more about them might be pretty good for you, too.

Even if you don’t become a database programmer or database administrator (DBA)Job title focused on directing, performing, or overseeing activities associated with a database or set of databases. These may include (but not necessarily be limited to): database design, creation, implementation, maintenance, backup and recovery, policy setting and enforcement, and security., you’re almost surely going to be called upon to dive in and use a database. You may even be asked to help identify your firm’s data requirements. It’s quite common for nontech employees to work on development teams with technical staff, defining business problems, outlining processes, setting requirements, and determining the kinds of data the firm will need to leverage. Database systems are powerful stuff, and can’t be avoided, so a bit of understanding will serve you well.

A complete discourse on technical concepts associated with database systems is beyond the scope of our managerial introduction, but here are some key concepts to help get you oriented, and that all managers should know.

• A table or fileA list of data, arranged in columns (fields) and rows (records). refers to a list of data.
• A database is either a single table or a collection of related tables. The course registration database above depicts five tables.
• A column or fieldA column in a database table. Columns represent each category of data contained in a record (e.g., first name, last name, ID number, date of birth). defines the data that a table can hold. The “Students” table above shows columns for STUDENT_ID, FIRST_NAME, LAST_NAME, CAMPU.S._ADDR (the “…” symbols above are meant to indicate that in practice there may be more columns or rows than are shown in this simplified diagram).
• A row or recordA row in a database table. Records represent a single instance of whatever the table keeps track of (e.g., student, faculty, course title). represents a single instance of whatever the table keeps track of. In the example above, each row of the “Students” table represents a student, each row of the “Enrollment” table represents the enrollment of a student in a particular course, and each row of the “Course List” represents a given section of each course offered by the University.
• A keyCode that unlocks encryption. is the field used to relate tables in a database. Look at how the STUDENT_ID key is used above. There is one unique STUDENT_ID for each student, but the STUDENT_ID may appear many times in the “Enrollment” table, indicating that each student may be enrolled in many classes. The “1” and “M” in the diagram above indicate the one to many relationships among the keys in these tables.

Databases organized like the one above, where multiple tables are related based on common keys, are referred to as relational databasesThe most common standard for expressing databases, whereby tables (files) are related based on common keys.. There are many other database formats (sporting names like hierarchical, and object-oriented), but relational databases are far and away the most popular. And all SQL databases are relational databases.

We’ve just scratched the surface for a very basic introduction. Expect that a formal class in database systems will offer you far more detail and better design principles than are conveyed in the elementary example above. But you’re already well on your way!

Transaction Processing Systems

For most organizations that sell directly to their customers, transaction processing systems (TPS)Systems that record a transaction (some form of business-related exchange), such as a cash register sale, ATM withdrawal, or product return. represent a fountain of potentially insightful data. Every time a consumer uses a point-of-sale system, an ATM, or a service desk, there’s a transactionSome kind of business exchange. (some kind of business exchange) occurring, representing an event that’s likely worth tracking.

The cash register is the data generation workhorse of most physical retailers, and the primary source that feeds data to the TPS. But while TPS can generate a lot of bits, it’s sometimes tough to match this data with a specific customer. For example, if you pay a retailer in cash, you’re likely to remain a mystery to your merchant because your name isn’t attached to your money. Grocers and retailers can tie you to cash transactions if they can convince you to use a loyalty cardSystems that provide rewards and usage incentives, typically in exchange for a method that provides a more detailed tracking and recording of customer activity. In addition to enhancing data collection, loyalty cards can represent a significant switching cost.. Use one of these cards and you’re in effect giving up information about yourself in exchange for some kind of financial incentive. The explosion in retailer cards is directly related to each firm’s desire to learn more about you and to turn you into a more loyal and satisfied customer.

Some cards provide an instant discount (e.g., the CVS Pharmacy ExtraCare card), while others allow you to build up points over time (Best Buy’s Reward Zone). The latter has the additional benefit of acting as a switching cost. A customer may think “I could get the same thing at Target, but at Best Buy, it’ll increase my existing points balance and soon I’ll get a cash back coupon.”

Enterprise Software (CRM, SCM, and ERP)

Firms increasingly set up systems to gather additional data beyond conventional purchase transactions or Web site monitoring. CRM or customer relationship management systems are often used to empower employees to track and record data at nearly every point of customer contact. Someone calls for a quote? Brings a return back to a store? Writes a complaint e-mail? A well-designed CRM system can capture all these events for subsequent analysis or for triggering follow-up events.

Enterprise software includes not just CRM systems but also categories that touch every aspect of the value chain, including supply chain management (SCM) and enterprise resource planning (ERP) systems. More importantly, enterprise software tends to be more integrated and standardized than the prior era of proprietary systems that many firms developed themselves. This integration helps in combining data across business units and functions, and in getting that data into a form where it can be turned into information (for more on enterprise systems, see Chapter 9 “Understanding Software: A Primer for Managers”).

Surveys

Sometimes firms supplement operational data with additional input from surveys and focus groups. Oftentimes, direct surveys can tell you what your cash register can’t. Zara store managers informally survey customers in order to help shape designs and product mix. Online grocer FreshDirect (see Chapter 2 “Strategy and Technology: Concepts and Frameworks for Understanding What Separates Winners from Losers”) surveys customers weekly and has used this feedback to drive initiatives from reducing packaging size to including star ratings on produce.R. Braddock, “Lessons of Internet Marketing from FreshDirect,” Wall Street Journal, May 11, 2009. Many CRM products also have survey capabilities that allow for additional data gathering at all points of customer contact.

External Sources

Sometimes it makes sense to combine a firm’s data with bits brought in from the outside. Many firms, for example, don’t sell directly to consumers (this includes most drug companies and packaged goods firms). If your firm has partners that sell products for you, then you’ll likely rely heavily on data collected by others.

Data bought from sources available to all might not yield competitive advantage on its own, but it can provide key operational insight for increased efficiency and cost savings. And when combined with a firm’s unique data assets, it may give firms a high-impact edge.

Consider restaurant chain Brinker, a firm that runs seventeen hundred eateries in twenty-seven countries under the Chili’s, On The Border, and Maggiano’s brands. Brinker (whose ticker symbol is EAT), supplements their own data with external feeds on weather, employment statistics, gas prices, and other factors, and uses this in predictive models that help the firm in everything from determining staffing levels to switching around menu items.R. King, “Intelligence Software for Business,” BusinessWeek podcast, February 27, 2009.

In another example, Carnival Cruise Lines combines its own customer data with third-party information tracking household income and other key measures. This data plays a key role in a recession, since it helps the firm target limited marketing dollars on those past customers that are more likely to be able to afford to go on a cruise. So far it’s been a winning approach. For three years in a row, the firm has experienced double-digit increases in bookings by repeat customers.R. King, “Intelligence Software for Business,” BusinessWeek podcast, February 27, 2009.

Incompatible Systems

Just because data is collected doesn’t mean it can be used. This limit is a big problem for large firms that have legacy systemsOlder information systems that are often incompatible with other systems, technologies, and ways of conducting business. Incompatible legacy systems can be a major roadblock to turning data into information, and they can inhibit firm agility, holding back operational and strategic initiatives., outdated information systems that were not designed to share data, aren’t compatible with newer technologies, and aren’t aligned with the firm’s current business needs. The problem can be made worse by mergers and acquisitions, especially if a firm depends on operational systems that are incompatible with its partner. And the elimination of incompatible systems isn’t just a technical issue. Firms might be under extended agreement with different vendors or outsourcers, and breaking a contract or invoking an escape clause may be costly. Folks working in M&A (the area of investment banking focused on valuing and facilitating mergers and acquisitions) beware—it’s critical to uncover these hidden costs of technology integration before deciding if a deal makes financial sense.

Operational Data Can’t Always Be Queried

Another problem when turning data into information is that most transactional databases aren’t set up to be simultaneously accessed for reporting and analysis. When a customer buys something from a cash register, that action may post a sales record and deduct an item from the firm’s inventory. In most TPS systems, requests made to the database can usually be performed pretty quickly—the system adds or modifies the few records involved and it’s done—in and out in a flash.

But if a manager asks a database to analyze historic sales trends showing the most and least profitable products over time, they may be asking a computer to look at thousands of transaction records, comparing results, and neatly ordering findings. That’s not a quick in-and-out task, and it may very well require significant processing to come up with the request. Do this against the very databases you’re using to record your transactions, and you might grind your computers to a halt.

Getting data into systems that can support analytics is where data warehouses and data marts come in, the topic of our next section.

Query and Reporting Tools

The idea behind query and reporting tools is to present users with a subset of requested data, selected, sorted, ordered, calculated, and compared, as needed. Managers use these tools to see and explore what’s happening inside their organizations.

Canned reportsReports that provide regular summaries of information in a predetermined format. provide regular summaries of information in a predetermined format. They’re often developed by information systems staff and formats can be difficult to alter. By contrast, ad hoc reporting toolsTools that put users in control so that they can create custom reports on an as-needed basis by selecting fields, ranges, summary conditions, and other parameters. allow users to dive in and create their own reports, selecting fields, ranges, and other parameters to build their own reports on the fly. DashboardsA heads-up display of critical indicators that allow managers to get a graphical glance at key performance metrics. provide a sort of heads-up display of critical indicators, letting managers get a graphical glance at key performance metrics. Some tools may allow data to be exported into spreadsheets. Yes, even the lowly spreadsheet can be a powerful tool for modeling “what if” scenarios and creating additional reports (of course be careful: if data can be easily exported, then it can potentially leave the firm dangerously exposed, raising privacy, security, legal, and competitive concerns).

A subcategory of reporting tools is referred to as online analytical processing (OLAP)A method of querying and reporting that takes data from standard relational databases, calculates and summarizes the data, and then stores the data in a special database called a data cube. (pronounced “oh-lap”). Data used in OLAP reporting is usually sourced from standard relational databases, but it’s calculated and summarized in advance, across multiple dimensions, with the data stored in a special database called a data cubeA special database used to store data in OLAP reporting.. This extra setup step makes OLAP fast (sometimes one thousand times faster than performing comparable queries against conventional relational databases). Given this kind of speed boost, it’s not surprising that data cubes for OLAP access are often part of a firm’s data mart and data warehouse efforts.

A manager using an OLAP tool can quickly explore and compare data across multiple factors such as time, geography, product lines, and so on. In fact, OLAP users often talk about how they can “slice and dice” their data, “drilling down” inside the data to uncover new insights. And while conventional reports are usually presented as a summarized list of information, OLAP results look more like a spreadsheet, with the various dimensions of analysis in rows and columns, with summary values at the intersection.

Data Mining

While reporting tools can help users explore data, modern data sets can be so large that it might be impossible for humans to spot underlying trends. That’s where data mining can help. Data miningThe process of using computers to identify hidden patterns in, and to build models from, large data sets. is the process of using computers to identify hidden patterns and to build models from large data sets.

Some of the key areas where businesses are leveraging data mining include the following:

• Customer segmentation—figuring out which customers are likely to be the most valuable to a firm.
• Marketing and promotion targeting—identifying which customers will respond to which offers at which price at what time.
• Market basket analysis—determining which products customers buy together, and how an organization can use this information to cross-sell more products or services.
• Collaborative filtering—personalizing an individual customer’s experience based on the trends and preferences identified across similar customers.
• Customer churn—determining which customers are likely to leave, and what tactics can help the firm avoid unwanted defections.
• Fraud detection—uncovering patterns consistent with criminal activity.
• Financial modeling—building trading systems to capitalize on historical trends.
• Hiring and promotion—identifying characteristics consistent with employee success in the firm’s various roles.

For data mining to work, two critical conditions need to be present: (1) the organization must have clean, consistent data, and (2) the events in that data should reflect current and future trends. The recent financial crisis provides lessons on what can happen when either of these conditions isn’t met.

First lets look at problems with using bad data. A report in the New York Times has suggested that in the period leading up to the 2008 financial crisis, some banking executives deliberately deceived risk management systems in order to skew capital-on-hand requirements. This deception let firms load up on risky debt, while carrying less cash for covering losses.S. Hansell, “How Wall Street Lied to Its Computers,” New York Times, September 18, 2008. Deceive your systems with bad data and your models are worthless. In this case, wrong estimates from bad data left firms grossly overexposed to risk. When debt defaults occurred; several banks failed, and we entered the worst financial crisis since the Great Depression.

Now consider the problem of historical consistency: Computer-driven investment models can be very effective when the market behaves as it has in the past. But models are blind when faced with the equivalent of the “hundred-year flood” (sometimes called black swans); events so extreme and unusual that they never showed up in the data used to build the model.

We saw this in the late 1990s with the collapse of the investment firm Long Term Capital Management. LTCM was started by Nobel Prize–winning economists, but when an unexpected Russian debt crisis caused the markets to move in ways not anticipated by its models, the firm lost 90 percent of its value in less than two months. The problem was so bad that the Fed had to step in to supervise the firm’s multibillion-dollar bailout. Fast forward a decade to the banking collapse of 2008, and we again see computer-driven trading funds plummet in the face of another unexpected event—the burst of the housing bubble.P. Wahba, “Buffeted ‘Quants’ Are Still in Demand,” Reuters, December 22, 2008.

Data mining presents a host of other perils, as well. It’s possible to over-engineerBuild a model with so many variables that the solution arrived at might only work on the subset of data you’ve used to create it. a model, building it with so many variables that the solution arrived at might only work on the subset of data you’ve used to create it. You might also be looking at a random but meaningless statistical fluke. In demonstrating how flukes occur, one quantitative investment manager uncovered a correlation that at first glance appeared statistically to be a particularly strong predictor for historical prices in the S&P 500 stock index. That predictor? Butter production in Bangladesh.P. Coy, “He Who Mines Data May Strike Fool’s Gold,” BusinessWeek, June 16, 1997. Sometimes durable and useful patterns just aren’t in your data.

One way to test to see if you’re looking at a random occurrence in the numbers is to divide your data, building your model with one portion of the data, and using another portion to verify your results. This is the approach Netflix has used to test results achieved by teams in the Netflix Prize, the firm’s million-dollar contest for improving the predictive accuracy of its movie recommendation engine (see Chapter 4 “Netflix: The Making of an E-commerce Giant and the Uncertain Future of Atoms to Bits”).

Finally, sometimes a pattern is uncovered but determining the best choice for a response is less clear. As an example, let’s return to the data-mining wizards at Tesco. An analysis of product sales data showed several money-losing products, including a type of bread known as “milk loaf.” Drop those products, right? Not so fast. Further analysis showed milk loaf was a “destination product” for a loyal group of high-value customers, and that these customers would shop elsewhere if milk loaf disappeared from Tesco shelves. The firm kept the bread as a loss-leader and retained those valuable milk loaf fans.B. Helm, “Getting Inside the Customer’s Mind,” BusinessWeek, September 11, 2008. Data miner, beware—first findings don’t always reveal an optimal course of action.

This last example underscores the importance of recruiting a data mining and business analytics team that possesses three critical skills: information technology (for understanding how to pull together data, and for selecting analysis tools), statistics (for building models and interpreting the strength and validity of results), and business knowledge (for helping set system goals, requirements, and offering deeper insight into what the data really says about the firm’s operating environment). Miss one of these key functions and your team could make some major mistakes.

While we’ve focused on tools in our discussion above, many experts suggest that business intelligence is really an organizational process as much as it is a set of technologies. Having the right team is critical in moving the firm from goal setting through execution and results.

A Data-Driven Value Chain

The Wal-Mart efficiency dance starts with a proprietary system called Retail Link, a system originally developed in 1991 and continually refined ever since. Each time an item is scanned by a Wal-Mart cash register, Retail Link not only records the sale, it also automatically triggers inventory reordering, scheduling, and delivery. This process keeps shelves stocked, while keeping inventories at a minimum. An AMR report ranked Wal-Mart as having the seventh best supply chain in the country (the only other retailer in the top twenty was Tesco, at number fifteen).T. Friscia, K. O’Marah, D. Hofman, and J. Souza, “The AMR Research Supply Chain Top 25 for 2009,” AMR Research, May 28, 2009, http://www.amrresearch.com/Content/View.aspx?compURI=tcm:7-43469. The firm’s annual inventory turnover ratioThe ratio of a company’s annual sales to its inventory. of 8.5 means that Wal-Mart sells the equivalent of its entire inventory roughly every six weeks (by comparison, Target’s turnover ratio is 6.4, Sears’ is 3.4, and the average for U.S. retail is less than 2).Twelve-month figures from midyear 2009, via Forbes and Reuters.

Back-office scanners keep track of inventory as supplier shipments come in. Suppliers are rated based on timeliness of deliveries, and you’ve got to be quick to work with Wal-Mart. In order to avoid a tractor-trailer traffic jam in store parking lots, deliveries are choreographed to arrive at intervals less than ten minutes apart. When Levi’s joined Wal-Mart, the firm had to guarantee it could replenish shelves every two days—no prior retailer had required a shorter than five day window from Levi’s.C. Fishman, “The Wal-Mart You Don’t Know,” Fast Company, December 19, 2007.

Wal-Mart has been a catalyst for technology adoption among its suppliers. The firm is currently leading an adoption effort that requires partners to leverage RFID technology to track and coordinate inventories. While the rollout has been slow, a recent P&G trial showed RFID boosted sales nearly 20 percent by ensuring that inventory was on shelves and located where it should be.D. Joseph, “Supermarket Strategies: What’s New at the Grocer,” BusinessWeek, June 8, 2009.

Data Mining Prowess

Wal-Mart also mines its mother lode of data to get its product mix right under all sorts of varying environmental conditions, protecting the firm from “a retailer’s twin nightmares: too much inventory, or not enough.”C. Hays, “What Wal-Mart Knows about Customer Habits,” New York Times, November 14, 2004. For example, the firm’s data mining efforts informed buyers that customers stock up on certain products in the days leading up to predicted hurricanes. Bumping up prestorm supplies of batteries and bottled water was a no brainer, but the firm also learned that Pop-Tarts sales spike seven fold before storms hit, and that beer is the top prestorm seller. This insight has lead to truckloads full of six packs and toaster pastries streaming into gulf states whenever word of a big storm surfaces.C. Hays, “What Wal-Mart Knows about Customer Habits,” New York Times, November 14, 2004.

Data mining also helps the firm tighten operational forecasts, helping to predict things like how many cashiers are needed at a given store at various times of day throughout the year. Data drives the organization, with mined reports forming the basis of weekly sales meetings, as well as executive strategy sessions.

Sharing Data, Keeping Secrets

While Wal-Mart is demanding of its suppliers, it also shares data with them, too. Data can help firms become more efficient so that Wal-Mart can keep dropping prices, and data can help firms uncover patterns that help suppliers sell more. P&G’s Gillette unit, for example, claims to have mined Wal-Mart data to develop promotions that increased sales as much as 19 percent. More than seventeen thousand suppliers are given access to their products’ Wal-Mart performance across metrics that include daily sales, shipments, returns, purchase orders, invoices, claims and forecasts. And these suppliers collectively interrogate Wal-Mart data warehouses to the tune of twenty-one million queries a year.K. Evans-Correia, “Dillman Replaced as Wal-Mart CIO,” SearchCIO, April 6, 2006.

While Wal-Mart shares sales data with relevant suppliers, the firm otherwise fiercely guards this asset. Many retailers pool their data by sharing it with information brokers like Information Resources and ACNielsen. This sharing allows smaller firms to pool their data to provide more comprehensive insight on market behavior. But Wal-Mart stopped sharing data with these agencies years ago. The firm’s scale is so big, the additional data provided by brokers wasn’t adding much value, and it no longer made sense to allow competitors access to what was happening in its own huge chunk of retail sales.

Other aspects of the firm’s technology remain under wraps, too. Wal-Mart custom builds large portions of its information systems to keep competitors off its trail. As for infrastructure secrets, the Wal-Mart Data Center in McDonald County, Missouri, was considered so off limits that the county assessor was required to sign a nondisclosure statement before being allowed on-site to estimate property value.M. McCoy, “Wal-Mart’s Data Center Remains Mystery,” Joplin Globe, May 28, 2006.

Challenges Abound

But despite success, challenges continue. While Wal-Mart grew dramatically throughout the 1990s, the firm’s U.S. business has largely matured. And as a mature business it faces a problem not unlike the example of Microsoft discussed at the end of Chapter 14 “Google: Search, Online Advertising, and Beyond”; Wal-Mart needs to find huge markets or dramatic cost savings in order to boost profits and continue to move its stock price higher.

The firm’s aggressiveness and sheer size also increasingly make Wal-Mart a target for criticism. Those low prices come at a price, and the firm has faced accusations of subpar wages and remains a magnet for union activists. Others had identified poor labor conditions at some of the firm’s contract manufacturers. Suppliers that compete for Wal-Mart’s business are often faced with a catch-22. If they bypass Wal-Mart they miss out on the largest single chunk of world retail sales. But if they sell to Wal-Mart, the firm may demand prices so aggressively low that suppliers end up cannibalizing their own sales at other retailers. Still more criticism comes from local citizen groups that have accused Wal-Mart of ruining the market for mom-and-pop stores.C. Fishman, “The Wal-Mart You Don’t Know,” Fast Company, December 19, 2007.

While some might see Wal-Mart as invincibly standing at the summit of world retail, it’s important to note that other megaretailers have fallen from grace. In the 1920s and 1930s, the A&P grocery chain once controlled 80 percent of U.S. grocery sales, at its peak operating five times the number of stores that Wal-Mart has today. But market conditions changed, and the government stepped in to draft antipredatory pricing laws when it felt A&Ps parent was too aggressive.

For all of Wal-Mart’s data brilliance, historical data offers little insight on how to adapt to more radical changes in the retail landscape. The firm’s data warehouse wasn’t able to foretell the rise of Target and other up-market discounters. And yet another major battle is brewing, as Tesco methodically attempts to take its globally honed expertise to U.S. shores. Savvy managers recognize that data use is a vital tool, but not the only tool in management’s strategic arsenal.

Collecting Data

Data drives the firm. Harrah’s collects customer data on just about everything you might do at their properties—gamble, eat, grab a drink, attend a show, stay in a room. The data’s then used to track your preferences and to size up whether you’re the kind of customer that’s worth pursuing. Prove your worth, and the firm will surround you with top-tier service and develop a targeted marketing campaign to keep wooing you back.V. Magnini, E. Honeycutt, and S. Hodge, “Data Mining for Hotel Firms: Use and Limitations,” Cornell Hotel and Restaurant Administration Quarterly, April 2003, http://www.entrepreneur.com/tradejournals/article/101938457.html.

The ace in the firm’s data collection hole is its Total Rewards loyalty card system. Launched over a decade ago, the system is constantly being enhanced by an IT staff of seven hundred, with an annual budget in excess of $100 million.P. Swabey, “Nothing Left to Chance,” Information Age, January 18, 2007. Total Rewards is an opt-inProgram (typically a marketing effort) that requires customer consent. This program is contrasted with opt-out programs, which enroll all customers by default. loyalty program, but customers consider the incentives to be so good that the card is used by some 80 percent of Harrah’s patrons, collecting data on over forty-four million customers.M. Wagner, “Harrah’s Places Its Bet On IT,” InformationWeek, September 16, 2008; and L. Haugsted, “Better Take Care of Big Spenders; Harrah’s Chief Offers Advice to Cablers,” Multichannel News, July 30, 2007.

Customers signing up for the card provide Harrah’s with demographic information such as gender, age, and address. Visitors then present the card for various transactions. Slide it into a slot machine, show it to the restaurant hostess, present it to the parking valet, share your account number with a telephone reservation specialist—every contact point is an opportunity to collect data. Between three hundred thousand and one million customers come through Harrah’s doors daily, adding to the firm’s data stash and keeping that asset fresh.N. Hoover, “Chief of the Year: Harrah’s CIO Tim Stanley,” Information Week Research and Reports, 2007.

Who Are the Most Valuable Customers?

All that data is heavily and relentlessly mined. Customer relationship management should include an assessment to determine which customers are worth having a relationship with. And because Harrah’s has so much detailed historical data, the firm can make fairly accurate projections of customer lifetime value (CLV)The present value of the likely future income stream generated by an individual purchaser.. CLV represents the present value of the likely future income stream generated by an individual purchaser.“Which Customers Are Worth Keeping and Which Ones Aren’t? Managerial Uses of CLV,” Knowledge@Wharton, July 30, 2003, http://knowledge.wharton.upenn.edu/article.cfm?articleid=820. Once you know this, you can get a sense of how much you should spend to keep that customer coming back. You can size them up next to their peer group and if they fall below expectations you can develop strategies to improve their spending.

The firm tracks over ninety demographic segments, and each responds differently to different marketing approaches. Identifying segments and figuring out how to deal with each involves an iterative model of mining the data to identify patterns, creating a hypothesis (customers in group X will respond to a free steak dinner; group Y will want ten dollars in casino chips), then testing that hypothesis against a control group, turning again to analytics to statistically verify the outcome.

The firm runs hundreds of these small, controlled experiments each year. Loveman says that when marketers suggest new initiatives, “I ask, did we test it first? And if I find out that we just whole-hogged, went after something without testing it, I’ll kill ’em. No matter how clever they think it is, we test it.”J. Nickell, “Welcome to Harrah’s,” Business 2.0, April 2002. The former ops professor is known to often quote quality guru W. Edwards Deming, saying, “In God we trust; all others must bring data.”

When Harrah’s began diving into the data, they uncovered patterns that defied the conventional wisdom in the gaming industry. Big money didn’t come from European princes, Hong Kong shipping heirs, or the Ocean’s 11 crowd—it came from locals. The less than 30 percent of customers who spent between one hundred and five hundred dollars per visit accounted for over 80 percent of revenues and nearly 100 percent of profits.P. Swabey, “Nothing Left to Chance,” Information Age, January 18, 2007.

The data also showed that the firm’s most important customers weren’t the families that many Vegas competitors were trying to woo with Disneyland-style theme casinos—it was Grandma! Harrah’s focuses on customers forty-five years and older: twenty-somethings have no money, while thirty-somethings have kids and are too busy. To the premiddle-aged crowd, Loveman says, “God bless you, but we don’t need you.”L. Haugsted, “Better Take Care of Big Spenders; Harrah’s Chief Offers Advice to Cablers,” Multichannel News, July 30, 2007.

Data-Driven Service: Get Close (but Not Too Close) to Your Customers

The names for reward levels on the Total Rewards card convey increasing customer value—Gold, Diamond, and Platinum. Spend more money at Harrah’s and you’ll enjoy shorter lines, discounts, free items, and more. And if Harrah’s systems determine you’re a high-value customer, expect white-glove treatment. The firm will lavish you with attention, using technology to try to anticipate your every need. Customers notice the extra treatment that top-tier Total Rewards members receive and actively work to improve their status.

To illustrate this, Loveman points to the obituary of an Ashville, North Carolina, woman who frequented a casino Harrah’s operates on a nearby Cherokee reservation. “Her obituary was published in the Asheville paper and indicated that at the time of her death, she had several grandchildren, she sang in the Baptist choir and she was a holder of the Harrah’s Diamond Total Rewards card.” Quipped Loveman, “When your loyalty card is listed in someone’s obituary, I would maintain you have traction.”G. Loveman, Speech and Comments, Chief Executive Club of Boston College, January 2005; emphasis added.

The degree of customer service pushed through the system is astonishing. Upon check in, a Harrah’s customer who enjoys fine dining may find his or her table is reserved, along with tickets for a show afterward. Others may get suggestions or special offers throughout their stay, pushed via text message to their mobile device.M. Wagner, “Harrah’s Places Its Bet On IT,” InformationWeek, September 16, 2008. The firm even tracks gamblers to see if they’re suffering unusual losses, and Harrah’s will dispatch service people to intervene with a feel-good offer: “Having a bad day? Here’s a free buffet coupon.”T. Davenport and J. Harris, Competing on Analytics: The New Science of Winning (Boston: Harvard Business School Press, 2007).

The firm’s CRM effort monitors any customer behavior changes. If a customer who usually spends a few hundred a month hasn’t shown up in a while, the firm’s systems trigger follow-up contact methods such as sending a letter with a promotion offer, or having a rep make a phone call inviting them back.G. Loveman, Speech and Comments, Chief Executive Club of Boston College, January 2005.

Customers come back to Harrah’s because they feel that those casinos treat them better than the competition. And Harrah’s laser-like focus on service quality and customer satisfaction are embedded into its information systems and operational procedures. Employees are measured on metrics that include speed and friendliness and are compensated based on guest satisfaction ratings. Hourly workers are notoriously difficult to motivate: they tend to be high-turnover, low-wage earners. But at Harrah’s, incentive bonuses depend on an entire location’s ratings. That encourages strong performers to share tips to bring the new guy up to speed. The process effectively changed the corporate culture at Harrah’s from an every-property-for-itself mentality to a collaborative, customer-focused enterprise.V. Magnini, E. Honeycutt, and S. Hodge, “Data Mining for Hotel Firms: Use and Limitations,” Cornell Hotel and Restaurant Administration Quarterly, April 2003, http://www.entrepreneur.com/tradejournals/article/101938457.html.

While Harrah’s is committed to learning how to make your customer experience better, the firm is also keenly sensitive to respecting consumer data. The firm has never sold or given away any of its bits to third parties. And the firm admits that some of its efforts to track customers have misfired, requiring special attention to find the sometimes subtitle line between helpful and “too helpful.” For example, the firm’s CIO has mentioned that customers found it “creepy and Big Brother-ish” when employees tried to greet them by name and talk with them about their past business history at Harrah’s, so the firm backed off.M. Wagner, “Harrah’s Places Its Bet On IT,” InformationWeek, September 16, 2008.

Innovation

Harrah’s is constantly tinkering with new innovations that help it gather more data and help push service quality and marketing program success. When the introduction of gaming in Pennsylvania threatened to divert lucrative New York City gamblers from Harrah’s Atlantic City properties, the firm launched an interactive billboard in New York’s Times Square, allowing passers-by to operate a virtual slot machine using text messages from their cell phones. Players dialing into the video billboard not only control the display, they receive text message offers promoting Harrah’s sites in Atlantic City.“Future Tense: The Global CMO,” Economist Intelligence Unit, September 2008.

At Harrah’s, tech experiments abound. RFID-enabled poker chips and under-table RFID readers allow pit bosses to track and rate game play far better than they could before. The firm is experimenting with using RFID-embedded bracelets for poolside purchases and Total Rewards tracking for when customers aren’t carrying their wallets. The firm has also incorporated drink ordering into gaming machines—why make customers get up to quench their thirst? A break in gambling is a halt in revenue.

The firm was also one of the first to sign on to use Microsoft’s Surface technology—a sort of touch-screen and sensor-equipped tabletop. Customers at these tables can play bowling and group pinball games and even pay for drinks using cards that the tables will automatically identify. Tech even helps Harrah’s fight card counters and crooks, with facial recognition software scanning casino patrons to spot the bad guys.S. Lohr, “Reaping Results: Data-Mining Goes Mainstream,” New York Times, May 20, 2007.

Strategy

A walk around Vegas during Harrah’s ascendency would find rivals with bigger, fancier casinos. Says Loveman, “We had to compete with the kind of place that God would build if he had the money.…The only thing we had was data.”P. Swabey, “Nothing Left to Chance,” Information Age, January 18, 2007.

That data advantage creates intelligence for a high-quality and highly personal customer experience. Data gives the firm a service differentiation edge. The loyalty program also represents a switching cost. And these assets combined to be leveraged across a firm that has gained so much scale that it’s now the largest player in its industry, gaining the ability to cross-sell customers on a variety of properties—Vegas vacations, riverboat gambling, locally focused reservation properties, and more.

Harrah’s chief marketing officer, David Norton, points out that when Total Rewards started, Harrah’s was earning about thirty-six cents on every dollar customers spent gaming—the rest went to competitors. A climb to forty cents would be considered monstrous. By 2005 that number had climbed to forty-five cents, making Harrah’s the biggest monster in the industry.E. Lundquist, “Harrah’s Bets Big on IT,” eWeek, July 20, 2005. Some of the firm’s technology investments have paid back tenfold in just two years—bringing in hundreds of millions of dollars.P. Swabey, “Nothing Left to Chance,” Information Age, January 18, 2007.

The firm’s technology has been pretty tough for others to match, too. Harrah’s holds several patents covering key business methods and technologies used in its systems. After being acquired by Harrah’s, employees of Caesars lamented that they had, for years, unsuccessfully attempted to replicate Harrah’s systems without violating the firm’s intellectual property.N. Hoover, “Chief of the Year: Harrah’s CIO Tim Stanley,” Information Week Research and Reports, 2007.

Challenges

Harrah’s efforts to gather data, extract information, and turn this into real profits is unparalleled, but it’s not a cure-all. Broader events can often derail even the best strategy. Gaming is a discretionary spending item, and when the economy tanks, gambling is one of the first things consumers will cut. Harrah’s has not been immune to the world financial crisis and experienced a loss in 2008.

Also note that if you look up Harrah’s stock symbol you won’t find it. The firm was taken privateThe process by which a publicly held company has its outstanding shares purchased by an individual or by a small group of individuals who wish to obtain complete ownership and control. in January 2008, when buyout firms Apollo Management and TPG Capital paid $30.7 billion for all of the firm’s shares. At that time Loveman signed a five-year deal to remain on as CEO, and he’s spoken positively about the benefits of being private—primarily that with the distraction of quarterly earnings off the table, he’s been able to focus on the long-term viability and health of the business.A. Knightly, “Harrah’s Boss Speaks,” Las Vegas Review-Journal, June 14, 2009.

But the firm also holds $24 billion in debt from expansion projects and the buyout, all at a time when economic conditions have not been favorable to leveraged firms.P. Lattman, “A Buyout-Shop Breather,” Wall Street Journal, May 30, 2009. A brilliantly successful firm that developed best-in-class customer relationship management in now in a position many consider risky due to debt assumed as part of an overly optimistic buyout occurring at precisely the time when the economy went into a terrible funk. Harrah’s awesome risk-reducing, profit-pushing analytics failed to offer any insight on the wisdom (or risk) in the debt and private equity deals.

The Benefits of SaaS

Firms can potentially save big using SaaS. Organizations that adopt SaaS forgo the large upfront costs of buying and installing software packages. For large enterprises, the cost to license, install, and configure products like ERP and CRM systems can easily run into the hundreds of thousands or even millions of dollars. And these costs are rarely a one time fee. Additional costs like annual maintenance contracts have also been rising as rivals fail or get bought up. Less competition among traditional firms recently allowed Oracle and SAP to raise maintenance fees to as much as 20 percent.Sarah Lacy, “On-Demand Computing: A Brutal Slog,” BusinessWeek, July 18, 2008.

Firms that adopt SaaS don’t just save on software and hardware, either. There’s also the added cost for the IT staff needed to run these systems. Forrester Research estimates that SaaS can bring cost savings of 25 to 60 percent if all these costs are factored in.J. Quittner, “How SaaS Helps Cut Small Business Costs,” BusinessWeek, December 5, 2008.

There are also accounting and corporate finance implications for SaaS. Firms that adopt software as a service never actually buy a system’s software and hardware, so these systems become a variable operating expense. This flexibility helps mitigate the financial risks associated with making a large capital investment in information systems. For example, if a firm pays Salesforce.com sixty-five dollars per month per user for its CRM software, it can reduce payments during a slow season with a smaller staff, or pay more during heavy months when a firm might employ temporary workers. At these rates, SaaS not only looks good to large firms, it makes very sophisticated technology available to smaller firms that otherwise wouldn’t be able to afford expensive systems, let alone the IT staff and hardware required to run them.

In addition to cost benefits, SaaS offerings also provide the advantage of being highly scalable. This feature is important because many organizations operate in environments prone to wide variance in usage. Some firms might expect systems to be particularly busy during tax time or the period around quarterly financial reporting deadlines, while others might have their heaviest system loads around a holiday season. A music label might see spikes when an artist drops a new album. Using conventional software, an organization would have to buy enough computing capacity to ensure that it could handle its heaviest anticipated workload. But sometimes these loads are difficult to predict, and if the difference between high workloads and average use is great, a lot of that expensive computer hardware will spend most of its time doing nothing. In SaaS, however, the vendor is responsible for ensuring that systems meet demand fluctuation. Vendors frequently sign a service level agreement (SLA)A negotiated agreement between the customer and the vendor. The SLA may specify the levels of availability, serviceability, performance, operation, or other commitment requirements. with their customers to ensure a guaranteed uptime and define their ability to meet demand spikes.

When looking at the benefits of SaaS, also consider the potential for higher quality and service levels. SaaS firms benefit from economies of scale that not only lower software and hardware costs, but also potentially boost quality. The volume of customers and diversity of their experiences means that an established SaaS vendor is most likely an expert in dealing with all sorts of critical computing issues. SaaS firms handle backups, instantly deploy upgrades and bug fixes, and deal with the continual burden of security maintenance—all costly tasks that must be performed regularly and with care, although each offers little strategic value to firms that perform these functions themselves in-house. The breadth of a SaaS vendor’s customer base typically pushes the firm to evaluate and address new technologies as they emerge, like quickly offering accessibility from mobile platforms like the BlackBerry and iPhone. For all but the savviest of IT shops, an established SaaS vendor can likely leverage its scale and experience to provide better, cheaper, more reliable standard information systems than individual companies typically can.

Software developers who choose to operate as SaaS providers also realize benefits. While a packaged software company like SAP must support multiple versions of its software to accommodate operating systems like Windows, Linux, and various flavors of Unix, an SaaS provider develops, tests, deploys, and supports just one version of the software executing on its own servers.

An argument might also be made that SaaS vendors are more attuned to customer needs. Since SaaS firms run a customer’s systems on their own hardware, they have a tighter feedback loop in understanding how products are used (and why they fail)—potentially accelerating their ability to enhance their offerings. And once made, enhancements or fixes are immediately available to customers the next time they log in.

SaaS applications also impact distribution costs and capacity. As much as 30 percent of the price of traditional desktop software is tied to the cost of distribution—pressing CD-ROMs, packaging them in boxes, and shipping them to retail outlets.M. Drummond, “The End of Software as We Know It,” Fortune, November 19, 2001. Going direct to consumers can cut out the middleman, so vendors can charge less or capture profits that they might otherwise share with a store or other distributor. Going direct also means that SaaS applications are available anywhere someone has an Internet connection, making them truly global applications. This feature has allowed many SaaS firms to address highly specialized markets (sometimes called vertical nichesSometimes referred to as vertical markets. Products and services designed to target a specific industry (e.g., pharmaceutical, legal, apparel retail).). For example, the Internet allows a company writing specialized legal software, for example, or a custom package for the pharmaceutical industry, to have a national deployment footprint from day one. Vendors of desktop applications that go SaaS benefit from this kind of distribution, too.

Finally, SaaS allows a vendor to counter the vexing and costly problem of software piracy. It’s just about impossible to make an executable, illegal copy of a subscription service that runs on a SaaS provider’s hardware.

Challenges Remain

Hardware clouds and SaaS share similar benefits and risk, and as our discussion of SaaS showed, cloud efforts aren’t for everyone. Some additional examples illustrate the challenges in shifting computing hardware to the cloud.

For all the hype about cloud computing, it doesn’t work in all situations. From an architectural standpoint, most large organizations run a hodgepodge of systems that include both package applications and custom code written in-house. Installing a complex set of systems on someone else’s hardware can be a brutal challenge and in many cases is just about impossible. For that reason we can expect most cloud computing efforts to focus on new software development projects rather than options for old software. Even for efforts that can be custom-built and cloud-deployed, other roadblocks remain. For example, some firms face stringent regulatory compliance issues. To quote one tech industry executive, “How do you demonstrate what you are doing is in compliance when it is done outside?”G. Gruman, “Early Experiments in Cloud Computing,” InfoWorld, April 7, 2008.

Firms considering cloud computing need to do a thorough financial analysis, comparing the capital and other costs of owning and operating their own systems over time against the variable costs over the same period for moving portions to the cloud. For high-volume, low-maintenance systems, the numbers may show that it makes sense to buy rather than rent. Cloud costs can seem super cheap at first. Sun’s early cloud effort offered a flat fee of one dollar per CPU per hour. Amazon’s cloud storage rates were twenty-five cents per gigabyte per month. But users often also pay for the number of accesses and the number of data transfers.C. Preimesberger, “Sun’s ‘Open’-Door Policy,” eWeek, April 21, 2008. A quarter a gigabyte a month may seem like a small amount, but system maintenance costs often include the need to clean up old files or put them on tape. If unlimited data is stored in the cloud, these costs can add up.

Firms should enter the cloud cautiously, particularly where mission-critical systems are concerned. When one of the three centers supporting Amazon’s cloud briefly went dark in 2008, start-ups relying on the service, including Twitter and SmugMug, reported outages. Apple’s MobileMe cloud-based product for synchronizing data across computers and mobile devices, struggled for months after its introduction when the cloud repeatedly went down. Vendors with multiple data centers that are able to operate with fault-tolerantCapable of continuing operation even if a component fails. provisioning, keeping a firm’s efforts at more than one location to account for any operating interruptions, will appeal to firms with stricter uptime requirements.

What Is Software?

When we refer to computer hardware (sometimes just hardware), we’re talking about the physical components of information technology—the equipment that you can physically touch, including computers, storage devices, networking equipment, and other peripherals.

Software refers to a computer program or collection of programs—sets of instructions that tell the hardware what to do. Software gets your computer to behave like a Web browser or word processor, makes your iPod play music and video, and enables your bank’s ATM to spit out cash.

It’s when we start to talk about the categories of software that most people’s eyes glaze over. To most folks, software is a big, incomprehensible alphabet soup of acronyms and geeky phrases: OS, VB, SAP, SQL, to name just a few.

Don’t be intimidated. The basics are actually pretty easy to understand. But it’s not soup; it’s more of a layer cake. Think about computer hardware as being at the bottom of the layer cake. The next layer is the operating systemThe software that controls the computer hardware and establishes standards for developing and executing applications., the collection of programs that control the hardware. Windows, Mac OS X, and Linux are operating systems. On top of that layer are applicationsIncludes desktop applications, enterprise software, utilities, and other programs that perform specific tasks for users and organizations.—these can range from end-user programs like those in Office, to the complex set of programs that manage a business’s inventory, payroll, and accounting. At the top of the cake are users.

The flexibility of these layers gives computers the customization options that managers and businesses demand. Understanding how the layers relate to each other helps you make better decisions on what options are important to your unique business needs, can influence what you buy, and may have implications for everything from competitiveness to cost overruns to security breaches. What follows is a manager’s guide to the main software categories with an emphasis on why each is important.

Messaging Standards

Two additional terms you might hear within the context of distributed computing are EDI and XML. EDI (electronic data interchange)A set of standards for exchanging messages containing formatted data between computer applications. is a set of standards for exchanging information between computer applications. EDI is most often used as a way to send the electronic equivalent of structured documents between different organizations. Using EDI, each element in the electronic document, like a firm name, address, or customer number, is coded so that it can be recognized by the receiving computer program. Eliminating paper documents makes businesses faster and lowers data entry and error costs. One study showed that firms that used EDI decreased their error rates by 82 percent and their cost of producing each document fell by up to 96 percent.“Petroleum Industry Continues to Explore EDI,” National Petroleum News 90, no. 12 (November 1998).

EDI is a very old standard, with roots stretching back to the 1948 Berlin Air Lift. While still in use, a new generation of more-flexible technologies for specifying data standards are taking its place. Chief among the technologies replacing EDI is extensible markup language (XML)A tagging language that can be used to identify data fields made available for use by other applications. Most APIs and Web services send messages where the data exchanged is wrapped in identifying XML tags.. XML has lots of uses, but in the context of distributed systems, it allows software developers to create a set of standards for common data elements that, like EDI messages, can be sent between different kinds of computers, different applications, and different organizations. XML is often thought of as easier to code than EDI, and it’s more robust because it can be extended—organizations can create formats to represent any kind of data (e.g., a common part number, photos, the complaint field collected by customer support personnel). In fact, most messages sent between Web services are coded in XML (the technology is a key enabler in mashups, discussed in Chapter 7 “Peer Production, Social Media, and Web 2.0”). Many computer programs also use XML as a way to export and import data in a common format that can be used regardless of the kind of computer hardware, operating system, or application program used. And if you design Web sites, you might encounter XML as part of the coding behind the cascading style sheets (CSS) that help maintain a consistent look and feel to the various Web pages in a given Web site.

Connectivity has made our systems more productive and enables entire new strategies and business models. But these wonderful benefits come at the price of increased risk. When systems are more interconnected, opportunities for infiltration and abuse also increase. Think of it this way—each “connection” opportunity is like adding another door to a building. The more doors that have to be defended, the more difficult security becomes. It should be no surprise that the rise of the Internet and distributed computing has led to an explosion in security losses by organizations worldwide.

Why Do Technology Projects Fail?

Even though information systems represent the largest portion of capital spending at most firms, an astonishing one in three technology development projects fail to be successfully deployed.L. Dignan, “Survey: One in 3 IT Projects Fail; Management OK with It,” ZDNet, December 11, 2007. Imagine if a firm lost its investment in one out of every three land purchases, or when building one in three factories. These statistics are dismal! Writing in IEEE Spectrum, risk consultant Robert Charette provides a sobering assessment of the cost of software failures, stating, “The yearly tab for failed and troubled software conservatively runs somewhere from $60 to $70 billion in the United States alone. For that money, you could launch the space shuttle one hundred times, build and deploy the entire 24-satellite Global Positioning System, and develop the Boeing 777 from scratch—and still have a few billion left over.”R. Charette, “Why Software Fails,” IEEE Spectrum, September 2005.

Why such a bad track record? Sometimes technology itself is to blame, other times it’s a failure to test systems adequately, and sometimes it’s a breakdown of process and procedures used to set specifications and manage projects. In one example, a multimillion-dollar loss on the NASA Mars Observer was traced back to a laughably simple oversight—Lockheed Martin contractors using English measurements, while the folks at NASA used the metric system.R. Lloyd, “Metric Mishap Caused Loss of NASA Orbiter,” CNN, September 20, 1999. Yes, a $125 million taxpayer investment was lost because a bunch of rocket scientists failed to pay attention to third grade math. When it comes to the success or failure of technical projects, the devil really is in the details.

Projects rarely fail for just one reason. Project post-mortems often point to a combination of technical, project management, and business decision blunders. The most common factors include the following:List largely based on R. Charette, “Why Software Fails,” IEEE Spectrum, September 2005.

• Unrealistic or unclear project goals
• Poor project leadership and weak executive commitment
• Inaccurate estimates of needed resources
• Badly defined system requirements and allowing “feature creep” during development
• Poor reporting of the project’s status
• Poor communication among customers, developers, and users
• Use of immature technology
• Unmanaged risks
• Inability to handle the project’s complexity
• Sloppy development and testing practices
• Poor project management
• Stakeholder politics
• Commercial pressures (e.g., leaving inadequate time or encouraging corner-cutting)

Managers need to understand the complexity involved in their technology investments, and that achieving success rarely lies with the strength of the technology alone.

But there is hope. Information systems organizations can work to implement procedures to improve the overall quality of their development practices. Mechanisms for quality improvement include capability maturity model integration (CMMI)A process-improvement approach (useful for but not limited to software engineering projects) that can assist in assessing the maturity, quality, and development of certain organizational business processes, and suggest steps for their improvement., which gauge an organization’s process maturity and capability in areas critical to developing and deploying technology projects, and provides a carefully chosen set of best practices and guidelines to assist quality and process improvement.R. Kay, “QuickStudy: Capability Maturity Model Integration (CMMI),” Computerworld, January 24, 2005; and Carnegie Mellon Software Engineering Institute, Welcome to CMMI, 2009, http://www.sei.cmu.edu/cmmi.

Firms are also well served to leverage established project planning and software development methodologies that outline critical businesses processes and stages when executing large-scale software development projects. The idea behind these methodologies is straightforward—why reinvent the wheel when there is an opportunity to learn from and follow blueprints used by those who have executed successful efforts. When methodologies are applied to projects that are framed with clear business goals and business metrics, and that engage committed executive leadership, success rates can improve dramatically.A. Shenhar and D. Dvir, Reinventing Project Management: The Diamond Approach to Successful Growth and Innovation (Boston: Harvard Business School Press, 2007).

While software development methodologies are the topic of more advanced technology courses, the savvy manager knows enough to inquire about the development methodologies and quality programs used to support large scale development projects, and can use these investigations as further input when evaluating whether those overseeing large scale efforts have what it takes to get the job done.

Why Study Facebook?

Looking at the “flavor of the month” and trying to distinguish the reality from the hype is a critical managerial skill. In Facebook’s case, there are a lot of folks with a vested interest in figuring out where the firm is headed. If you want to work there, are you signing on to a firm where your stock options and 401k contributions are going to be worth something or worthless? If you’re an investor and Facebook goes publicThe first time a firm sells stock to the public; formally called an initial public stock offering (IPO)., should you shortShort selling is an attempt to profit from a falling stock price. Short sellers sell shares they don’t own with an obligation of later repayment. They do so in the hope that the price of sold shares will fall. They then repay share debt with shares purchased at a lower price and pocket the difference (spread) between initial share price and repayment price. the firm or increase your holdings? Would you invest in or avoid firms that rely on Facebook’s business? Should your firm rush to partner with the firm? Would you extend the firm credit? Offer it better terms to secure its growing business, or worse terms because you think it’s a risky bet? Is this firm the next Google (underestimated at first, and now wildly profitable and influential), the next GeoCities (Yahoo! paid $3 billion for it—no one goes to the site today), or the next Skype (deeply impactful with over half a billion accounts worldwide, but not much of a profit generator)? The jury is still out on all this, but let’s look at the fundamentals with an eye to applying what we’ve learned. No one has a crystal ball, but we do have some key concepts that can guide our analysis. There are a lot of broadly applicable managerial lessons that can be gleaned by examining Facebook’s successes and missteps. Studying the firm provides a context for examining nework effects, platforms, partnerships, issues in the rollout of new technologies, privacy, ad models, and more.

Attention Challenges: The Hunt Versus The Hike

In terms of revenue model, Facebook is radically different from Google and the hot-growth category of search advertising. Users of Google and other search sites are on a hunt—a task-oriented expedition to collect information that will drive a specific action. Search users want to learn something, buy something, research a problem, or get a question answered. To the extent that the hunt overlaps with ads, it works. Just searched on a medical term? Google will show you an ad from a drug company. Looking for a toy? You’ll see Google ads from eBay sellers and other online shops. Type in a vacation destination and you get a long list of ads from travel providers aggressively courting your spending. Even better, Google only charges text advertisers when a user clicks through. No clicks? The ad runs at no cost to the firm. From a return on investment perspective, this is extraordinarily efficient. How often do users click on Google ads? Enough for this to be the single most profitable activity among any Internet firm. In 2009, Google revenue totaled nearly $24 billion. Profits exceeded $6.5 billion, almost all of this from pay-per-click ads (see Chapter 14 “Google: Search, Online Advertising, and Beyond” for more details).

While users go to Google to hunt, they go to Facebook as if they were going on a hike—they have a rough idea of what they’ll encounter, but they’re there to explore and look around, enjoy the sights (or site). They’ve usually allocated time for fun and they don’t want to leave the terrain when they’re having conversations, looking at photos or videos, and checking out updates from friends.

These usage patterns are reflected in click-through rates. Google users click on ads around 2 percent of the time (and at a much higher rate when searching for product information). At Facebook, click-throughs are about 0.04 percent.B. Urstadt, “The Business of Social Networks,” Technology Review, July/August 2008. Rates quoted in this piece seem high, but a large discrepancy between site rates holds across reported data.

Most banner ads don’t charge per click but rather CPMCost per thousand impressions (the M representing the roman numeral for one thousand). (cost per thousand) impressionsEach time an ad is served to a user for viewing. (each time an ad appears on someone’s screen). But Facebook banner ads performed so poorly that the firm pulled them in early 2010.C. McCarthy, “More Social, Please: Facebook Nixes Banner Ads,” CNET, February 5, 2010. Lookery, a one-time ad network that bought ad space on Facebook in bulk, had been reselling inventory at a CPM of 7.5 cents (note that Facebook does offer advertisers pay-per-click as well as impression-based, or CPM, options). Even Facebook ads with a bit of targeting weren’t garnering much (Facebook’s Social Ads, which allow advertisers to target users according to location and age, have a floor price of fifteen cents CPM).B. Urstadt, “The Business of Social Networks,” Technology Review, July/August 2008; J. Hempel, “Finding Cracks in Facebook,” Fortune, May 13, 2008; and E. Schonfeld, “Are Facebook Ads Going to Zero? Lookery Lowers Its Guarantee to 7.5-cent CMPs,” TechCrunch, July 22, 2008. Other social networks also suffered. In 2008, MySpace lowered its banner ad rate from $3.25 CPM to less than two dollars. By contrast, information and news-oriented sites do much better, particularly if these sites draw in a valuable and highly targeted audience. The social networking blog Mashable has CPM rates ranging between seven and thirty-three dollars. Technology Review magazine boasts a CPM of seventy dollars. TechTarget, a Web publisher focusing on technology professionals, has been able to command CPM rates of one hundred dollars and above (an ad inventory that valuable helped the firm go public in 2007).

Getting Creative with Promotions: Does It Work?

Facebook and other social networks are still learning what works. Ad inventory displayed on high-traffic home pages have garnered big bucks for firms like Yahoo! With Facebook offering advertisers greater audience reach than most network television programs, there’s little reason to suggest that chunks of this business won’t eventually flow to the social networks. But even more interesting is how Facebook and widget sites have begun to experiment with relatively new forms of advertising. Many feel that Facebook has a unique opportunity to get consumers to engage with their brand, and some initial experiments point where this may be heading.

Many firms have been leveraging so-called engagement adsPromotion technique popular with social media that attempts to get consumers to interact with an ad, then shares that action with friends. by making their products part of the Facebook fun. Using an engagement ad, a firm can set up a promotion where a user can do things such as “Like” or become a fan of a brand, RSVP to an event and invite others, watch and comment on a video and see what your friends have to say, send a “virtual gift” with a personal message, or answer a question in a poll. The viral nature of Facebook allows actions to flow back into the news feed and spread among friends.

COO Sheryl Sandberg discussed Ben & Jerry’s promotion for the ice cream chain’s free cone day event. To promote the upcoming event, Ben & Jerry’s initially contracted to make two hundred and fifty thousand “gift cones” available to Facebook users; they could click on little icons that would gift a cone icon to a friend, and that would show up in their profile. Within a couple of hours, customers had sent all two hundred and fifty thousand virtual cones. Delighted, Ben & Jerry’s bought another two hundred and fifty thousand cones. Within eleven hours, half a million people had sent cones, many making plans with Facebook friends to attend the real free cone day. The day of the Facebook promotion, Ben & Jerry’s Web site registered fifty-three million impressions, as users searched for store locations and wrote about their favorite flavors.Q. Hardy, “Facebook Thinks Outside Boxes,” Forbes, May 28, 2008. The campaign dovetailed with everything Facebook was good at: it was viral, generating enthusiasm for a promotional event and even prompting scheduling.

In other promotions, Honda gave away three quarters of a million hearts during a Valentine’s Day promo,S. Sandberg, “Sheryl Sandberg on Facebook’s Future,” BusinessWeek, April 8, 2009. and the Dr. Pepper Snapple Group offered two hundred and fifty thousand virtual Sunkist sodas, which earned the firm one hundred thirty million brand impressions in twenty-two hours. Says Sunkist’s brand manager, “A Super Bowl ad, if you compare it, would have generated somewhere between six to seven million.”E. Wong, “Ben & Jerry’s, Sunkist, Indy Jones Unwrap Facebook’s ‘Gift of Gab,’” Brandweek, June 1, 2008.

Of course, even with this business, Facebook may find that it competes with widget makers. Unlike Apple’s App Store (where much of developer-earned revenue comes from selling apps), the vast majority of Facebook apps are free and supported by ads. That means Facebook and its app providers are both running at a finite pot of advertising dollars. Slide’s Facebook apps have attracted top-tier advertisers, such as Coke and Paramount Pictures—a group Facebook regularly courts as well. By some estimates, in 2009, Facebook app developers took in well over half a billion dollars—exceeding Facebook’s own haul.M. Learmonth and A. Klaasen, “Facebook Apps Will Make More Money Than Facebook in 2009,” Silicon Alley Insider, May 18, 2009. And there’s controversy. Zynga was skewered in the press when some of its partners were accused of scamming users into signing up for subscriptions or installing unwanted software in exchange for game credits (Zynga has since taken steps to screen partners and improve transparency).M. Arrington, “Zynga Takes Steps to Remove Scams from Games,” TechCrunch, November 2, 2009.

While these efforts might be innovative, are they even effective? Some of these programs are considered successes; others, not so much. Jupiter Research surveyed marketers trying to create a viral impact online and found that only about 15 percent of these efforts actually caught on with consumers.M. Cowan, “Marketers Struggle to Get Social,” Reuters, June 19, 2008, http://www.reuters.com/news/video?videoId=84894. While the Ben & Jerry’s gift cones were used up quickly, a visit to Facebook in the weeks after this campaign saw CareerBuilder, Wide Eye Caffeinated Spirits, and Coors Light icons lingering days after their first appearance. Brands seeking to deploy their own applications in Facebook have also struggled. New Media Age reported that applications rolled out by top brands such as MTV, Warner Bros., and Woolworths were found to have as little as five daily users. Congestion may be setting in for all but the most innovative applications, as standing out in a crowd of over 550,000 applications becomes increasingly difficult.Facebook Press Room, Statistics, April 29, 2010, http://www.facebook.com/press/info.php?statistics.

Consumer products giant P&G has been relentlessly experimenting with leveraging social networks for brand engagement, but the results show what a tough slog this can be. The firm did garner fourteen thousand Facebook “fans” for its Crest Whitestrips product, but those fans were earned while giving away free movie tickets and other promos. The New York Times quipped that with those kinds of incentives, “a hemorrhoid cream” could have attracted a similar group of “fans.” When the giveaways stopped, thousands promptly “unfanned” Whitestrips. Results for Procter & Gamble’s “2X Ultra Tide” fan page were also pretty grim. P&G tried offbeat appeals for customer-brand bonding, including asking Facebookers to post “their favorite places to enjoy stain-making moments.” But a check eleven months after launch had garnered just eighteen submissions, two from P&G, two from staffers at spoof news site The Onion, and a bunch of short posts such as “Tidealicious!”R. Stross, “Advertisers Face Hurdles on Social Networking Sites,” New York Times, December 14, 2008.

Efforts around engagement opportunities like events (Ben & Jerry’s) or products consumers are anxious to identify themselves with (a band or a movie) may have more success than trying to promote consumer goods that otherwise offer little allegiance, but efforts are so new that metrics are scarce, impact is tough to gauge, and best practices are still unclear.

Reputation Damage and Increased Scrutiny—The Facebook TOS Debacle

Facebook also suffered damage to its reputation, brand, and credibility, further reinforcing perceptions that the company acts brazenly, without considering user needs, and is fast and loose on privacy and user notification. Facebook worked through the feeds outrage, eventually convincing users of the benefits of feeds. But Beacon was a fiasco. And now users, the media, and watchdogs were on the alert.

When the firm modified its terms of service (TOS) policy in Spring 2009, the uproar was immediate. As a cover story in New York magazine summed it up, Facebook’s new TOS appeared to state, “We can do anything we want with your content, forever,” even if a user deletes their account and leaves the service.V. Grigoriadis, “Do You Own Facebook? Or Does Facebook Own You?” New York, April 5, 2009. Yet another privacy backlash!

Activists organized, the press crafted juicy, attention-grabbing headlines, and the firm was forced once again to backtrack. But here’s where others can learn from Facebook’s missteps and response. The firm was contrite and reached out to explain and engage users. The old TOS were reinstated, and the firm posted a proposed new version that gave the firm broad latitude in leveraging user content without claiming ownership. And the firm renounced the right to use this content if a user closed their Facebook account. This new TOS was offered in a way that solicited user comments, and it was submitted to a community vote, considered binding if 30 percent of Facebook users participated. Zuckerberg’s move appeared to have turned Facebook into a democracy and helped empower users to determine the firm’s next step.

Despite the uproar, only about 1 percent of Facebook users eventually voted on the measure, but the 74 percent to 26 percent ruling in favor of the change gave Facebook some cover to move forward.J. Smith, “Facebook TOS Voting Concludes, Users Vote for New Revised Documents,” Inside Facebook, April 23, 2009. This event also demonstrates that a tempest can be generated by a relatively small number of passionate users. Firms ignore the vocal and influential at their own peril!

In Facebook’s defense, the broad TOS was probably more a form of legal protection than any nefarious attempt to exploit all user posts ad infinitum. The U.S. legal environment does require that explicit terms be defined and communicated to users, even if these are tough for laypeople to understand. But a “trust us” attitude toward user data doesn’t work, particularly for a firm considered to have committed ham-handed gaffes in the past. Managers must learn from the freewheeling Facebook community. In the era of social media, your actions are now subject to immediate and sustained review. Violate the public trust and expect the equivalent of a high-powered investigative microscope examining your every move, and a very public airing of the findings.

More Privacy Controversy

The decision to launch these new features as “opt-out” instead of “opt-in” immediately drew the concern of lawmakers. Given the Beacon debacle, the TOS controversy, and Google’s problems with Buzz (see Chapter 14 “Google: Search, Online Advertising, and Beyond”), you’d think Facebook would have known better. But within a week of Beacon’s launch, four U.S. senators contacted the firm, asking why it was so difficult to opt out of the information-sharing platform.F. Lardinois, “Is It Time for Facebook to Make Opt-In the Default?” Read Write Web, April 27, 2010. Amid a crush of negative publicity, the firm was forced to quickly roll out simplified privacy management controls.

Facebook’s struggles show the tension faced by any firm that wants to collect data to improve the user experience (and hopefully make money along the way). Opt-out guarantees the largest possible audience and that’s key to realizing the benefits of network effects, data, and scale. Making efforts opt-in creates the very real risk that not enough users will sign up and that the reach and impact of these kinds of initiatives will be limited.F. Lardinois, “Is It Time for Facebook to Make Opt-In the Default?” Read Write Web, April 27, 2010. Fast Company calls this the paradox of privacy, saying, “We want some semblance of control over our personal data, even if we likely can’t be bothered to manage it.”F. Manjoo, “Does Privacy on Facebook, Google, and Twitter Even Matter?” Fast Company, May 1, 2010. Evidence suggests that most people are accepting some degree of data sharing as long as they know that they can easily turn it off if they want to. For example, when Google rolled out ads that tracked users across the network of Web sites running Google ads, the service also provided a link in each ad where users could visit an “ad preferences manager” to learn how they were being profiled, to change settings, and to opt out (see Chapter 14 “Google: Search, Online Advertising, and Beyond”). It turns out only one in fifteen visitors to the ad preferences manager ended up opting out completely.F. Manjoo, “Does Privacy on Facebook, Google, and Twitter Even Matter?” Fast Company, May 1, 2010. Managers seeking to leverage data should learn from the examples of Facebook and Google and be certain to offer clear controls that empower user choice.

Free Riders and Security Concerns

Facebook also allows third-party developers to create all sorts of apps to access Facebook data. Facebook feeds are now streaming through devices that include Samsung, Vizio, and Sony televisions; Xbox 360 and Wii game consoles; Verizon’s FiOS pay television service; and the Amazon Kindle. While Facebook might never have the time or resources to create apps that put its service on every gadget on the market, they don’t need to. Developers using Facebook’s access tools will gladly pick up the slack.

But there are major challenges with a more open approach, most notably a weakening of strategic assets, revenue sharing, and security. First, let’s discuss weakened assets. Mark Zuckerberg’s geeks have worked hard to make their site the top choice for most of the world’s social networkers and social network application developers. Right now, everyone goes to Facebook because everyone else is on Facebook. But as Facebook opens up access to users and content, it risks supporting efforts that undermine the firm’s two most compelling sources of competitive advantage: network effects and switching costs. Any effort that makes it easier to pack up your “social self” and move it elsewhere risks undermining vital competitive resources advantages (it still remains more difficult to export contacts, e-mails, photos, and video from Facebook than it does from sites supporting OpenSocial, a rival platform backed by Google and supported by many of Facebook’s competitors).F. Vogelstein, “The Great Wall of Facebook,” Wired, July 2009. This situation also puts more pressure on Facebook to behave. Lower those switching costs at a time when users are disgusted with firm behavior, and it’s not inconceivable that a sizable chunk of the population could bolt for a new rival (to Facebook’s credit, the site also reached out to prior critics like MoveOn.org, showing Facebook’s data-sharing features and soliciting input months before their official release).

Along with asset weakening comes the issue of revenue sharing. As mentioned earlier, hosting content (especially photos and rich media) is a very expensive proposition. What incentive does a site have to store data if it will just be sent to a third-party site that will run ads around this content and not share the take? Too much data portability presents a free rider problemWhen others take advantage of a user or service without providing any sort of reciprocal benefit. where firms mooch off Facebook’s infrastructure without offering much in return. Consider services like TweetDeck. The free application allows users to access their Facebook feeds and post status updates—alongside Twitter updates and more—all from one interface. Cool for the user, but bad for Facebook, since each TweetDeck use means Facebook users are “off-site,” not looking at ads, and hence not helping Zuckerberg & Co. earn revenue. It’s as if the site has encouraged the equivalent of an ad blocker, yet Facebook’s openness lets this happen!

Finally, consider security. Allowing data streams that contain potentially private posts and photographs to squirt across the Internet and land where you want them raises all sorts of concerns. What’s to say an errant line of code doesn’t provide a back door to your address book or friends list? To your messaging account? To let others see photos you’d hoped to only share with family? Security breaches can occur on any site, but once the data is allowed to flow freely, every site with access is, for hackers, the equivalent of a potential door to open or a window to crawl through.

Examples of Wiki Use

Wikis can be vital tools for collecting and leveraging knowledge that would otherwise be scattered throughout an organization; reducing geographic distance; removing boundaries between functional areas; and flattening preexisting hierarchies. Companies have used wikis in a number of ways:

• At Pixar, all product meetings have an associated wiki to improve productivity. The online agenda ensures that all attendees can arrive knowing the topics and issues to be covered. Anyone attending the meeting (and even those who can’t make it) can update the agenda, post supporting materials, and make comments to streamline and focus in-person efforts.
• At European investment bank Dresdner Kleinwort Wasserstein, employees use wikis for everything from setting meeting agendas to building multimedia training for new hires. Six months after launch, wiki use had surpassed activity on the firm’s established intranet. Wikis are also credited with helping to reduce Dresdner e-mail traffic by 75 percent.D. Carlin, “Corporate Wikis Go Viral,” BusinessWeek, March 12, 2007.
• Sony’s PlayStation team uses wikis to regularly maintain one-page overviews on the status of various projects. In this way, legal, marketing, and finance staff can get quick, up-to-date status reports on relevant projects, including the latest projected deadlines, action items, and benchmark progress. Strong security measures are enforced that limit access to only those who must be in the know, since the overviews often discuss products that have not been released.
• Employees at investment-advisory firm Manning and Napier use a wiki to collaboratively track news in areas of critical interest. Providing central repositories for employees to share articles and update evolving summaries on topics such as health care legislation, enables the firm to collect and focus what would otherwise be fragmented findings and insight. Now all employees can refer to central pages that each serve as a lightning rod attracting the latest and most relevant findings.
• Intellipedia is a secure wiki built on Intelink, a U.S. government system connecting sixteen spy agencies, military organizations, and the Department of State. The wiki is a “magnum opus of espionage,” handling some one hundred thousand user accounts and five thousand page edits a day. Access is classified in tiers as “unclassified,” “secret,” and “top secret” (the latter hosting 439,387 pages and 57,248 user accounts). A page on the Mumbai terror attacks was up within minutes of the event, while a set of field instructions relating to the use of chlorine-based terror bombs in Iraq was posted and refined within two days of material identification—with the document edited by twenty-three users at eighteen locations.M. Calabrese, “Wikipedia for Spies: The CIA Discovers Web 2.0,” Time, April 8, 2009.

When brought outside the firewall, corporate wikis can also be a sort of value-generation greenhouse, allowing organizations to leverage input from their customers and partners:

• Intuit has created a “community wiki” that encourages the sharing of experience and knowledge not just regarding Intuit products, such as QuickBooks, but also across broader topics its customers may be interested in, such as industry-specific issues (e.g., architecture, nonprofit) or small business tips (e.g., hiring and training employees). The TurboTax maker has also sponsored TaxAlmanac.org, a wiki-based tax resource and research community.
• Microsoft leveraged its customer base to supplement documentation for its Visual Studio software development tool. The firm was able to enter the Brazilian market with Visual Studio in part because users had created product documentation in Portuguese.R. King, “No Rest for the Wiki,” BusinessWeek, March 12, 2007.
• ABC and CBS have created public wikis for the television programs Lost, The Amazing Race, and CSI, among others, offering an outlet for fans, and a way for new viewers to catch up on character backgrounds and complex plot lines.
• Executive Travel, owned by American Express Publishing, has created a travel wiki for its more than one hundred and thirty thousand readers with the goal of creating what it refers to as “a digital mosaic that in theory is more authoritative, comprehensive, and useful” than comments on a Web site, and far more up-to-date than any paper-based travel guide.R. King, “No Rest for the Wiki,” BusinessWeek, March 12, 2007. Of course, one challenge in running such a corporate effort is that there may be a competing public effort already in place. Wikitravel.org currently holds the top spot among travel-based wikis, and network effects suggest it will likely grow and remain more current than rival efforts.

Corporate Use of Social Networks

Hundreds of firms have established “fan” pages on Facebook and communites on LinkedIn. These are now legitimate customer- and client-engagement platforms that also support advertising. If a customer has decided to press the “like” button of a firm’s Facebook page and become a “fan,” corporate information will appear in their newsfeed, gaining more user attention than the often-ignored ads that run on the sides of social networks. (For more on social networks and advertising, see Chapter 8 “Facebook: Building a Business from the Social Graph”.)

But social networks have also become organizational productivity tools. Many employees have organized groups using publicly available social networking sites because similar tools are not offered by their firms. Workforce Management reported that MySpace had over forty thousand groups devoted to companies or coworkers, while Facebook had over eight thousand.E. Frauenheim, “Social Revolution,” Workforce Management, October 2007. Assuming a large fraction of these groups are focused on internal projects, this demonstrates a clear pent-up demand for corporate-centric social networks (and creates issues as work dialogue moves outside firm-supported services).

Many firms are choosing to meet this demand by implementing internal social network platforms that are secure and tailored to firm needs. At the most basic level, these networks have supplanted the traditional employee directory. Social network listings are easy to update and expand. Employees are encouraged to add their own photos, interests, and expertise to create a living digital identity.

Firms such as Deloitte, Dow Chemical, and Goldman Sachs have created social networks for “alumni” who have left the firm or retired. These networks can be useful in maintaining contacts for future business leads, rehiring former employees (20 percent of Deloitte’s experienced hires are so-called boomerangs, or returning employees), or recruiting retired staff to serve as contractors when labor is tight.R. King, “Social Networks: Execs Use Them Too,” BusinessWeek, November 11, 2006. Maintaining such networks will be critical in industries like IT and health care that are likely to be plagued by worker shortages for years to come.

Social networking can also be important for organizations like IBM, where some 42 percent of employees regularly work from home or client locations. IBM’s social network makes it easier to locate employee expertise within the firm, organize virtual work groups, and communicate across large distances.W. Bulkley, “Playing Well with Others,” Wall Street Journal, June 18, 2007. As a dialogue catalyst, a social network transforms the public directory into a font of knowledge sharing that promotes organization flattening and value-adding expertise sharing.

While IBM has developed their own social network platforms, firms are increasingly turning to third-party vendors like SelectMinds (adopted by Deloitte, Dow Chemical, and Goldman Sachs) and LiveWorld (adopted by Intuit, eBay, the NBA, and Scientific American). Ning allows anyone to create a social network and currently hosts over 2.3 million separate online communities.K. Swisher, “Ning CEO Gina Bianchini to Step Down—Becomes an EIR at Andreessen Horowitz,” AllThingsD, March 15, 2010.

Firms have also created their own online communities to foster brainstorming and customer engagement. Dell’s IdeaStorm.com forum collects user feedback and is credited with prompting line offerings, such as the firm’s introduction of a Linux-based laptop.D. Greenfield, “How Companies Are Using I.T. to Spot Innovative Ideas,” InformationWeek, November 8, 2008. At MyStarbucksIdea.com, the coffee giant has leveraged user input to launch a series of innovations ranging from splash sticks that prevent spills in to-go cups, to new menu items. Both IdeaStorm and MyStarbucksIdea run on a platform offered by Salesforce.com that not only hosts these sites but also provides integration into Facebook and other services. Starbucks (the corporate brand with the most Facebook “fans”) has extensively leveraged the site, using Facebook as a linchpin in the “Free Pastry Day” promotion (credited with generating one million in-store visits in a single day) and promotion of the firm’s AIDS-related (Starbucks) RED campaign, which garnered an astonishing three hundred ninety million “viral impressions” through feeds, wall posts, and other messaging.M. Brandau, “Starbucks Brews Up Spot on the List of Top Social Brands in 2008,” Nation’s Restaurant News, April 6, 2009.

RSS

RSSA method for sending/broadcasting data to users who subscribe to a service’s “RSS feed.” Many Web sites and blogs forward headlines to users who subscribe to their “feed,” making it easy to scan headlines and click to access relevant news and information. (an acronym that stands for both “really simple syndication” and “rich site summary”) enables busy users to scan the headlines of newly available content and click on an item’s title to view items of interest, thus sparing them from having to continually visit sites to find out what’s new. Users begin by subscribing to an RSS feed for a Web site, blog, podcast, or other data source. The title or headline of any new content will then show up in an RSS readerA tool for subscribing to and accessing RSS feeds. Most e-mail programs and Web browsers can also act as RSS readers. There are also many Web sites (including Google Reader) that allow users to subscribe to and read RSS feeds.. Subscribe to the New York Times Technology news feed, for example, and you will regularly receive headlines of tech news from the Times. Viewing an article of interest is as easy as clicking the title you like. Subscribing is often as easy as clicking on the RSS icon appearing on the home page of a Web site of interest.

Many firms use RSS feeds as a way to mange information overload, opting to distribute content via feed rather than e-mail. Some even distribute corporate reports via RSS. RSS readers are offered by third-party Web sites such as Google and Yahoo! and they have been incorporated into all popular browsers and most e-mail programs. Most blogging platforms provide a mechanism for bloggers to automatically publish a feed when each new post becomes available. Google’s FeedBurner is the largest publisher of RSS blog feeds, and offers features to distribute content via e-mail as well.

Folksonomies

FolksonomiesKeyword-based classification systems created by user communities (also known as social tagging). (sometimes referred to as social tagging) are keyword-based classification systems created by user communities as they generate and review content. (The label is meant to refer to a people-powered taxonomy.) Bookmarking site Del.icio.us, photo-sharing site Flickr (both owned by Yahoo!), and Twitter’s hash tags all make heavy use of folksonomies.

With this approach, classification schemes emerge from the people most likely to understand them—the users. By leveraging the collective power of the community to identify and classify content, objects on the Internet become easier to locate, and content carries a degree of recommendation and endorsement.

Flickr cofounder Stewart Butterfield describes the spirit of folksonomies, saying, “The job of tags isn’t to organize all the world’s information into tidy categories, it’s to add value to the giant piles of data that are already out there.”D. Terdiman, “Folksonomies Tap People Power,” Wired, February 1, 2005. The Guggenheim Museum in New York City and the San Francisco Museum of Modern Art, among other museums, are taking a folksonomic approach to their online collections, allowing user-generated categories to supplement the specialized lexicon of curators. Amazon.com has introduced a system that allows readers to classify books, and most blog posts and wiki pages allow for social tagging, oftentimes with hot topics indexed and accessible via a “tag cloud” in the page’s sidebar.

Mash-up

Mash-upsThe combination of two or more technologies or data feeds into a single, integrated tool. are combinations of two or more technologies or data feeds into a single, integrated tool. Some of the best known mash-ups leverage Google’s mapping tools. HousingMaps.com combines Craigslist.org listings with Google Maps for a map-based display for apartment hunters. IBM linked together job feeds and Google Maps to create a job-seeker service for victims of Hurricane Katrina. SimplyHired links job listings with Google Maps, LinkedIn listings, and salary data from PayScale.com. And Salesforce.com has tools that allow data from its customer relationship management (CRM) system to be combined with data feeds and maps from third parties.

Mash-ups are made easy by a tagging system called XMLAbbreviation of Extensible Markup Language. A tagging language that can be used to identify data fields made available for use by other applications. For example, programmers may wrap XML tags around elements in an address data stream (e.g., 〈business name〉, 〈street address〉, 〈city〉, 〈state〉) to allow other programs to recognize and use these data items. (for extensible markup language). Site owners publish the parameters of XML data feeds that a service can accept or offer (e.g., an address, price, product descriptions, images). Other developers are free to leverage these public feeds using application programming interfaces (APIs), published instructions on how to make programs call one another, to share data, or to perform tasks. Using APIs and XML, mash-up authors smoosh together seemingly unrelated data sources and services in new and novel ways. Lightweight, browser-friendly software technologies like Ajax and HTML5 can often make a Web site interface as rich as a desktop application, and rapid deployment frameworks like Ruby on Rails will enable and accelerate mash-up creation and deployment.

Location-Based Services

Computing devices increasingly know where you are—and this is creating all sorts of new opportunities for social media. Twitter, Facebook, and Google Buzz are among the many social services that have added location-based options, allowing you to tweet or post a status update attached with a physical location as determined by your phone’s global positioning system (GPS)A network of satellites and supporting technologies used to identify a device’s physical location., triangulation from nearby cell phone towers, or proximity to neighboring Wi-Fi hotspots. This introduces a whole new way to gather and share information. In a new part of town and curious what folks are saying about the spot? Search for tweets tagged as being posted around that location.

Augmented-realityComputer applications that overlay real-world images with computer-generated imagery and data. apps can overlay real data on top of images from a GPS and compass-equipped smartphone. Swivel your iPhone around with Stella Artois’s Bar Finder app open, and it’ll point you to the nearest Stella-equipped watering hole (it’ll also let you text your friends to join you for a drink and call a cab for a safe ride home). Wikitude overlays images appearing through your phone’s camera lens with geotagged data from Wikipedia. Point your Yelp app down the street and activate the monocle feature to see starred reviews hover over the top of establishments that appear on screen.

Boston-based SCVNGR (pronounced “scavenger”), a gaming app, has allowed over four hundred clients, including Princeton, MetLife, and Boston’s Museum of Fine Arts, to create their own mobile phone-based scavenger hunts. The profitable firm has a 90 percent client return rate and had attracted funding from Google Ventures and Highland Capital Partners all before founder Seth Priebatsch turned twenty-one.J. Kincaid, “SCVNGR Raises $4 Million from Google Ventures,” TechCrunch, December 24, 2009.

Perhaps the best known among the location-based pure plays is Foursquare. The service allows players to “check in” at different locations, allowing players to earn “badges” displayed in the app for completing specific achievements (“gym rat” for exercise buffs, “school night” for weeknight bar hoppers). Check into a location more than anyone else and you become that spot’s “mayor.” Foursquare users can follow public location postings from their friends, discovering when someone’s close by and gaining recommendations on new places to explore. Foursquare grew to over one million users roughly one year after the service debuted at the 2009 South by Southwest conference. Firms are now using Foursquare for promotions and to support loyalty programs—offering “mayor specials” or sending out coupons and other incentives when users are nearby. Starbucks, the Bravo television channel, frozen yogurt chain Tasti D-Lite, and the Milwaukee-based burger chain AJ Bombers are among the diverse clients leveraging the service.

Of course, all this public location sharing raises privacy concerns. The Web site PleaseRobMe.com was created to draw attention to the potentially dangerous issues around real-time location sharing. After a brief demonstration period, the site stopped its real-time aggregation of publicly accessible user-location data and now serves as an awareness site warning of the “stalkerish” side of location-based apps. In most cases, though, users remain firmly in control—determining if they want to keep a visit private or release their locale to verified “app friends” or to the broader online space.

Virtual Worlds

In virtual worldsA computer-generated environment where users present themselves in the form of an avatar, or animated character., users appear in a computer-generated environment in the form of an avatarAn online identity expressed by an animated or cartoon figure., or animated character. Users can customize the look of their avatar, interact with others by typing or voice chat, and can travel about the virtual world by flying, teleporting, or more conventional means.

The most popular general-purpose virtual world is Second Life by Linden Labs, although many others exist. Most are free, although game-oriented worlds, such as World of Warcarft (with ten million active subscribers), charge a fee. Many corporations and organizations have established virtual outposts by purchasing “land” in the world of Second Life, while still others have contracted with networks to create their own, independent virtual worlds.

Most organizations have struggled to commercialize these Second Life forays, but activity has been wide-ranging in its experimentation. Reuters temporarily “stationed” a reporter in Second Life, presidential candidates have made appearances in the virtual world, organizations ranging from Sun Microsystems to Armani have set up virtual storefronts, and there’s a significant amount of virtual mayhem. Second Life “terrorists” have “bombed” virtual outposts run by several organizations, including ABC News, American Apparel, and Reebok.

Even grade schoolers are heavy virtual world users. Many elementary school students get their first taste of the Web through Webkinz, an online world that allows for an animated accompaniment with each of the firm’s plush toys. Webkinz’s parent company, privately held Ganz, doesn’t release financial figures. But according to Compete.com, by the end of 2008 Webkinz.com had roughly the same number of unique visitors as FoxNews.com. The kiddie set virtual world market is considered so lucrative that Disney acquired ClubPenguin for $350 million with agreements to pay another potential three hundred fifty million if the effort hits growth incentives.B. Barnes, “Disney Acquires Web Site for Children,” New York Times, August 2, 2007.

YouTube, Podcasting, and Rich Media

Blogs, wikis, and social networks not only enable sharing text and photos, they also allow for the creation and distribution of audio and video. PodcastsDigital audio or video files served as a series of programs or a multimedia blog. are digital audio files (some also incorporate video), provided as a series of programs. Podcasts range from a sort of media blog, archives of traditional radio and television programs, and regular offerings of original online content. While the term podcast derives from Apple’s wildly successful iPod, podcasts can be recorded in audio formats such as MP3 that can be played on most portable media players. (In perhaps the ultimate concession to the market leader, even the iPod rival Microsoft Zune refers to serialized audio files as podcasts on its navigation menu).

There are many podcast directories, but Apple’s iTunes is by far the largest. Anyone who wants to make a podcast available on iTunes can do so for free. A podcast publisher simply records an audio file, uploads the file to a blog or other hosting server, then sends the RSS feed to Apple (copyrighted material cannot be used without permission, with violators risking banishment from iTunes). Files are discovered in the search feature of the iTunes music store, and listings seamlessly connect the user with the server hosting the podcast. This path creates the illusion that Apple serves the file even though it resides on a publisher’s servers.

While blogs have made stars of some unknowns, the most popular podcasts are from mainstream media outlets. A recent visit to the podcasting section of iTunes showed that eight of the top ten most popular podcasts were high-quality productions of mainstream media programs, including offerings from CBS, Comedy Central, NPR, and PBS. Podcasts are also revolutionizing education, with scores of universities “open sourcing” their classrooms and offering lectures for public consumption via Apple’s iTunesU.

In contrast to iTunes, YouTube actually hosts video on its own servers, so all you need to do is shoot a video and upload it to the site. YouTube is a bastion of amateur video, with most clips shot and uploaded by nonprofessionals. It’s also become a protest site (e.g., “A Comcast Technician Sleeping on my Couch”). However, YouTube has also become a go-to distribution platform for professional content such as ad clips, customer support guides, music videos, TV shows, movies, and more. Much of this rich mediaContent that is more complex than simple text. The term can refer to images, animation, audio, and video. content can be distributed or streamed within another Web site, blog, or social network profile.

Creating the Team

Firms need to treat social media engagement as a key corporate function with clear and recognizable leadership within the organization. Social media is no longer an ad hoc side job or a task delegated to an intern. When McDonald’s named its first social media chief, the company announced that it was important to have someone “dedicated 100% of the time, rather than someone who’s got a day job on top of a day job.”E. York, “McDonald’s Names First Social-Media Chief,” Chicago Business, April 13, 2010. Firms without social media baked into employee job functions often find that their online efforts are started with enthusiasm, only to suffer under a lack of oversight and follow-through. One hotel operator found franchisees were quick to create Facebook pages, but many rarely monitored them. Customers later notified the firm that unmonitored hotel “fan” pages contained offensive messages—a racist rant on one, paternity claims against an employee on another.

Organizations with a clearly established leadership role for social media can help create consistency in firm dialogue; develop and communicate policy; create and share institutional knowledge; provide training, guidance, and suggestions; offer a place to escalate issues in the event of a crisis or opportunity; and catch conflicts that might arise if different divisions engage without coordination.

While firms are building social media responsibility into job descriptions, also recognize that social media is a team sport that requires input from staffers throughout an organization. The social media team needs support from public relations, marketing, customer support, HR, legal, IT, and other groups, all while acknowledging that what’s happening in the social media space is distinct from traditional roles in these disciplines. The team will hone unique skills in technology, analytics, and design, as well as skills for using social media for online conversations, listening, trust building, outreach, engagement, and response. As an example of the interdisciplinary nature of social media practice, consider that the social media team at Starbucks (regarded by some as the best in the business) is organized under the interdisciplinary “vice president of brand, content, and online.”Starbucks was named the best firm for social media engagement in a study by Altimeter Group and WetPaint. See the 2009 ENGAGEMENTdb report at http://engagementdb.com.

Also note that while organizations with SMARTs (social media teams) provide leadership, support, and guidance, they don’t necessarily drive all efforts. GM’s social media team includes representatives from all the major brands. The idea is that employees in the divisions are still the best to engage online once they’ve been trained and given operational guardrails. Says GM’s social media chief, “I can’t go in to Chevrolet and tell them ‘I know your story better than you do, let me tell it on the Web.’”C. Barger, talk at the Social Media Club of Detroit, November 18, 2009. Also available via UStream and DigitalMarketingZen.com. Similarly, the roughly fifty Starbucks “Idea Partners” who participate in MyStarbucksIdea are specialists. Part of their job is to manage the company’s social media. In this way, conversations about the Starbucks Card are handled by card team experts, and merchandise dialogue has a product specialist who knows that business best. Many firms find that the social media team is key for coordination and supervision (e.g., ensuring that different divisions don’t overload consumers with too much or inconsistent contact), but the dynamics of specific engagement still belong with the folks who know products, services, and customers best.

Responsibilities and Policy Setting

In an age where a generation has grown up posting shoot-from-the-hip status updates and YouTube is seen as a fame vehicle for those willing to perform sensational acts, establishing corporate policies and setting employee expectations are imperative for all organizations. The employees who don’t understand the impact of social media on the firm can do serious damage to their employers and their careers (look to Domino’s for an example of what can go wrong).

Many experts suggest that a good social media policy needs to be three things: “short, simple, and clear.”J. Soat, “7 Questions Key to Social Networking Success,” InformationWeek, January 16, 2010. Fortunately, most firms don’t have to reinvent the wheel. Several firms, including Best Buy, IBM, Intel, The American Red Cross, and Australian telecom giant Telstra, have made their social media policies public.

Most guidelines emphasize the “three Rs”: representation, responsibility, and respect.

• Representation. Employees need clear and explicit guidelines on expectations for social media engagement. Are they empowered to speak on behalf of the firm? If they do, it is critical that employees transparently disclose this to avoid legal action. U.S. Federal Trade Commission rules require disclosure of relationships that may influence online testimonial or endorsement. On top of this, many industries have additional compliance requirements (e.g., governing privacy in the health and insurance fields, retention of correspondence and disclosure for financial services firms). Firms may also want to provide guidelines on initiating and conducting dialogue, when to respond online, and how to escalate issues within the organization.
• Responsibility. Employees need to take responsibility for their online actions. Firms must set explicit expectations for disclosure, confidentiality and security, and provide examples of engagement done right, as well as what is unacceptable. An effective social voice is based on trust, so accuracy, transparency, and accountability must be emphasized. Consequences for violations should be clear.
• Respect. Best Buy’s policy for its Twelpforce explicitly states participants must “honor our differences” and “act ethically and responsibly.” Many employees can use the reminder. Sure customer service is a tough task and every rep has a story about an unreasonable client. But there’s a difference between letting off steam around the water cooler and venting online. Virgin Atlantic fired thirteen of the airline’s staffers after they posted passenger insults and inappropriate inside jokes on Facebook.L. Conway, “Virgin Atlantic Sacks 13 Staff for Calling Its Flyers ‘Chavs,’” The Independent, November 1, 2008.

Policies also need to have teeth. Remember, a fourth “R” is at stake—reputation (both the firm’s and the employee’s). Violators should know the consequences of breaking firm rules and policies should be backed by action. Best Buy’s policy simply states, “Just in case you are forgetful or ignore the guidelines above, here’s what could happen. You could get fired (and it’s embarrassing to lose your job for something that’s so easily avoided).”

Despite these concerns, trying to micromanage employee social media use is probably not the answer. At IBM, rules for online behavior are surprisingly open. The firm’s code of conduct reminds employees to remember privacy, respect, and confidentiality in all electronic communications. Anonymity is not permitted on IBM’s systems, making everyone accountable for their actions. As for external postings, the firm insists that employees not disparage competitors or reveal customers’ names without permission and asks that any employee posts from IBM accounts or that mention the firm also include disclosures indicating that opinions and thoughts shared publicly are the individual’s and not Big Blue’s.

Some firms have more complex social media management challenges. Consider hotels and restaurants where outlets are owned and operated by franchisees rather than the firm. McDonald’s social media team provides additional guidance so that regional operations can create, for example, a Twitter handle (e.g., @mcdonalds_cincy) that handle a promotion in Cincinnati that might not run in other regions.E. York, “McDonald’s Names First Social-Media Chief,” Chicago Business, April 13, 2010. A social media team can provide coordination while giving up the necessary control. Without this kind of coordination, customer communication can quickly become a mess.

Training is also a critical part of the SMART mandate. GM offers an intranet-delivered video course introducing newbies to the basics of social media and to firm policies and expectations. GM also trains employees to become “social media proselytizers and teachers.” GM hopes this approach enables experts to interact directly with customers and partners, allowing the firm to offer authentic and knowledgeable voices online.

Training should also cover information security and potential threats. Social media has become a magnet for phishing, virus distribution, and other nefarious online activity. Over one-third of social networking users claim to have been sent malware via social networking sites (see Chapter 13 “Information Security: Barbarians at the Gateway (and Just About Everywhere Else)”). The social media team will need to monitor threats and spread the word on how employees can surf safe and surf smart.

Since social media is so public, it’s easy to amass examples of what works and what doesn’t, adding these to the firm’s training materials. The social media team provides a catch point for institutional knowledge and industry best practice; and the team can update programs over time as new issues, guidelines, technologies, and legislation emerge.

The social media space introduces a tension between allowing expression (among employees and by the broader community) and protecting the brand. Firms will fall closer to one end or the other of this continuum depending on compliance requirements, comfort level, and goals. Expect the organization’s position to move. Firms will be cautious as negative issues erupt, others will jump in as new technologies become hot and early movers generate buzz and demonstrate results. But it’s the SMART responsibility to avoid knee-jerk reaction and to shepherd firm efforts with the professionalism and discipline of other management domains.

Monitoring

Concern over managing a firm’s online image has led to the rise of an industry known as online reputation managementThe process of tracking and responding to online mentions of a product, organization, or individual. Services supporting online reputation management range from free Google Alerts to more sophisticated services that blend computer-based and human monitoring of multiple media channels.. Firms specializing in this field will track a client firm’s name, brand, executives’ names, or other keywords, reporting online activity and whether sentiment trends toward the positive or negative.

But social media monitoring is about more than about managing one’s reputation; it also provides critical competitive intelligence, it can surface customer support issues, and it can uncover opportunities for innovation and improvement. Firms that are quick to lament the very public conversations about their brands happening online need to embrace social media as an opportunity to learn more.

Resources for monitoring social media are improving all the time, and a number of tools are available for free. All firms can take advantage of Google Alerts, which flag blog posts, new Web pages, and other publicly accessible content, regularly delivering a summary of new links to your mailbox (for more on using Google for intelligence gathering, see Chapter 14 “Google: Search, Online Advertising, and Beyond”). Twitter search and third-party Twitter clients like TweetDeck can display all mentions of a particular term. Tools like Twitrratr will summarize mentions of a phrase and attempt to classify tweets as “positive,” “neutral,” or “negative.”

Facebook provides a summary of fan page activity to administrators (including stats on visits, new fans, wall posts, etc.), while Facebook’s Insights tool measures user exposure, actions, and response behavior relating to a firm’s Facebook pages and ads.

Bit.ly and many other URL-shortening services allow firms to track Twitter references to a particular page. Since bit.ly applies the same shortened URL to all tweets pointing to a page, it allows firms to follow not only if a campaign has been spread through “retweeting” but also if new tweets were generated outside of a campaign. Graphs plot click-throughs over time, and a list of original tweets can be pulled up to examine what commentary accompanied a particular link.

Location-based services like Foursquare have also rolled out robust tools for monitoring how customers engage with firms in the brick-and-mortar world. Foursquare’s analytics and dashboard present firms with a variety of statistics, such as who has “checked in” and when, a venue’s male-to-female ratio, and which times of day are more active for certain customers. “Business owners will also be able to offer instant promotions to try to engage new customers and keep current ones.”N. Bolton, “Foursquare Introduces New Tools for Businesses,” March 9, 2010. Managers can use the tools to notice if a once-loyal patron has dropped off the map, potentially creating a special promotion to lure her back.

Monitoring should also not be limited to customers and competitors. Firms are leveraging social media both inside their firms and via external services (e.g., corporate groups on Facebook and LinkedIn), and these spaces should also be on the SMART radar. This kind of monitoring can help firms keep pace with employee sentiment and insights, flag discussions that may involve proprietary information or other inappropriate topics, and provide guidance for those who want to leverage social media for the firm’s staff—that is, anything from using online tools to help organize the firm’s softball league to creating a wiki for a project group. Social media are end-user services that are particularly easy to deploy but that can also be used disastrously and inappropriately, so it’s vital for IT experts and other staffers on the social media team to be visible and available, offering support and resources for those who want to take a dip into social media’s waters.

Establishing a Presence

Firms hoping to get in on the online conversation should make it easy for their customers to find them. Many firms take an embassyIn the context of social media, an established online presence where customers can reach and interact with the firm. An effective embassy approach uses a consistent firm name in all its social media properties. approach to social media, establishing presence at various services with a consistent name. Think facebook.com/starbucks, twitter.com/starbucks, youtube.com/starbucks, flickr.com/starbucks, and so on. Corporate e-mail and Web sites can include icons linking to these services in a header or footer. The firm’s social media embassies can also be highlighted in physical space such as in print, on bags and packaging, and on store signage. Firms should try to ensure that all embassies carry consistent design elements, so users see familiar visual cues that underscore they are now at a destination associated with the organization.

As mentioned earlier, some firms establish their own communities for customer engagement. Examples include Dell’s IdeaStorm and MyStarbucksIdea. Not every firm has a customer base that is large and engaged enough to support hosting its own community. But for larger firms, these communities can create a nexus for feedback, customer-driven innovation, and engagement.

Customers expect an open dialogue, so firms engaging online should be prepared to deal with feedback that’s not all positive. Firms are entirely within their right to screen out offensive and inappropriate comments. Noting this, firms might think twice before turning on YouTube comments (described as “the gutter of the Internet” by one leading social media manager).Brad Nelson, presentation at the Social Media Conference NW, Mount Vernon, WA, March 25, 2010. Such comments could expose employees or customers profiled in clips to withering, snarky ridicule. However, firms engaged in curating their forums to present only positive messages should be prepared for the community to rebel and for embarrassing cries of censorship to be disclosed. Firms that believe in the integrity of their work and the substance of their message shouldn’t be afraid. While a big brand like Starbucks is often a target of criticism, social media also provides organizations with an opportunity to respond fairly to that criticism and post video and photos of the firm’s efforts. In Starbucks’ case, the firm shares its work investing in poor coffee-growing communities as well as efforts to support AIDS relief. A social media presence allows a firm to share these works without waiting for conventional public relations (PR) to yield results or for journalists to pick up and interpret the firm’s story. Starbucks executives have described the majority of comments the company receives through social media as “a love letter to the firm.” By contrast, if your firm isn’t prepared to be open or if your products and services are notoriously subpar and your firm is inattentive to customer feedback, then establishing a brand-tarring social media beachhead might not make sense. A word to the self-reflective: Customer conversations will happen online even if you don’t have any social media embassies. Users can form their own groups, hash tags, and forums. A reluctance to participate may signal that the firm is facing deeper issues around its product and service.

While firms can learn a lot from social media consultants and tool providers, it’s considered bad practice to outsource the management of a social media presence to a third-party agency. The voice of the firm should come from the firm. In fact, it should come from employees who can provide authentic expertise. Starbucks’ primary Twitter feed is managed by Brad Nelson, a former barista, while the firm’s director of environmental affairs, Jim Hanna, tweets and engages across social media channels on the firm’s green efforts.

Engage and Respond

Having an effective social media presence offers “four Ms” of engagement: it’s a megaphone allowing for outbound communication; it’s a magnet drawing communities inward for conversation; and it allows for monitoring and mediation of existing conversations.J. Gallaugher and S. Ransbotham, “Social Media and Dialog Management at Starbucks” (presented at the MISQE Social Media Workshop, Phoenix, AZ, December 2009). This dialogue can happen privately (private messaging is supported on most services) or can occur very publicly (with the intention to reach a wide audience). Understanding when, where, and how to engage and respond online requires a deft and experienced hand.

Many firms will selectively and occasionally retweet praise posts, underscoring the firm’s commitment to customer service. Highlighting service heroes also reinforces exemplar behavior to employees who may be following the firm online, too. Users are often delighted when a major brand retweets their comments, posts a comment on their blog, or otherwise acknowledges them online—just be sure to do a quick public profile investigation to make sure your shout-outs are directed at customers you want associated with your firm. Escalation procedures should also include methods to flag noteworthy posts, good ideas, and opportunities that the social media team should be paying attention to. The customer base is often filled with heartwarming stories of positive customer experiences and rich with insight on making good things even better.

Many will also offer an unsolicited apology if the firm’s name or products comes up in a disgruntled post. You may not be able to respond to all online complaints, but selective acknowledgement of the customer’s voice (and attempts to address any emergent trends) is a sign of a firm that’s focused on customer care. Getting the frequency, tone, and cadence for this kind of dialogue is more art than science, and managers are advised to regularly monitor other firms with similar characteristics for examples of what works and what doesn’t.

Many incidents can be responded to immediately and with clear rules of engagement. For example, Starbuck issues corrective replies to the often-tweeted urban legend that the firm does not send coffee to the U.S. military because of a corporate position against the war. A typical response might read, “Not true, get the facts here” with a link to a Web page that sets the record straight.

Reaching out to key influencers can also be extremely valuable. Prominent bloggers and other respected social media participants can provide keen guidance and insight. The goal isn’t to create a mouthpiece, but to solicit input, gain advice, gauge reaction, and be sure your message is properly interpreted. Influencers can also help spread accurate information and demonstrate a firm’s commitment to listening and learning. In the wake of the Domino’s gross-out, executives reached out to the prominent blog The Consumerist.A. Jacques, “Domino’s Delivers during Crisis: The Company’s Step-by-Step Response after a Vulgar Video Goes Viral,” The Public Relations Strategist, October 24, 2009. Facebook has solicited advice and feedback from MoveOn.org months before launching new features.B. Stone, “Facebook Aims to Extend Its Reach across the Web,” New York Times, December 2, 2008. Meanwhile, Kaiser Permanente leveraged advice from well-known health care bloggers in crafting its approach to social media.J. Kane, R. Fichman, J. Gallaugher, and J. Glaser, “Community Relations 2.0,” Harvard Business Review, November 2009.

However, it’s also important to recognize that not every mention is worthy of a response. The Internet is filled with PR seekers, the unsatisfiably disgruntled, axe grinders seeking to trap firms, dishonest competitors, and inappropriate groups of mischief makers commonly referred to as trolls. One such group hijacked Time Magazine’s user poll of the World’s Most Influential People, voting their twenty-one-year-old leader to the top of the list ahead of Barack Obama, Vladimir Putin, and the pope. Prank voting was so finely calibrated among the group that the rankings list was engineered to spell out a vulgar term using the first letter of each nominee’s name.E. Schonfeld, “Time Magazine Throws Up Its Hands As It Gets Pawned by 4Chan,” TechCrunch, April 27, 2009.

To prepare, firms should “war game” possible crises, ensuring that everyone knows their role, and that experts are on call. A firm’s social media policy should also make it clear how employees who spot a crisis might “pull the alarm” and mobilize the crisis response team. Having all employees aware of how to respond gives the firm an expanded institutional radar that can lower the chances of being blindsided. This can be especially important as many conversations take place in the so-called dark Web beyond the reach of conventional search engines and monitoring tools (e.g., within membership communities or sites, such as Facebook, where only “friends” have access).

In the event of an incident, silence can be deadly. Consumers expect a response to major events, even if it’s just “we’re listening, we’re aware, and we intend to fix things.” When director Kevin Smith was asked to leave a Southwest Airline flight because he was too large for a single seat, Smith went ballistic on Twitter, berating Southwest’s service to his thousands of online followers. Southwest responded that same evening via Twitter, posting, “I’ve read the tweets all night from @ThatKevinSmith—He’ll be getting a call at home from our Customer Relations VP tonight.”

In the event of a major crisis, firms can leverage online media outside the social sphere. In the days following the Domino’s incident, the gross-out video consistently appeared near the top of Google searches about the firm. When appropriate, companies can buy ads to run alongside keywords explaining their position and, if appropriate, offering an apology.S. Gregory, “Domino’s YouTube Crisis: 5 Ways to Fight Back,” Time, April 18, 2009. Homeopathic cold remedy Zicam countered blog posts citing inaccurate product information by running Google ads adjacent to these links, containing tag lines such as “Zicam: Get the Facts.”Zicam had regularly been the victim of urban legends claiming negative side effects from use; see Snopes.com, “Zicam Warning,” http://www.snopes.com/medical/drugs/zicam.asp. However, the firm subsequently was cited in an unrelated FDA warning on the usage of its product; see S. Young, “FDA Warns against Using 3 Popular Zicam Cold Meds,” CNN.com, June 16, 2009.

Review sites such as Yelp and TripAdvisor also provide opportunities for firms to respond to negative reviews. This can send a message that a firm recognizes missteps and is making an attempt to address the issue (follow-through is critical, or expect an even harsher backlash). Sometimes a private response is most effective. When a customer of Farmstead Cheeses and Wines in the San Francisco Bay area posted a Yelp complaint that a cashier was rude, the firm’s owner sent a private reply to the poster pointing out that the employee in question was actually hard of hearing. The complaint was subsequently withdrawn and the critic eventually joined the firm’s Wine Club.K. Paterson, “Managing an Online Reputation,” New York Times, July 29, 2009. Private responses may be most appropriate if a firm is reimbursing clients or dealing with issues where public dialogue doesn’t help the situation. One doesn’t want to train members of the community that public griping gets reward. For similar reasons, in some cases store credit rather than reimbursement may be appropriate compensation.

It’s time to take social media seriously. We’re now deep into a revolution that has rewritten the rules of customer-firm communication. There are emerging technologies and skills to acquire, a shifting landscape of laws and expectations, a minefield of dangers, and a wealth of unexploited opportunities. Organizations that professionalize their approach to social media and other Web 2.0 technologies are ready to exploit the upside—potentially stronger brands, increased sales, sharper customer service, improved innovation, and more. Those that ignore the new landscape risk catastrophe and perhaps even irrelevance.

Exchange

Facebook for one person isn’t much fun, and the first guy in the world with a fax machine didn’t have much more than a paperweight. But as each new Facebook friend or fax user comes online, a network becomes more valuable because its users can potentially communicate with more people. These examples show the importance of exchange in creating value. Every product or service subject to network effects fosters some kind of exchange. For firms leveraging technology, this might include anything you can represent in the ones and zeros of digital storage, such as movies, music, money, video games, and computer programs. And just about any standard that allows things to plug into one another, interconnect, or otherwise communicate will live or die based on its ability to snare network effects.

Staying Power

Users don’t want to buy a product or sign up for a service that’s likely to go away, and a number of factors can halt the availability of an effort: a firm could bankrupt or fail to attract a critical mass of user support, or a rival may successfully invade its market and draw away current customers. Networks with greater numbers of users suggest a stronger staying powerThe long-term viability of a product or service.. The staying power, or long-term viability, of a product or service is particularly important for consumers of technology products. Consider that when someone buys a personal computer and makes a choice of Windows, Mac OS, or Linux, their investment over time usually greatly exceeds the initial price paid for the operating system. One invests in learning how to use a system, buying and installing software, entering preferences or other data, creating files—all of which mean that if a product isn’t supported anymore, much of this investment is lost.

The concept of staying power (and the fear of being stranded in an unsupported product or service) is directly related to switching costsThe cost a consumer incurs when moving from one product to another. It can involve actual money spent (e.g., buying a new product) as well as investments in time, any data loss, and so forth. (the cost a consumer incurs when moving from one product to another) and switching costs can strengthen the value of network effects as a strategic asset. The higher the value of the user’s overall investment, the more they’re likely to consider the staying power of any offering before choosing to adopt it. Similarly, the more a user has invested in a product, the less likely he or she is to leave.

Switching costs also go by other names. You might hear the business press refer to products (particularly Web sites) as being “sticky” or creating “friction.” Others may refer to the concept of “lock-in.” And the elite Boston Consulting Group is really talking about a firm’s switching costs when it refers to how well a company can create customers who are “barnacles” (that are tightly anchored to the firm) and not “butterflies” (that flutter away to rivals). The more friction available to prevent users from migrating to a rival, the greater the switching costs. And in a competitive market where rivals with new innovations show up all the time, that can be a very good thing!

Complementary Benefits

Complementary benefitsProducts or services that add additional value to the primary product or service that makes up a network. are those products or services that add additional value to the network. These products might include “how-to” books, software add-ons, even labor. You’ll find more books on auctioning over eBay, more virtual storefronts in Second Life, and more accountants that know Excel, than on any of their rivals. Why? Book authors, Second Life partners, and accountants invest their time where they’re likely to reach the biggest market and get the greatest benefit. In auctions, virtual worlds, and spreadsheet software, eBay, Second Life, and Excel each dwarf their respective competition.

Products and services that encourage others to offer complementary goods are sometimes called platformsProducts and services that allow for the development and integration of software products and other complementary goods. Windows, the iPhone, the Wii, and the standards that allow users to create Facebook apps are all platforms..T. Eisenmann, G. Parker, and M. Van Alstyne, “Strategies for Two-Sided Markets,” Harvard Business Review, October 2006. Allowing other firms to contribute to your platform can be a brilliant strategy, because those firms will spend their time and money to enhance your offerings. Consider the billion-dollar hardware ecosystem that Apple has cultivated around the iPod. There are over ninety brands selling some 280 models of iPod speaker systems.S. Hansell, “The iPod Economy and C.E.S.,” New York Times, January 7, 2008. Thirty-four auto manufacturers now trumpet their cars as being iPod-ready, many with in-car docking stations and steering wheel iPod navigation systems. Each add-on enhances the value of choosing an iPod over a rival like the Microsoft Zune. And now with the App Store for the iPhone, iPod touch, and iPad, Apple is doing the same thing with software add-ons. Software-based ecosystems can grow very quickly. In less than a year after its introduction, the iTunes App Store boasted over fifty thousand applications, collectively downloaded over one billion times.

These three value-adding sources—exchange, staying power, and complementary benefits—often work together to reinforce one another in a way that makes the network effect even stronger. When users exchanging information attract more users, they can also attract firms offering complementary products. When developers of complementary products invest time writing software—and users install, learn, and customize these products—switching costs are created that enhance the staying power of a given network. From a strategist’s perspective this can be great news for dominant firms in markets where network effects exist. The larger your network, the more difficult it becomes for rivals to challenge your leadership position.

Understanding Network Structure

To understand the key sources of network value, it’s important to recognize the structure of the network. Some networks derive most of their value from a single class of users. An example of this kind of network is instant messaging (IM). While there might be some add-ons for the most popular IM tools, they don’t influence most users’ choice of an IM system. You pretty much choose one IM tool over another based on how many of your contacts you can reach. Economists would call IM a one-sided marketA market that derives most of its value from a single class of users (e.g., instant messaging). (a market that derives most of its value from a single class of users), and the network effects derived from IM users attracting more IM users as being same-side exchange benefitsBenefits derived by interaction among members of a single class of participant (e.g., the exchange value when increasing numbers of IM users gain the ability to message each other). (benefits derived by interaction among members of a single class of participant).

But some markets are comprised of two distinct categories of network participant. Consider video games. People buy a video game console largely based on the number of really great games available for the system. Software developers write games based on their ability to reach the greatest number of paying customers, so they’re most likely to write for the most popular consoles first. Economists would call this kind of network a two-sided marketNetwork markets comprised of two distinct categories of participant, both of which that are needed to deliver value for the network to work (e.g., video game console owners and developers of video games). (network markets comprised of two distinct categories of participant, both of which that are needed to deliver value for the network to work). When an increase in the number of users on one side of the market (console owners, for example) creates a rise in the other side (software developers), that’s called a cross-side exchange benefitWhen an increase in the number of users on one side of the market (console owners, for example) creates a rise in the other side (software developers)..

Move Early

In the world of network effects, this is a biggie. Being first allows your firm to start the network effects snowball rolling in your direction. In Japan, worldwide auction leader eBay showed up just five months after Yahoo! launched its Japanese auction service. But eBay was never able to mount a credible threat and ended up pulling out of the market. Being just five months late cost eBay billions in lost sales, and the firm eventually retreated, acknowledging it could never unseat Yahoo!’s network effects lead.

Another key lesson from the loss of eBay Japan? Exchange depends on the ability to communicate! EBay’s huge network effects in the United States and elsewhere didn’t translate to Japan because most Japanese aren’t comfortable with English, and most English speakers don’t know Japanese. The language barrier made Japan a “greenfield” market with no dominant player, and Yahoo!’s early move provided the catalyst for victory.

Timing is often critical in the video game console wars, too. Sony’s PlayStation 2 enjoyed an eighteen-month lead over the technically superior Xbox (as well as Nintendo’s GameCube). That time lead helped to create what for years was the single most profitable division at Sony. By contrast, the technically superior PS3 showed up months after Xbox 360 and at roughly the same time as the Nintendo Wii, and has struggled in its early years, racking up multibillion-dollar losses for Sony.C. Null, “Sony’s Losses on PS3: $3 Billion and Counting,” Yahoo! Today in Tech, June 27, 2008, http://tech.yahoo.com/blogs/null/96355.

Subsidize Adoption

Starting a network effect can be tough—there’s little incentive to join a network if there’s no one in the system to communicate with. In one admittedly risky strategy, firms may offer to subsidize initial adoption in hopes that network effects might kick in shortly after. Subsidies to adopters might include a price reduction, rebate, or other giveaways. PayPal, a service that allows users to pay one another using credit cards, gave users a modest rebate as a sign-up incentive to encourage adoption of its new effort (in one early promotion, users got back fifteen dollars when spending their first thirty dollars). This brief subsidy paid to early adopters paid off handsomely. EBay later tried to enter the market with a rival effort, but as a late mover its effort was never able to overcome PayPal’s momentum. PayPal was eventually purchased by eBay for $1.5 billion, and the business unit is now considered one of eBay’s key drivers of growth and profit.

Leverage Viral Promotion

Since all products and services foster some sort of exchange, it’s often possible to leverage a firm’s customers to promote the product or service. Internet calling service Skype has over five hundred million registered users yet has spent almost nothing on advertising. Most Skype users were recruited by others who shared the word on free and low-cost Internet calls. Within Facebook, feeds help activities to spread virally (see Chapter 8 “Facebook: Building a Business from the Social Graph”). Feeds blast updates on user activities on the site, acting as a catalyst for friends to join groups and load applications that their buddies have already signed up for.

Expand by Redefining the Market

If a big market attracts more users (and in two-sided markets, more complements), why not redefine the space to bring in more users? Nintendo did this when launching the Wii. While Sony and Microsoft focused on the graphics and raw processing power favored by hard-core male gamers, Nintendo chose to develop a machine to appeal to families, women, and age groups that normally shunned alien shoot-’em ups. By going after a bigger, redefined market, Nintendo was able to rack up sales that exceeded the Xbox 360, even though it followed the system by twelve months.M. Sanchanta, “Nintendo’s Wii Takes Console Lead,” Financial Times, September 12, 2007.

Market expansion sometimes puts rivals who previously did not compete on a collision course as markets undergo convergenceWhen two or more markets, once considered distinctly separate, begin to offer features and capabilities. As an example: the markets for mobile phones and media players are converging. (when two or more markets, once considered distinctly separate, begin to offer similar features and capabilities). Consider the market for portable electronic devices. Separate product categories for media players, cameras, gaming devices, phones, and global positioning systems (GPS) are all starting to merge. Rather than cede its dominance as a media player, Apple leveraged a strategy known as envelopmentWhen one market attempts to conquer a new market by making it a subset, component, or feature of its primary offering., where a firm seeks to make an existing market a subset of its product offering. Apple deftly morphed the iPod into the iPhone, a device that captures all of these product categories in one device. But the firm went further; the iPhone is Wi-Fi capable, offers browsing, e-mail, and an application platform based on a scaled-down version of the same OS X operating system used in Macintosh computers. As a “Pocket Mac,” the appeal of the device broadened beyond just the phone or music player markets, and within two quarters of launch, iPhone become the second-leading smartphone in North America—outpacing Palm, Microsoft, Motorola and every other rival, except RIM’s BlackBerry.R. Kim, “iPhone No. 2 Smartphone Platform in North America,” The Tech Chronicles—The San Francisco Chronicle, December 17, 2007.

Alliances and Partnerships

Firms can also use partnerships to grow market share for a network. Sometimes these efforts bring rivals together to take out a leader. In a classic example, consider ATM networks. Citibank was the first major bank in New York City to offer a large ATM network. But the Citi network was initially proprietary, meaning customers of other banks couldn’t take advantage of Citi ATMs. Citi’s innovation was wildly popular and being a pioneer in rolling out cash machines helped the firm grow deposits fourfold in just a few years. Competitors responded with a partnership. Instead of each rival bank offering another incompatible network destined to trail Citi’s lead, competing banks agreed to share their ATM operations through NYCE (New York Cash Exchange). While Citi’s network was initially the biggest, after the NYCE launch a Chase bank customer could use ATMs at a host of other banks that covered a geography far greater than Citi offered alone. Network effects in ATMs shifted to the rival bank alliance, Citi eventually joined NYCE and today, nearly every ATM in the United States carries a NYCE sticker.

Google has often pushed an approach to encourage rivals to cooperate to challenge a leader. Its Open Social standard for social networking (endorsed by MySpace, LinkedIn, Bebo, Yahoo! and others) is targeted at offering a larger alternative to Facebook’s more closed efforts (see Chapter 8 “Facebook: Building a Business from the Social Graph”), while its Android open source mobile phone operating system has gained commitments from many handset makers that collectively compete with Apple’s iPhone.

Leverage Distribution Channels

Firms can also think about novel ways to distribute a product or service to consumers. Sun faced a challenge when launching the Java programming language—no computers could run it. In order for Java to work, computers need a little interpreter program called the Java Virtual Machine (JVM). Most users weren’t willing to download the JVM if there were no applications written in Java, and no developers were willing to write in Java if no one could run their code. Sun broke the logjam when it bundled the JVM with Netscape’s browser. When millions of users downloaded Netscape, Sun’s software snuck in, almost instantly creating a platform of millions for would-be Java developers. Today, even though Netscape has failed, Sun’s Java remains one of the world’s most popular programming languages. Indeed, Java was cited as one of the main reasons for Oracle’s 2009 acquisition of Sun, with Oracle’s CEO saying the language represented “the single most important software asset we have ever acquired.”A. Ricadela, “Oracle’s Bold Java Plans,” BusinessWeek, June 2, 2009.

As mentioned in Chapter 2 “Strategy and Technology: Concepts and Frameworks for Understanding What Separates Winners from Losers”, Microsoft is in a particularly strong position to leverage this approach. The firm often bundles its new products into its operating systems, Office suite, Internet Explorer browser, and other offerings. The firm used this tactic to transform once market-leader Real Networks into an also-ran in streaming audio. Within a few years of bundling Windows Media Player (WMP) with its other products, WMP grabbed the majority of the market, while Real’s share had fallen to below 10 percent.BusinessWire, “Media Player Format Share for 2006 Confirms Windows Media Remains Dominant with a 50.8% Share of Video Streams Served, Followed by Flash at 21.9%—‘CDN Growth and Market Share Shifts: 2002–2006,’” December 18, 2006; and T. Eisenmann, G. Parker, and M. Van Alstyne, “Strategies for Two-Sided Markets,” Harvard Business Review, October 2006.

Caution is advised, however. Regional antitrust authorities may consider product bundling by dominant firms to be anticompetitive. European regulators have forced Microsoft to unbundle Windows Media Player from its operating system and to provide a choice of browsers alongside Internet Explorer.

Seed the Market

When Sony launched the PS3, it subsidized each console by selling at a price estimated at three hundred dollars below unit cost.C. Null, “Sony’s Losses on PS3: $3 Billion and Counting,” Yahoo! Today in Tech, June 27, 2008, http://tech.yahoo.com/blogs/null/96355. Subsidizing consoles is a common practice in the video game industry—game player manufacturers usually make most of their money through royalties paid by game developers. But Sony’s subsidy had an additional benefit for the firm—it helped sneak a Blu-ray player into every home buying a PS3 (Sony was backing the Blu-ray standard over the rival HD DVD effort). Since Sony is also a movie studio and manufacturer of DVD players and other consumer electronics, it had a particularly strong set of assets to leverage to encourage the adoption of Blu-ray over rival HD DVD.

Giving away products for half of a two-sided market is an extreme example of this kind of behavior, but it’s often used. In two-sided markets, you charge the one who will pay. Adobe gives away the Acrobat reader to build a market for the sale of software that creates Acrobat files. Firms with Yellow Page directories give away countless copies of their products, delivered straight to your home, in order to create a market for selling advertising. And Google does much the same by providing free, ad-supported search.

Encourage the Development of Complementary Goods

There are several ways to motivate others to create complementary goods for your network. These efforts often involve some form of developer subsidy or other free or discounted service. A firm may charge lower royalties or offer a period of royalty-free licensing. It can also offer free software development kits (SDKs), training programs, co-marketing dollars, or even start-up capital to potential suppliers. Microsoft and Apple both allow developers to sell their products online through Xbox LIVE Marketplace and iTunes, respectively. This channel lowers developer expenses by eliminating costs associated with selling physical inventory in brick-and-mortar stores and can provide a free way to reach millions of potential consumers without significant promotional spending.

Venture funds can also prompt firms to create complementary goods. Facebook announced it would spur development for the site in part by administering the fbFund, which initially pledged $10 million in start-up funding (in allotments of up to $250,000 each) to firms writing applications for its platform.

Leverage Backward Compatibility

Those firms that control a standard would also be wise to ensure that new products have backward compatibilityThe ability to take advantage of complementary products developed for a prior generation of technology. with earlier offerings. If not, they reenter a market at installed-base zero and give up a major source of advantage—the switching costs built up by prior customers. For example, when Nintendo introduced its 16-bit Super Nintendo system, it was incompatible with the firm’s highly successful prior generation 8-bit model. Rival Sega, which had entered the 16-bit market two years prior to Nintendo, had already built up a large library of 16-bit games for its system. Nintendo entered with only its debut titles, and no ability to play games owned by customers of its previous system, so there was little incentive for existing Nintendo fans to stick with the firm.M. Schilling, “Technological Leapfrogging: Lessons from the U.S. Video Game Console Industry,” California Management Review, Spring 2003.

Backward compatibility was the centerpiece of Apple’s strategy to revitalize the Macintosh through its move to the Intel microprocessor. Intel chips aren’t compatible with the instruction set used by the PowerPC processor used in earlier Mac models. Think of this as two entirely different languages—Intel speaks French, PowerPC speaks Urdu. To ease the transition, Apple included a free software-based adaptorA product that allows a firm to tap into the complementary products, data, or user base of another product or service., called Rosetta, that automatically emulated the functionality of the old chip on all new Macs (a sort of Urdu to French translator). By doing so, all new Intel Macs could use the base of existing software written for the old chip; owners of PowerPC Macs were able to upgrade while preserving their investment in old software; and software firms could still sell older programs while they rewrote applications for new Intel-based Macs.

Even more significant, since Intel is the same standard used by Windows, Apple developed a free software adaptor called Boot Camp that allowed Windows to be installed on Macs. Boot Camp (and similar solutions by other vendors) dramatically lowered the cost for Windows users to switch to Macs. Within two years of making the switch, Mac sales skyrocketed to record levels. Apple now boasts a commanding lead in notebook sales to the education market,P. Seitz, “An Apple for Teacher, Students: Mac Maker Surges in Education,” Investor’s Business Daily, August 8, 2008. and a survey by Yankee Group found that 87 percent of corporations were using at least some Macintosh computers, up from 48 percent at the end of the PowerPC era two years earlier.P. Burrows, “The Mac in the Gray Flannel Suit,” BusinessWeek, May 1, 2008.

Rivals: Be Compatible with the Leading Network

Companies will want to consider making new products compatible with the leading standard. Microsoft’s Live Maps and Virtual Earth 3D arrived late to the Internet mapping game. Users had already put in countless hours building resources that meshed with Google Maps and Google Earth. But by adopting the same keyhole markup language (KML) standard used by Google, Microsoft could, as TechCrunch put it, “drink from Google’s milkshake.” Any work done by users for Google in KML could be used by Microsoft. Voilà, an instant base of add-on content!

Incumbents: Close Off Rival Access and Constantly Innovate

Oftentimes firms that control dominant networks will make compatibility difficult for rivals who try to connect with their systems. AOL has been reluctant to open up its instant messaging tool to rivals, and Skype for years had been similarly closed to non-Skype clients.

Firms that constantly innovate make it particularly difficult for competitors to become compatible. Again, we can look to Apple as an example of these concepts in action. While Macs run Windows, Windows computers can’t run Mac programs. Apple has embedded key software in Mac hardware, making it tough for rivals to write a software emulator like Boot Camp that would let Windows PCs drink from the Mac milkshake. And if any firm gets close to cloning Mac hardware, Apple sues. The firm also modifies software on other products like the iPhone and iTunes each time wily hackers tap into closed aspects of its systems. And Apple has regularly moved to block third-party hardware, such as Palm’s mobile phones, from plugging into iTunes. Even if firms create adaptors that emulate a standard, a firm that constantly innovates creates a moving target that’s tough for others to keep up with.

Apple has been far more aggressive than Microsoft in introducing new versions of its software. Since the firm never stays still, would-be cloners never get enough time to create a reliable emulator that runs the latest Apple software.

Large, Well-Known Followers: Preannouncements

Large firms that find new markets attractive but don’t yet have products ready for delivery might preannounce efforts in order to cause potential adaptors to sit on the fence, delaying a purchasing decision until the new effort rolls out. Preannouncements only work if a firm is large enough to pose a credible threat to current market participants. Microsoft, for example, can cause potential customers to hold off on selecting a rival because users see that the firm has the resources to beat most players (suggesting staying power). Statements from start-ups, however, often lack credibility to delay user purchases. The tech industry acronym for the impact firms try to impart on markets through preannouncements is FUD for fear, uncertainty, and doubt.

Feel confident! Now you’ve got a solid grounding in network effects, the key resource leveraged by some of the most dominant firms in technology. And these concepts apply beyond the realm of tech, too. Network effects can explain phenomena ranging from why some stock markets are more popular than others to why English is so widely spoken, even among groups of nonnative speakers. On top of that, the strategies explored in the last half of the chapter show how to use these principles to sniff out, create, and protect this key strategic asset. Go forth, tech pioneer—opportunity awaits!

Some Definitions

This phenomenon of “faster, cheaper” computing is often referred to as Moore’s LawChip performance per dollar doubles every eighteen months., after Intel cofounder, Gordon Moore. Moore didn’t show up one day, stance wide, hands on hips, and declare “behold my law,” but he did write a four-page paper for Electronics Magazine in which he described how the process of chip making enabled more powerful chips to be manufactured at cheaper prices.G. Moore, “Cramming More Components onto Integrated Circuits,” Electronics Magazine, April 19, 1965.

Moore’s friend, legendary chip entrepreneur and CalTech professor Carver Mead, later coined the “Moore’s Law” moniker. That name sounded snappy, plus as one of the founders of Intel, Moore had enough geek cred for the name to stick. Moore’s original paper offered language only a chip designer would love, so we’ll rely on the more popular definition: chip performance per dollar doubles every eighteen months (Moore’s original paper assumed two years, but many sources today refer to the eighteen-month figure, so we’ll stick with that).

Moore’s Law applies to chips—broadly speaking, to processors, or the electronics stuff that’s made out of silicon.Although other materials besides silicon are increasingly being used. The microprocessorThe part of the computer that executes the instructions of a computer program. is the brain of a computing device. It’s the part of the computer that executes the instructions of a computer program, allowing it to run a Web browser, word processor, video game, or virus. For processors, Moore’s Law means that next generation chips should be twice as fast in eighteen months, but cost the same as today’s models (or from another perspective, in a year and a half, chips that are same speed as today’s models should be available for half the price).

Random-access memory (RAM)The fast, chip-based volatile storage in a computing device. is chip-based memory. The RAM inside your personal computer is volatile memoryStorage (such as RAM chips) that is wiped clean when power is cut off from a device., meaning that when the power goes out, all is lost that wasn’t saved to nonvolatile memoryStorage that retains data even when powered down (such as flash memory, hard disk, or DVD storage). (i.e., a more permanent storage media like a hard disk or flash memory). Think of RAM as temporary storage that provides fast access for executing computer programs and files. When you “load” or “launch” a program, it usually moves from your hard drive to those RAM chips, where it can be more quickly executed by the processor.

Cameras, MP3 players, USB drives, and mobile phones often use flash memoryNonvolatile, chip-based storage, often used in mobile phones, cameras, and MP3 players. Sometimes called flash RAM, flash memory is slower than conventional RAM, but holds its charge even when the power goes out. (sometimes called flash RAM). It’s not as fast as the RAM used in most traditional PCs, but holds data even when the power is off (so flash memory is also nonvolatile memory). You can think of flash memory as the chip-based equivalent of a hard drive. In fact, flash memory prices are falling so rapidly that several manufactures including Apple and the One Laptop per Child initiative (see the “Tech for the Poor” sidebar later in this section) have begun offering chip-based, nonvolatile memory as an alternative to laptop hard drives. The big advantage? Chips are solid state electronicsSemiconductor-based devices. Solid state components often suffer fewer failures and require less energy than mechanical counterparts because they have no moving parts. RAM, flash memory and microprocessors are solid state devices. Hard drives are not. (meaning no moving parts), so they’re less likely to fail, and they draw less power. The solid state advantage also means that chip-based MP3 players like the iPod nano make better jogging companions than hard drive players, which can skip if jostled. For RAM chips and flash memory, Moore’s Law means that in eighteen months you’ll pay the same price as today for twice as much storage.

Computer chips are sometimes also referred to as semiconductorsA substance such as silicon dioxide used inside most computer chips that is capable of enabling as well as inhibiting the flow of electricity. From a managerial perspective, when someone refers to semiconductors, they are talking about computer chips, and the semiconductor industry is the chip business. (a substance such as silicon dioxide used inside most computer chips that is capable of enabling as well as inhibiting the flow of electricity). So if someone refers to the semiconductor industry, they’re talking about the chip business.Semiconductor materials, like the silicon dioxide used inside most computer chips, are capable of enabling as well as inhibiting the flow of electricity. These properties enable chips to perform math or store data.

Strictly speaking, Moore’s Law does not apply to other technology components. But other computing components are also seeing their price versus performance curves skyrocket exponentially. Data storage doubles every twelve months. Networking speed is on a tear, too. With an equipment change at the ends of the cables, the amount of data that can be squirted over an optical fiber lineA high-speed glass or plastic-lined networking cable used in telecommunications. can double every nine months.Fiber-optic lines are glass or plastic data transmission cables that carry light. These cables offer higher transmission speeds over longer distances than copper cables that transmit electricity. These numbers should be taken as rough approximations and shouldn’t be expected to be strictly precise over time. However, they are useful as rough guides regarding future computing price/performance trends. Despite any fluctuation, it’s clear that the price/performance curve for many technologies is exponential, offering astonishing improvement over time.

Get Out Your Crystal Ball

Faster and cheaper makes possible the once impossible. As a manager, your job will be about predicting the future. First, consider how the economics of Moore’s Law opens new markets. When technology gets cheap, price elasticityThe rate at which the demand for a product or service fluctuates with price change. Goods and services that are highly price elastic (e.g., most consumer electronics) see demand spike as prices drop, whereas goods and services that are less price elastic are less responsive to price change (think heart surgery). kicks in. Tech products are highly price elastic, meaning consumers buy more products as they become cheaper.As opposed to goods and services that are price inelastic (like health care and housing), which consumers will try their best to buy even if prices go up. And it’s not just that existing customers load up on more tech; entire new markets open up as firms find new uses for these new chips.

Just look at the five waves of computing we’ve seen over the previous five decades.M. Copeland, “How to Ride the Fifth Wave,” Business 2.0, July 1, 2005. In the first wave in the 1960s, computing was limited to large, room-sized mainframe computers that only governments and big corporations could afford. Moore’s Law kicked in during the 1970s for the second wave, and minicomputers were a hit. These were refrigerator-sized computers that were as speedy as or speedier than the prior generation of mainframes, yet were affordable by work groups, factories, and smaller organizations. The 1980s brought wave three in the form of PCs, and by the end of the decade nearly every white-collar worker in America had a fast and cheap computer on their desk. In the 1990s wave four came in the form of Internet computing—cheap servers and networks made it possible to scatter data around the world, and with more power, personal computers displayed graphical interfaces that replaced complex commands with easy-to-understand menus accessible by a mouse click. At the close of the last century, the majority of the population in many developed countries had home PCs, as did most libraries and schools.

Now we’re in wave five, where computers are so fast and so inexpensive that they have become ubiquitous—woven into products in ways few imagined years before. Silicon is everywhere! It’s in the throwaway radio frequency identification (RFID) tags that track your luggage at the airport. It provides the smarts in the world’s billion-plus mobile phones. It’s the brains inside robot vacuum cleaners, next generation Legos, and the table lamps that change color when the stock market moves up or down. These digital shifts can rearrange entire industries. Consider that today the firm that sells more cameras than any other is Nokia, a firm that offers increasingly sophisticated chip-based digital cameras as a giveaway as part of its primary product, mobile phones. This shift has occurred with such sweeping impact that former photography giants Pentax, Konica, and Minolta have all exited the camera business.

One of the most agile surfers of this fifth wave is Apple, Inc.—a firm with a product line that is now so broad that in January 2007, it dropped the word “Computer” from its name. Apple’s breakout resurgence owes a great deal to the iPod. At launch, the original iPod sported a 5 GB hard drive that Steve Jobs declared would “put 1,000 songs in your pocket.” Cost? $399. Less than six years later, Apple’s highest-capacity iPod sold for fifty dollars less than the original, yet held forty times the songs. By that time the firm had sold over one hundred fifty million iPods—an adoption rate faster than the original Sony Walkman. Apple’s high-end models have morphed into Internet browsing devices capable of showing maps, playing videos, and gulping down songs from Starbucks’ Wi-Fi while waiting in line for a latte.

The original iPod has also become the jumping-off point for new business lines including the iPhone, Apple TV, iPad, and iTunes. As an online store, iTunes is always open. ITunes regularly sells tens of millions of songs on Christmas Day alone, a date when virtually all of its offline competition is closed for the holiday. In a short five years after its introduction, iTunes has sold over 4 billion songs and has vaulted past retail giants Wal-Mart, Best Buy, and Target to become the number one music retailer in the world. Today’s iTunes is a digital media powerhouse, selling movies, TV shows, games, and other applications. And with podcasting, Apple’s iTunes University even lets students at participating schools put their professors’ lectures on their gym playlist for free. Surfing the fifth wave has increased the value of Apple stock sixteenfold six years after the iPod’s launch. Ride these waves to riches, but miss the power and promise of Moore’s Law and you risk getting swept away in its riptide. Apple’s rise occurred while Sony, a firm once synonymous with portable music, sat on the sidelines unwilling to get on the surfboard. Sony’s stock stagnated, barely moving in six years. The firm has laid off thousands of workers while ceding leadership in digital music (and video) to Apple.

While the change in hard drive prices isn’t directly part of Moore’s Law (hard drives are magnetic storage, not silicon chips), as noted earlier, the faster and cheaper phenomenon applies to storage, too. Look to Amazon as another example of jumping onto a once-impossible opportunity courtesy of the price/performance curve. When Amazon.com was founded in 1995, the largest corporate database was one terabyte, or TB (see Note 5.14 “Bits and Bytes” below) in size. In 2003, the firm offered its “Search Inside the Book” feature, digitizing the images and text from thousands of books in its catalog. “Search Inside the Book” lets customers peer into a book’s contents in a way that’s both faster and more accurate than browsing a physical bookstore. Most importantly for Amazon and its suppliers, titles featured in “Search Inside the Book” enjoyed a 7 percent sales increase over nonsearchable books. When “Search Inside the Book” launched, the database to support this effort was 20 TB in size. In just eight years, the firm found that it made good business sense to launch an effort that was a full twenty times larger than anything used by any firm less than a decade earlier. And of course, all of these capacities seem laughably small by today’s standards. (See Chapter 11 “The Data Asset: Databases, Business Intelligence, and Competitive Advantage”.) For Amazon, the impossible had not just become possible; it became good business. By 2009, digital books weren’t just for search; they were for sale. Amazon’s Kindle reader (a Moore’s Law marvel sporting a microprocessor and flash storage) became the firm’s top-selling product in terms of both unit sales and dollar volume. The real business opportunity for Amazon isn’t Kindle as a consumer electronics device but as an ever-present, never-closing store, which also provides the firm with a migration path from atoms to bits. (For more on that topic, see Chapter 4 “Netflix: The Making of an E-commerce Giant and the Uncertain Future of Atoms to Bits”.) By 2009, Amazon (by then the largest book retailer in North America) reported, “For books that are available on the Kindle, sales are already 35 percent of the same books in print.”E. Schonfeld, “For Books Available on Kindle, Sales Are Now Tracking at 35 Percent of Print Sales,” TechCrunch, May 6, 2009. Apple’s 2010 introduction of the iPad, complete with an iBook store, shows how Moore’s Law rewrites the boundaries of competition—bringing a firm that started as a computer retailer and a firm that started as an online bookstore in direct competition with one another.

Here’s another key implication—if you are producing products with a significant chip-based component, the chips inside that product rapidly fall in value. That’s great when it makes your product cheaper and opens up new markets for your firm, but it can be deadly if you overproduce and have excess inventory sitting on shelves for long periods of time. Dell claims its inventory depreciates as much as a single percentage point in value each week.B. Breen, “Living in Dell Time,” Fast Company, November 24, 2004. That’s a big incentive to carry as little inventory as possible, and to unload it, fast!

While the strategic side of tech may be the most glamorous, Moore’s Law impacts mundane management tasks, as well. From an accounting and budgeting perspective, as a manager you’ll need to consider a number of questions: How long will your computing equipment remain useful? If you keep upgrading computing and software, what does this mean for your capital expense budget? Your training budget? Your ability to make well-reasoned predictions regarding tech’s direction will be key to answering these questions.

Buying Time

One way to overcome this problem is with multicore microprocessorsMicroprocessors with two or more (typically lower power) calculating processor cores on the same piece of silicon., made by putting two or more lower power processor cores (think of a core as the calculating part of a microprocessor) on a single chip. Philip Emma, IBM’s Manager of Systems Technology and Microarchitecture, offers an analogy. Think of the traditional fast, hot, single-core processors as a three hundred-pound lineman, and a dual-core processor as two 160-pound guys. Says Emma, “A 300-pound lineman can generate a lot of power, but two 160-pound guys can do the same work with less overall effort.”A. Ashton, “More Life for Moore’s Law,” BusinessWeek, June 20, 2005. For many applications, the multicore chips will outperform a single speedy chip, while running cooler and drawing less power. Multicore processors are now mainstream.

Today, most PCs and laptops sold have at least a two-core (dual-core) processor. The Microsoft Xbox 360 has three cores. The PlayStation 3 includes the so-called cell processor developed by Sony, IBM, and Toshiba that runs nine cores. By 2010, Intel began shipping PC processors with eight cores, while AMD introduced a twelve-core chip. Intel has even demonstrated chips with upwards of fifty cores.

Multicore processors can run older software written for single-brain chips. But they usually do this by using only one core at a time. To reuse the metaphor above, this is like having one of our 160-pound workers lift away, while the other one stands around watching. Multicore operating systems can help achieve some performance gains. Versions of Windows or the Mac OS that are aware of multicore processors can assign one program to run on one core, while a second application is assigned to the next core. But in order to take full advantage of multicore chips, applications need to be rewritten to split up tasks so that smaller portions of a problem are executed simultaneously inside each core.

Writing code for this “divide and conquer” approach is not trivial. In fact, developing software for multicore systems is described by Shahrokh Daijavad, software lead for next-generation computing systems at IBM, as “one of the hardest things you learn in computer science.”A. Ashton, “More Life for Moore’s Law,” BusinessWeek, June 20, 2005. Microsoft’s chief research and strategy officer has called coding for these chips “the most conceptually different [change] in the history of modern computing.”M. Copeland, “A Chip Too Far?” Fortune, September 1, 2008. Despite this challenge, some of the most aggressive adaptors of multicore chips have been video game console manufacturers. Video game applications are particularly well-suited for multiple cores since, for example, one core might be used to render the background, another to draw objects, another for the “physics engine” that moves the objects around, and yet another to handle Internet communications for multiplayer games.

Another approach to breathing life into Moore’s Law is referred to as stacked or three-dimensional semiconductorsSemiconductors that are manufactured as a stack of multiple, interconnected layers instead of in one flat plane.. In this approach, engineers slice a flat chip into pieces, then reconnect the pieces vertically, making a sort of “silicon sandwich.” The chips are both faster and cooler since electrons travel shorter distances. What was once an end-to-end trip on a conventional chip might just be a tiny movement up or down on a stacked chip. But stacked chips present their own challenges. In the same way that a skyscraper is more difficult and costly to design and build than a ranch house, 3-D semiconductors are tougher to design and manufacture. IBM has developed stacked chips for mobile phones, claiming the technique improves power efficiency by up to 40 percent. HP Labs is using a technology called memristors, or memory resistors, to improve on conventional transistors and speed the transition to 3-D chips, yielding significant improvement over 2-D offerings.J. Markoff, “HP Sees a Revolution in Memory Chip,” New York Times, April 7, 2010.

Why Study Netflix?

Studying Netflix gives us a chance to examine how technology helps firms craft and reinforce a competitive advantage. We’ll pick apart the components of the firm’s strategy and learn how technology played a starring role in placing the firm atop its industry. We also realize that while Netflix emerged the victorious underdog at the end of the first show, there will be at least one sequel, with the final scene yet to be determined. We’ll finish the case with a look at the very significant challenges the firm faces as new technology continues to shift the competitive landscape.

Selection: The Long Tail in Action

Customers have flocked to Netflix in part because of the firm’s staggering selection. A traditional video store (and Blockbuster had some 7,800 of them) stocks roughly three thousand DVD titles on its shelves. For comparison, Netflix is able to offer its customers a selection of over one hundred thousand DVD titles, and rising! At traditional brick-and-mortar retailers, shelf space is the biggest constraint limiting a firm’s ability to offer customers what they want when they want it. Just which films, documentaries, concerts, cartoons, TV shows, and other fare make it inside the four walls of a Blockbuster store is dictated by what the average consumer is most likely to be interested in. To put it simply, Blockbuster stocks blockbusters.

Finding the right product mix and store size can be tricky. Offer too many titles in a bigger storefront and there may not be enough paying customers to justify stocking less popular titles (remember, it’s not just the cost of the DVD—firms also pay for the real estate of a larger store, the workers, the energy to power the facility, etc.). You get the picture—there’s a breakeven point that is arrived at by considering the geographic constraint of the number of customers that can reach a location, factored in with store size, store inventory, the payback from that inventory, and the cost to own and operate the store. Anyone who has visited a video store only to find a title out of stock has run up against the limits of the physical store model.

But many online businesses are able to run around these limits of geography and shelf space. Internet firms that ship products can get away with having just a few highly automated warehouses, each stocking just about all the products in a particular category. And for firms that distribute products digitally (think songs on iTunes), the efficiencies are even greater because there’s no warehouse or physical product at all (more on that later).

Offer a nearly limitless selection and something interesting happens: there’s actually more money to be made selling the obscure stuff than the hits. Music service Rhapsody makes more from songs outside of the top ten thousand than it does from songs ranked above ten thousand. At Amazon.com, roughly 60 percent of books sold are titles that aren’t available in even the biggest Borders or Barnes & Noble Superstores.C. Anderson, “The Long Tail,” Wired 12, no. 10 (October 2004), http://www.wired.com/wired/archive/12.10/tail.html. And at Netflix, roughly 75 percent of DVD titles shipped are from back-catalog titles, not new releases (at Blockbuster outlets the equation is nearly flipped, with some 70 percent of business coming from new releases).B. McCarthy, “Netflix, Inc.” (remarks, J. P. Morgan Global Technology, Media, and Telecom Conference, Boston, May 18, 2009). Consider that Netflix sends out forty-five thousand different titles each day. That’s fifteen times the selection available at your average video store! Each quarter, roughly 95 percent of titles are viewed—that means that every few weeks Netflix is able to find a customer for nearly every DVD title that has ever been commercially released.

This phenomenon whereby firms can make money by selling a near-limitless selection of less-popular products is known as the long tailIn this context, refers to an extremely large selection of content or products. The long tail is a phenomenon whereby firms can make money by offering a near-limitless selection.. The term was coined by Chris Anderson, an editor at Wired magazine, who also wrote a best-selling business book by the same name. The “tail” (see Figure 4.2 “The Long Tail”) refers to the demand for less popular items that aren’t offered by traditional brick-and-mortar shops. While most stores make money from the area under the curve from the vertical axis to the dotted line, long tail firms can also sell the less popular stuff. Each item under the right part of the curve may experience less demand than the most popular products, but someone somewhere likely wants it. And as demonstrated from the examples above, the total demand for the obscure stuff is often much larger than what can be profitably sold through traditional stores alone. While some debate the size of the tail (e.g., whether obscure titles collectively are more profitable for most firms), two facts are critical to keep above this debate: (1) selection attracts customers, and (2) the Internet allows large-selection inventory efficiencies that offline firms can’t match.

The long tail works because the cost of production and distribution drop to a point where it becomes economically viable to offer a huge selection. For Netflix, the cost to stock and ship an obscure foreign film is the same as sending out the latest Will Smith blockbuster. The long tail gives the firm a selection advantage (or one based on scale) that traditional stores simply cannot match.

For more evidence that there is demand for the obscure stuff, consider Bollywood cinema—a term referring to films produced in India. When ranked by the number of movies produced each year, Bollywood is actually bigger than Hollywood, but in terms of U.S. demand, even the top-grossing Hindi film might open in only one or two American theaters, and few video stores carry many Bollywood DVDs. Again, we see the limits that geography and shelf space impose on traditional stores. As Anderson puts it, when it comes to traditional methods of distribution, “an audience too thinly spread is the same as no audience at all.”C. Anderson, “The Long Tail,” Wired 12, no. 10 (October 2004), http://www.wired.com/wired/archive/12.10/tail.html. While there are roughly 1.7 million South Asians living in the United States, Bollywood fans are geographically disbursed, making it difficult to offer content at a physical storefront. Fans of foreign films would often find the biggest selection at an ethnic grocery store, but even then, that wouldn’t be much. Enter Netflix. The firm has found the U.S. fans of South Asian cinema, sending out roughly one hundred thousand Bollywood DVDs a month. As geographic constraints go away, untapped markets open up!

The power of Netflix can revive even well-regarded work by some of Hollywood’s biggest names. In between The Godfather and The Godfather Part II, director Francis Ford Coppola made The Conversation, a film starring Gene Hackman that, in 1975, was nominated for a Best Picture Academy Award. Coppola has called The Conversation the finest film he has ever made,D. Leonhardt, “What Netflix Could Teach Hollywood,” New York Times, June 7, 2006. but it was headed for obscurity as the ever-growing pipeline of new releases pushed the film off of video store shelves. Netflix was happy to pick up The Conversation and put it in the long tail. Since then, the number of customers viewing the film has tripled, and on Netflix, this once underappreciated gem became the thirteenth most watched film from its time period.

For evidence on Netflix’s power to make lucrative markets from nonblockbusters, visit the firm’s “Top 100 page.”http://www.netflix.com/Top100. You’ll see a list loaded with films that were notable for their lack of box office success. As of this writing the number one rank had been held for over five years in a row, not by a first-run mega-hit, but by the independent film Crash (an Oscar winner, but box office weakling).R. Elder, “‘Crash’ Remains Top DVD Rental,” Chicago Tribune, April 14, 2009.

Netflix has used the long tail to its advantage, crafting a business model that creates close ties with film studios. In most cases, studios earn a percentage of the subscription revenue for every disk sent out to a Netflix customer. In exchange, Netflix gets DVDs at a very low cost. The movie business is characterized by large fixed costs up front. Studio marketing budgets are concentrated on films when they first appear in theaters, and when they’re first offered on DVD. After that, studios are done promoting a film, focusing instead on their most current titles. But Netflix is able to find an audience for a film without the studios spending a dime on additional marketing. Since so many of the titles viewed on Netflix are in the long tail, revenue sharing is all gravy for the studios—additional income they would otherwise be unlikely to get. It’s a win-win for both ends of the supply chain. These supplier partnerships grant Netflix a sort of soft bargaining power that’s distinctly opposite the strong-arm price bullying that giants like Wal-Mart are often accused of.

Cinematch: Technology Creates a Data Asset That Delivers Profits

Netflix proves there’s both demand and money to be made from the vast back catalog of film and TV show content. But for the model to work best, the firm needed to address the biggest inefficiency in the movie industry—“audience finding,” that is, matching content with customers. To do this, Netflix leverages some of the industry’s most sophisticated technology, a proprietary recommendation system that the firm calls Cinematch.

Each time a customer visits Netflix after sending back a DVD, the service essentially asks “So, how did you like the movie?” With a single click, each film can be rated on a scale of one to five stars. If you’re new to Netflix, the service can prompt you with a list of movies (or you can search out and rate titles on your own). Love Rushmore but hate The Life Aquatic? Netflix wants to know.

The magic of Cinematch happens not by offering a gross average user rating—user tastes are too varied and that data’s too coarse to be of significant value. Instead, Cinematch develops a map of user ratings and steers you toward titles preferred by people with tastes that are most like yours. Techies and marketers call this trick collaborative filteringA classification of software that monitors trends among customers and uses this data to personalize an individual customer’s experience.. The term refers to a classification of software that monitors trends among customers and uses this data to personalize an individual customer’s experience. Input from collaborative filtering software can be used to customize the display of a Web page for each user so that an individual is greeted only with those items the software predicts they’ll most likely be interested in. The kind of data mining done by collaborative filtering isn’t just used by Netflix; other sites use similar systems to recommend music, books, even news stories. While other firms also employ collaborative filtering, Netflix has been at this game for years, and is constantly tweaking its efforts. The results are considered the industry gold standard.

Collaborative filtering software is powerful stuff, but is it a source of competitive advantage? Ultimately it’s just math. Difficult math, to be sure, but nothing prevents other firms from working hard in the lab, running and refining tests, and coming up with software that’s as good, or perhaps one day even better than Netflix’s offering. But what the software has created for the early-moving Netflix is an enormous data advantage that is valuable, results yielding, and impossible for rivals to match. Even if Netflix gave Cinematch to its competitors, they’d be without the over 3 billion ratings that the firm has amassed (according to the firm, users add about a million new ratings to the system each day). More ratings make the system seem smarter, and with more info to go on, Cinematch can make more accurate recommendations than rivals.

Evidence suggests that users trust and value Cinematch. Recommended titles make up over 60 percent of the content users place in their queues—an astonishing penetration rate. Compare that to how often you’ve received a great recommendation from the sullen teen behind the video store counter. While data and algorithms improve the service and further strengthen the firm’s brand, this data is also a switching cost. Drop Netflix for Blockbuster and the average user abandons the two hundred or more films they’ve rated. Even if one is willing to invest the time in recreating their ratings on Blockbuster’s site, the rival will still make less accurate recommendations because there are fewer users and less data to narrow in on similarities across customers.

One way to see how strong these switching costs are is to examine the Netflix churn rateThe rate at which customers leave a product or service.. Churn is a marketing term referring to the rate at which customers leave a product or service. A low churn is usually key to profitability because it costs more to acquire a customer than to keep one. And the longer a customer stays with the firm, the more profitable they become and the less likely they are to leave. If customers weren’t completely satisfied with the Netflix experience, many would be willing to churn out and experiment with rivals offering cheaper service. However, the year after Blockbuster and Wal-Mart launched with copycat efforts, the rate at which customers left Netflix actually fell below 4 percent, an all-time low. And the firm’s churn rates have continued to fall over time. By the middle of 2008, rates for customers in Netflix most active regions of the country were below 3 percent, meaning fewer than three in one hundred Netflix customers canceled their subscriptions each year.Netflix Investor Day presentation, May 2008, accessed via http://ir.netflix.com/events.cfm. To get an idea of how enviable the Netflix churn rates are, consider that a year earlier the mobile phone industry had a churn rate of 38.6 percent, while roughly one in four U.S. banking customers defected that year.“Industry Customer Churn Rate Increases 15%,” GeoConnexion, January 8, 2008. The article contains a summary of the Pittney Bowes G1 finding.

All of this impacts marketing costs, too. Happy customers refer friends (free marketing from a source consumers trust more than a TV commercial). Ninety-four percent of Netflix subscribers say they have recommended the service to someone else, and 71 percent of new subscribers say an existing subscriber has encouraged them to sign up. It’s no wonder subscriber acquisition costs have been steadily falling, further contributing to the firm’s overall profitability.

A Look at Operations

Tech also lies at the heart of the warehouse operations that deliver customer satisfaction and enhance brand value. As mentioned earlier, brand is built through customer experience, and a critical component of customer experience is for subscribers to get their DVDs as quickly as possible. In order to do this, Netflix has blanketed the country with a network of fifty-eight ultrahigh-tech distribution centers that collectively handle in excess of 1.8 million DVDs a day. These distribution centers are purposely located within driving distance of 119 U.S. Postal Service (USPS) processing and distribution facilities.

By 4:00 a.m. each weekday, Netflix trucks collect the day’s DVD shipments from these USPS hubs and returns the DVDs to the nearest Netflix center. DVDs are fed into custom-built sorters that handle disc volume on the way in and the way out. That same machine fires off an e-mail as soon as it detects your DVD was safely returned (now rate it via Cinematch). Most DVDs never hit the restocking shelves. Scanners pick out incoming titles that are destined for other users and place these titles into a sorted outbound pile with a new, appropriately addressed red envelope. Netflix not only helps out the postal service by picking up and dropping off the DVDs at its hubs, it presorts all outgoing mail for faster delivery. This extra effort has a payoff—Netflix gets the lowest possible postal rates for first-class mail delivery. And despite the high level of automation, 100 percent of all discs are inspected by hand so that cracked ones can be replaced, and dirty ones can be given a wipe down.B. McCarthy, “Netflix, Inc.” (remarks, J. P. Morgan Global Technology, Media, and Telecom Conference, Boston, May 18, 2009). Total in and out turnaround time for a typical Netflix DVD is just eight hours!N. Kenny, “Special Report: Inside Netflix,” WMC TV, July 7, 2009.

First-class mail takes only one day to be delivered within a fifty-mile radius, so the warehouse network allows Netflix to service over 97 percent of its customer base within a two-day window—one day is allotted for receipt; early the next morning the next item in their queue is processed; and the new title arrives at the customer’s address by that afternoon. And in 2009, the firm added Saturday processing. All this means a customer with the firm’s most popular “three disc at a time” plan could watch a movie a day and never be without a fresh title.

Warehouse processes don’t exist in a vacuum; they are linked to Cinematch to offer the firm additional operational advantages. The software recommends movies that are likely to be in stock so users aren’t frustrated by a wait.

Everyone on staff is expected to have an eye on improving the firm’s processes. Every warehouse worker gets a free DVD player and Netflix subscription so that they understand the service from the customer’s perspective and can provide suggestions for improvement. Quality management features are built into systems supporting nearly every process at the firm, allowing Netflix to monitor and record the circumstances surrounding any failures. When an error occurs, a tiger team of quality improvement personnel swoops in to figure out how to prevent any problems from recurring. Each phone call is a cost, not a revenue enhancement, and each error increases the chance that a dissatisfied customer will bolt for a rival.

By paying attention to process improvements and designing technology to smooth operations, Netflix has slashed the number of customer representatives even as subscriptions ballooned. In the early days, when the firm had one hundred and fifteen thousand customers, Netflix had one-hundred phone support reps. By the time the customer base had grown thirtyfold, errors had been reduced to the point where only forty-three reps were needed.J. McGregor, “High Tech Achiever,” Fast Company, October 2005. Even more impressive, because of the firm’s effective use of technology to drive the firm’s operations, fulfillment costs as a percentage of revenue have actually dropped even though postal rates have increased and Netflix has cut prices.

Killer Asset Recap: Understanding Scale

Netflix executives are quite frank that the technology and procedures that make up their model can be copied, but they also realize the challenges that any copycat rival faces. Says the firm’s VP of Operations Andy Rendich, “Anyone can replicate the Netflix operations if they wish. It’s not going to be easy. It’s going to take a lot of time and a lot of money.”Netflix Investor Day presentation, 2008, accessed via http://ir.netflix.com/events.cfm.

While we referred to Netflix as David to the Goliaths of Wal-Mart and Blockbuster, within the DVD-by-mail segment Netflix is now the biggest player by far, and this size gives the firm significant scale advantages. The yearly cost to run a Netflix-comparable nationwide delivery infrastructure is about $300 million.S. Reda and D. Schulz, “Concepts that Clicked,” Stores, May 2008. Think about how this relates to economies of scale. In Chapter 2 “Strategy and Technology: Concepts and Frameworks for Understanding What Separates Winners from Losers”, we said that firms enjoy scale economies when they are able to leverage the cost of an investment across increasing units of production. Even if rivals have identical infrastructures, the more profitable firm will be the one with more customers (see Figure 4.7). And the firm with better scale economies is in a position to lower prices, as well as to spend more on customer acquisition, new features, or other efforts. Smaller rivals have an uphill fight, while established firms that try to challenge Netflix with a copycat effort are in a position where they’re straddling markets, unable to gain full efficiencies from their efforts.

For Blockbuster, the arrival of Netflix plays out like a horror film where it is the victim. For several years now, the in-store rental business has been a money loser. Things got worse in 2005 when Netflix pressure forced Blockbuster to drop late fees, costing it about $400 million.T. Mullaney, “Netflix: The Mail-Order House That Clobbered Blockbuster,” BusinessWeek, May 25, 2006. The Blockbuster store network once had the advantage of scale, but eventually its many locations were seen as an inefficient and bloated liability. Between 2006 and 2007, the firm shuttered over 570 stores.A. Farrell, “Blockbuster’s CEO Ousted,” Forbes, July 2, 2007. By 2008, Blockbuster had been in the red for ten of the prior eleven years. During a three-year period that included the launch of its Total Access DVD-by-mail effort, Blockbuster lost over $4 billion.N. MacDonald, “Blockbuster Proves It’s Not Dead Yet,” Maclean’s, March 12, 2008. The firm tried to outspend Netflix on advertising, even running Super Bowl ads for Total Access in 2007, but a money loser can’t outspend its more profitable rival for long, and it has since significantly cut back on promotion. Blockbuster also couldn’t sustain subscription rates below Netflix’s, so it has given up its price advantage. In early 2008, Blockbuster even briefly pursued a merger with another struggling giant, Circuit City, a strategy that has left industry experts scratching their heads. A Viacom executive said about the firm, “Blockbuster will certainly not survive and it will not be missed.”E. Epstein, “Hollywood’s New Zombie: The Last Days of Blockbuster,” Slate, January 9, 2006, http://www.slate.com/id/2133995. This assessment has to sting, given that Viacom was once Blockbuster’s parent (the firm was spun off in 2004).

For Netflix, what delivered the triple scale advantage of the largest selection; the largest network of distribution centers; the largest customer base; and the firm’s industry-leading strength in brand and data assets? Moving first. Timing and technology don’t always yield sustainable competitive advantage, but in this case, Netflix leveraged both to craft what seems to be an extraordinarily valuable pool of assets that continue to grow and strengthen over time. To be certain, competing against a wounded giant like Blockbuster will remain difficult. The latter firm has few options and may spend itself into oblivion, harming Netflix in its collapsing gasp. And as we’ll see in the next section, while technology shifts helped Netflix attack Blockbuster’s once-dominant position, even newer technology shifts may threaten Netflix. As they like to say in the mutual fund industry “Past results aren’t a guarantee of future returns.”

Access to Content

First the content. Three years after the launch of Netflix streaming option (enabled via a “Watch Now” button next to movies that can be viewed online), only 17,000 videos were offered, just 17 percent of the firm’s long tail. And not the best 17 percent. Why so few titles? It’s not just studio reluctance or fear of piracy. There are often complicated legal issues involved in securing the digital distribution rights for all of the content that makes up a movie. Music, archival footage, and performer rights may all hold up a title from being available under “Watch Now.” The 2007 Writers Guild strike occurred largely due to negotiations over digital distribution, showing just how troublesome these issues can be.

Add to that the exclusivity contracts negotiated by key channels, in particular the so-called premium television networks. Film studios release their work in a system called windowingIndustry practice whereby content (usually a motion picture) is available to a given distribution channel for a specified time period or “window,” usually under a different revenue model (e.g., ticket sale, purchase, license fee).. Content is available to a given distribution channel (in theaters, through hospitality channels like hotels and airlines, on DVD, via pay-per-view, via pay cable, then broadcast commercial TV) for a specified time window, usually under a different revenue model (ticket sales, disc sales, license fees for broadcast). Pay television channels in particular have negotiated exclusive access to content as they strive to differentiate themselves from one another. This exclusivity means that even when a title becomes available for streaming by Netflix, it may disappear when a pay TV window opens up. If HBO or Showtime has an exclusive for a film, it’s pulled from the Netflix streaming service until the exclusive pay TV time window closes. A 2008 partnership with the Starz network helped provide access to some content locked up inside pay television windows, and deals with Disney and CBS allow for streaming of current-season shows.S. Portnoy, “Netflix News: Starz Catalog Added to Online Service, Streaming to PS3, Xbox 360 through PlayOn Beta Software,” ZDNet, October 2, 2008, http://blogs.zdnet.com/home-theater/?p=120. But the firm still has a long way to go before the streaming tail seems comparably long when compared against its disc inventory.

While studios embrace the audience-finding and revenue-sharing advantages of Netflix, they also don’t want to undercut higher-revenue early windows. Fox, Universal, and Warner have all demanded that Netflix delay sending DVDs to customers until twenty-eight days after titles go on sale. In exchange, Netflix has received guarantees that these studios will offer more content for digital streaming.

There’s also the influence of the king of DVD sales: Wal-Mart. The firm accounts for about 40 percent of DVD sales—a scale that delivers a lot of the bargaining power it has used to “encourage” studios to hold content from competing windows or to limit offering digital titles at competitive pricing during the peak new release period.R. Grover, “Wal-Mart and Apple Battle for Turf,” BusinessWeek, August 31, 2006. Apparently, Wal-Mart isn’t ready to yield ground in the shifts from atoms to bits, either. In February 2010, the retail giant spent an estimated $100 million to buy the little-known video streaming outfit VUDU.B. Stone, “Wal-Mart Adds Clout to Streaming,” New York Times, February 22, 2010. Wal-Mart’s negotiating power with studios may help it gain special treatment for VUDU. As an example, VUDU was granted exclusive high-definition streaming rights for the hit movie Avatar, offering the title online the same day the DVD appeared for sale.J. Jacobson, “VUDU/Wal-Mart Gets Avatar HD Streaming Exclusive,” Electronic House, April 22, 2010.

Studios may also be wary of the increasing power Netflix has over product distribution, and as such, they may be motivated to keep rivals around. Studios have granted Blockbuster more favorable distribution terms than Netflix. In many cases, Blockbuster can now distribute DVDs the day of release instead of waiting nearly a month, as Netflix does.J. Birchall, “Blockbuster Strikes Deal to Ensure DVD Supply,” Financial Times, April 8, 2010. Studios are likely concerned that Netflix may be getting so big that it will one day have Wal-Mart-like negotiating leverage.

Taken together, all these factors make it clear that shifting the long tail from atoms to bits will be significantly more difficult than buying DVDs and stacking them in a remote warehouse.

But How Does It Get to the TV?

The other major problem lies in getting content to the place where most consumers want to watch it: the living room TV. Netflix’s “Watch Now” button first worked only on Windows PCs. Although the service was introduced in January 2007, the months before were fueled with speculation that the firm would partner with TiVo. Just one month later, TiVo announced its partner—Amazon.com. At that point Netflix found itself up against a host of rivals that all had a path to the television: Apple had its own hardware solution in Apple TV (not to mention the iPod and iPhone for portable viewing), the cable companies delivered OnDemand through their set-top boxes, and now Amazon had TiVo.

An internal team at Netflix developed a prototype set top box that Hastings himself supported offering. But most customers aren’t enthusiastic about purchasing yet another box for their set top, the consumer electronics business is brutally competitive, and selling hardware would introduce an entirely new set of inventory, engineering, marketing, distribution, and competitive complexities.

The solution Netflix eventually settled on was to think beyond one hardware alternative and instead recruit others to provide a wealth of choice. The firm developed a software platform and makes this available to firms seeking to build Netflix access into their devices. Today, Netflix streaming is baked into televisions and DVD players from LG, Panasonic, Samsung, Sony, Toshiba, and Vizio, among others. It’s also available on all major video game consoles. A Netflix app for Apple’s iPad was available the day the device shipped. Even TiVo now streams Netflix. And that internally developed Netflix set-top box? The group was spun out to form Roku, an independent firm that launched their own $99 Netflix streamer.

The switch to Blu-ray movies may offer the most promise. Blu-ray players are on the fast track to commoditization. If consumer electronics firms incorporate Netflix access into their players as a way to attract more customers with an additional, differentiating feature, Hastings’s firm could end up with more living room access than either Amazon or Apple. There are 73 million households in the United States that have a DVD player and an Internet connection. Should a large portion of these homes end up with a Netflix-ready Blu-ray player, Hastings will have built himself an enviable base through which to grow the video streaming business.

Who’s going to win the race for delivering bits to the television is still very much an uncertain bet. The models all vary significantly. Apple’s early efforts were limited, with the firm offering only video purchases for Apple TV, but eventually moving to online “rentals” that can also play on the firm’s entire line of devices. Movie studios are now all in Apple’s camp, although the firm did temporarily lose NBC’s television content in a dispute over pricing. Amazon and Microsoft also have online rentals and purchase services, and can get their content to the television via TiVo and Xbox, respectively (yes, this makes Microsoft both a partner and a sort of competitor, a phenomenon often referred to as coopetitionWhen firms find themselves in situations where they are both competitors and collaborators, or “frenemies.” Technology is increasingly redefining products, pushing the boundaries of delivery channels, and creating situations where firms often find themselves in these collaborative/rival relationships., or frenemiesA. Brandenberger and B. Nalebuff, Co-opetition: A Revolution Mindset that Combines Competition and Cooperation: The Game Theory Strategy That’s Changing the Game of Business (New York: Broadway Business, 1997); and S. Johnson, “The Frenemy Business Relationship,” Fast Company, November 25, 2008.). Hulu, a joint venture backed by NBC, Fox, and other networks, is free, earning money from ads that run like TV commercials. While Hulu has also received glowing reviews, the venture has lagged in offering a method to get streaming content to the television. Netflix pioneered “all-you-can-eat” subscription streaming. Anyone who has at least the $8.99 subscription plan can view an unlimited number of video streams. And Blockbuster isn’t dead yet. It also streams over TiVo and has other offerings in the works.

There’s a clear upside to the model when it shifts to streaming: it will eliminate a huge chunk of costs associated with shipping and handling. Postage represents one-third of the firm’s expenses. A round-trip DVD mailing, even at the deep discounts Netflix receives from the U.S. Postal Service, runs about eighty cents. The bandwidth and handling costs to send bits to a TV set are around a nickel.B. McCarthy, “Netflix, Inc.” (remarks, J. P. Morgan Global Technology, Media, and Telecom Conference, Boston, May 18, 2009). At some point, if postage goes away, Netflix may be in a position to offer even greater profits to its studio suppliers, and to make more money itself, too.

Wrangling licensing costs presents a further challenge. Estimates peg Netflix 2009 streaming costs at about $100 million, up 250 percent in three years. But these expenses still deliver just a fraction of the long tail. Streaming licensing deals are tricky because they’re so inconsistent even when titles are available. Rates vary, with some offered via a flat rate for unlimited streams, a per-stream rate, a rate for a given number of streams, and various permutations in between. Some vendors have been asking as much as four dollars per stream for more valuable contentD. Rayburn, “Netflix Streaming Costs,” Streaming Media, June/July 2009.—a fee that would quickly erase subscriber profits, making any such titles too costly to add to the firm’s library. Remember, Netflix doesn’t charge more for streaming—it’s built into the price of its flat-rate subscriptions.

Any extra spending doesn’t come at the best time. The switch to Blu-ray movies means that Netflix will be forced into the costly proposition of carrying two sets of video inventory: standard and high-def. Direct profits may not be the driver. Rather, the service may be a feature that attracts new customers to the firm and helps prevent subscriber flight to rival video-on-demand efforts. The stealth arrival of a Netflix set-top box, in the form of upgraded Blu-ray players, might open even more customer acquisition opportunities to the firm. Bought a Blu-ray player? For just nine dollars per month you can get a ticket to the all-you-can-eat Netflix buffet. And more customers ready to watch content streamed by Netflix may prime the pump for studios to become more aggressive in licensing more of their content. Many TV networks and movie studios are leery of losing bargaining power to a dominant firm, having witnessed how Apple now dictates pricing terms to music labels. The goodwill Netflix has earned over the years may pay off if it can become the studios’ partner of first choice.

While one day the firm will lose the investment in its warehouse infrastructure, nearly all assets have a limited lifespan. That’s why corporations depreciate assets, writing their value down over time. The reality is that the shift from atoms to bits won’t flick on like a light switch; it will be a hybrid transition that takes place over several years. If the firm can grab long-tail content, grow its customer base, and lock them in with the switching costs created by Cinematch (all big “ifs”), it just might emerge as a key player in a bits-only world.

Is the hybrid strategy a dangerous straddling gambit or a clever ploy to remain dominant? Netflix really doesn’t have a choice but to try. Hastings already has a long history as one of the savviest strategic thinkers in tech. As the networks say, stay tuned!

Why Study Zara?

While competitors falter, Zara is undergoing one of the fastest global expansions the fashion world has ever seen, opening one store per day and entering new markets worldwide—seventy-three countries so far. The chain’s profitability is among the highest in the industry.D. Sull and S. Turconi, “Fast Fashion Lessons,” Business Strategy Review, Summer 2008. The fashion director for luxury goods maker LVMH calls Zara “the most innovative and devastating retailer in the world.”J. Surowiecki, “The Most Devastating Retailer in the World,” New Yorker, September 18, 2000.

Zara’s duds look like high fashion but are comparatively inexpensive (average item price is $27, although prices vary by country).C. Rohwedder, “Zara Grows as Retail Rivals Struggle,” Wall Street Journal, March 26, 2009. A Goldman analyst has described the chain as “Armani at moderate prices,” while another industry observer suggests that while fashions are more “Banana Republic,” prices are more “Old Navy.”J. Folpe, “Zara Has a Made-to-Order Plan for Success,” Fortune, September 4, 2000. Legions of fans eagerly await “Z-day,” the twice-weekly inventory delivery to each Zara location that brings in the latest clothing lines for women, men, and children.

In order to understand and appreciate just how counterintuitive and successful Zara’s strategy is, and how technology makes all of this possible, it’s important to first examine the conventional wisdom in apparel retail. To do that we’ll look at former industry leader—Gap.

Gap: An Icon in Crisis

Most fashion retailers place orders for a seasonal collection months before these lines make an appearance in stores. While overseas contract manufacturers may require hefty lead times, trying to guess what customers want months in advance is a tricky business. In retail in general and fashion in particular, there’s a saying: inventory equals death. Have too much unwanted product on hand and you’ll be forced to mark down or write off items, killing profits. For years, Gap sold most of what it carried in stores. Micky Drexler, a man with a radar-accurate sense of style and the iconic CEO who helped turn Gap’s button-down shirts and khakis into America’s business casual uniform, led the way. Drexler’s team had spot-on tastes throughout the 1990s, but when sales declined in the early part of the following decade, Drexler was left guessing on ways to revitalize the brand, and he guessed wrong—disastrously wrong. Chasing the youth market, Drexler filled Gap stores with miniskirts, low-rise jeans, and even a much-ridiculed line of purple leather pants.J. Boorstein, “Fashion Victim,” Fortune, April 13, 2006. The throngs of teenagers he sought to attract never showed up, and the shift in offerings sent Gap’s mainstay customers to retailers that easily copied the styles that Gap had made classic.

The inventory hot potato Drexler was left with crushed the firm. Gap’s same-store sales declined for twenty-nine months straight. Profits vanished. Gap founder and chairman Dan Fisher lamented, “It took us thirty years to get to $1 billion in profits and two years to get to nothing.”P. Sellers, “Gap’s New Guy Upstairs,” Fortune, April 14, 2003. The firm’s debt was downgraded to junk status. Drexler was out and for its new head the board chose Paul Pressler, a Disney executive who ran theme parks and helped rescue the firm’s once ailing retail effort.

Pressler shut down hundreds of stores, but the hemorrhaging continued largely due to bad bets on colors and styles.L. Lee, “Paul Pressler’s Fall from The Gap,” BusinessWeek, February 26, 2007. During one holiday season, Gap’s clothes were deemed so off target that the firm scrapped its advertising campaign and wrote off much of the inventory. The marketing model used by Gap to draw customers in via big-budget television promotion had collapsed. Pressler’s tenure saw same-store sales decline in eighteen of twenty-four months.J. Boorstein, “Fashion Victim,” Fortune, April 13, 2006. A Fortune article on Pressler’s leadership was titled “Fashion Victim.” BusinessWeek described his time as CEO as a “Total System Failure,”L. Lee, “Paul Pressler’s Fall from the Gap,” BusinessWeek, February 26, 2007. and Wall Street began referring to him as DMW for Dead Man Walking. In January 2007, Pressler resigned, with Gap hoping its third chief executive of the decade could right the ailing giant.

Design

Rather than create trends by pushing new lines via catwalk fashion shows, Zara designs follow evidence of customer demand. Data on what sells and what customers want to see goes directly to “The Cube” outside La Coruña, where teams of some three hundred designers crank out an astonishing thirty thousand items a year versus two to four thousand items offered up at big chains like H&M (the world’s third largest fashion retailer) and Gap.M. Pfeifer, “Fast and Furious,” Latin Trade, September 2007; and “The Future of Fast Fashion,” Economist, June 18, 2005. While H&M has offered lines by star designers like Stella McCartney and Karl Lagerfeld, as well as celebrity collaborations with Madonna and Kylie Minogue, the Zara design staff consists mostly of young, hungry Project Runway types fresh from design school. There are no prima donnas in “The Cube.” Team members must be humble enough to accept feedback from colleagues and share credit for winning ideas. Individual bonuses are tied to the success of the team, and teams are regularly rotated to cross-pollinate experience and encourage innovation.

Manufacturing and Logistics

In the fickle world of fashion, even seemingly well-targeted designs could go out of favor in the months it takes to get plans to contract manufacturers, tool up production, then ship items to warehouses and eventually to retail locations. But getting locally targeted designs quickly onto store shelves is where Zara really excels. In one telling example, when Madonna played a set of concerts in Spain, teenage girls arrived to the final show sporting a Zara knockoff of the outfit she wore during her first performance.“The Future of Fast Fashion,” Economist, June 18, 2005. The average time for a Zara concept to go from idea to appearance in store is fifteen days versus their rivals who receive new styles once or twice a season. Smaller tweaks arrive even faster. If enough customers come in and ask for a round neck instead of a V neck, a new version can be in stores with in just ten days.J. Tagliabue, “A Rival to Gap That Operates Like Dell,” New York Times, May 30, 2003. To put that in perspective, Zara is twelve times faster than Gap despite offering roughly ten times more unique products!M. Helft, “Fashion Fast Forward,” Business 2.0, May 2002. At H&M, it takes three to five months to go from creation to delivery—and they’re considered one of the best. Other retailers need an average of six months to design a new collection and then another three months to manufacture it. VF Corp (Lee, Wrangler) can take nine months just to design a pair of jeans, while J. Jill needs a year to go from concept to store shelves.L. Sullivan, “Designed to Cut Time,” InformationWeek, February 28, 2005. At Zara, most of the products you see in stores didn’t exist three weeks earlier, not even as sketches.J. Surowiecki, “The Most Devastating Retailer in the World,” New Yorker, September 18, 2000.

The firm is able to be so responsive through a competitor-crushing combination of vertical integrationWhen a single firm owns several layers in its value chain. and technology-orchestrated coordination of suppliers, just-in-time manufacturing, and finely tuned logistics. Vertical integration is when a single firm owns several layers in its value chainThe set of activities through which a product or service is created and delivered to customers..Definition from the “father” of the value chain, Michael Porter. See M. Porter, “Strategy and the Internet,” Harvard Business Review 79, no. 3 (March 2001): 62–78, among others. While H&M has nine hundred suppliers and no factories, nearly 60 percent of Zara’s merchandise is produced in-house, with an eye on leveraging technology in those areas that speed up complex tasks, lower cycle time, and reduce error. Profits from this clothing retailer come from blending math with a data-driven fashion sense. Inventory optimization models help the firm determine how many of which items in which sizes should be delivered to each specific store during twice-weekly shipments, ensuring that each store is stocked with just what it needs.C. Gentry, “European Fashion Stores Edge Past U.S. Counterparts,” Chain Store Age, December 2007. Outside the distribution center in La Coruña, fabric is cut and dyed by robots in twenty-three highly automated factories. Zara is so vertically integrated, the firm makes 40 percent of its own fabric and purchases most of its dyes from its own subsidiary. Roughly half of the cloth arrives undyed so the firm can respond as any midseason fashion shifts occur. After cutting and dying, many items are stitched together through a network of local cooperatives that have worked with Inditex so long they don’t even operate with written contracts. The firm does leverage contract manufacturers (mostly in Turkey and Asia) to produce staple items with longer shelf lives, such as t-shirts and jeans, but such goods account for only about one-eighth of dollar volume.N. Tokatli, “Global Sourcing: Insights from the Global Clothing Industry—The Case of Zara, a Fast Fashion Retailer,” Journal of Economic Geography 8, no. 1 (2008): 21–38.

All of the items the firm sells end up in a five-million-square-foot distribution center in La Coruña, or a similar facility in Zaragoza in the northeast of Spain. The La Coruña facility is some nine times the size of Amazon’s warehouse in Fernley, Nevada, or about the size of ninety football fields.M. Helft, “Fashion Fast Forward,” Business 2.0, May 2002. The facilities move about two and a half million items every week, with no item staying in-house for more than seventy-two hours. Ceiling-mounted racks and customized sorting machines patterned on equipment used by overnight parcel services, and leveraging Toyota-designed logistics, whisk items from factories to staging areas for each store. Clothes are ironed in advance and packed on hangers, with security and price tags affixed. This system means that instead of wrestling with inventory during busy periods, employees in Zara stores simply move items from shipping box to store racks, spending most of their time on value-added functions like helping customers find what they want. Efforts like this help store staff regain as much as three hours in prime selling time.C. Rohwedder and K. Johnson, “Pace-Setting Zara Seeks More Speed to Fight Its Rising Cheap-Chic Rivals,” Wall Street Journal, February 20, 2008; and K. Capell, “Zara Thrives by Breaking All the Rules,” BusinessWeek, October 9, 2008.

Trucks serve destinations that can be reached overnight, while chartered cargo flights serve farther destinations within forty-eight hours.K. Capell, “Zara Thrives by Breaking All the Rules,” BusinessWeek, October 9, 2008. The firm recently tweaked its shipping models through Air France–KLM Cargo and Emirates Air so flights can coordinate outbound shipment of all Inditex brands with return legs loaded with raw materials and half-finished clothes items from locations outside of Spain. Zara is also a pioneer in going green. In fall 2007, the firm’s CEO unveiled an environmental strategy that includes the use of renewable energy systems at logisticsCoordinating and enabling the flow of goods, people, information, and other resources among locations. centers including the introduction of biodiesel for the firm’s trucking fleet.

Stores

Most products are manufactured for a limited production run. While running out of bestsellers might be seen as a disaster at most retailers, at Zara the practice delivers several benefits.

First, limited runs allow the firm to cultivate the exclusivity of its offerings. While a Gap in Los Angeles carries nearly the same product line as one in Milwaukee, each Zara store is stocked with items tailored to the tastes of its local clientele. A Fifth Avenue shopper quips, “At Gap, everything is the same,” while a Zara shopper in Madrid says, “You’ll never end up looking like someone else.”K. Capell, “Fashion Conquistador,” BusinessWeek, September 4, 2006. Upon visiting a Zara, the CEO of the National Retail Federation marveled, “It’s like you walk into a new store every two weeks.”M. Helft, “Fashion Fast Forward,” Business 2.0, May 2002.

Second, limited runs encourage customers to buy right away and at full price. Savvy Zara shoppers know the newest items arrive on black plastic hangers, with store staff transferring items to wooden ones later on. Don’t bother asking when something will go on sale; if you wait three weeks the item you wanted has almost certainly been sold or moved out to make room for something new. Says one twenty-three year-old Barcelona shopper, “If you see something and don’t buy it, you can forget about coming back for it because it will be gone.”K. Capell, “Fashion Conquistador,” BusinessWeek, September 4, 2006. A study by consulting firm Bain & Company estimated that the industry average markdown ratio is approximately 50 percent, while Zara books some 85 percent of its products at full price.D. Sull and S. Turconi, “Fast Fashion Lessons,” Business Strategy Review, Summer 2008; and K. Capell, “Fashion Conquistador,” BusinessWeek, September 4, 2006.

The constant parade of new, limited-run items also encourages customers to visit often. The average Zara customer visits the store seventeen times per year, compared with only three annual visits made to competitors.N. Kumar and S. Linguri, “Fashion Sense,” Business Strategy Review, Summer 2006. Even more impressive—Zara puts up these numbers with almost no advertising. The firm’s founder has referred to advertising as a “pointless distraction.” The assertion carries particular weight when you consider that during Gap’s collapse, the firm increased advertising spending but sales dropped.P. Bhatnagar, “How Do You Ad(dress) the Gap?” Fortune, October 11, 2004. Fashion retailers spend an average of 3.5 percent of revenue promoting their products, while ad spending at Inditex is just 0.3 percent.“Zara, A Spanish Success Story,” CNN.com, June 15, 2001, http://edition.cnn.com/BUSINESS/programs/yourbusiness/stories2001/zara.

Finally, limited production runs allow the firm to, as Zara’s CEO once put it, “reduce to a minimum the risk of making a mistake, and we do make mistakes with our collections.”C. Vitzthum, “Zara’s Success Lies in Low-Cost Lines and a Rapid Turnover of Collections,” Wall Street Journal, May 18, 2001. Failed product introductions are reported to be just 1 percent, compared with the industry average of 10 percent.N. Kumar and S. Linguri, “Fashion Sense,” Business Strategy Review, Summer 2006. So even though Zara has higher manufacturing costs than rivals, Inditex gross margins are 56.8 percent compared to 37.5 percent at Gap.C. Rohwedder, “Zara Grows as Retail Rivals Struggle,” Wall Street Journal, March 26, 2009. For labor cost comparison, K. Capell, “Zara Thrives by Breaking All the Rules,” BusinessWeek, October 9, 2008, reports that workers in Spain earn an average of $1,650/month versus $206/month in China’s Guangdong Province.

While stores provide valuable front-line data, headquarters plays a major role in directing in-store operations. Software is used to schedule staff based on each store’s forecasted sales volume, with locations staffing up at peak times such as lunch or early evening. The firm claims these more flexible schedules have shaved staff work hours by 2 percent. This constant refinement of operations throughout the firm’s value chain has helped reverse a prior trend of costs rising faster than sales.C. Rohwedder and K. Johnson, “Pace-Setting Zara Seeks More Speed to Fight Its Rising Cheap-Chic Rivals,” Wall Street Journal, February 20, 2008.

Even the store displays are directed from “The Cube,” where a basement staging area known as “Fashion Street” houses a Potemkin village of bogus storefronts meant to mimic some of the chain’s most exclusive locations throughout the world. It’s here that workers test and fine-tune the chain’s award-winning window displays, merchandise layout, and even determine the in-store soundtrack. Every two weeks, new store layout marching orders are forwarded to managers at each location.C. Rohwedder and K. Johnson, “Pace-Setting Zara Seeks More Speed to Fight Its Rising Cheap-Chic Rivals,” Wall Street Journal, February 20, 2008.

The Danger of Relying on Technology

Firms strive for sustainable competitive advantageFinancial performance that consistently outperforms industry averages., financial performance that consistently outperforms their industry peers. The goal is easy to state, but hard to achieve. The world is so dynamic, with new products and new competitors rising seemingly overnight, that truly sustainable advantage might seem like an impossibility. New competitors and copycat products create a race to cut costs, cut prices, and increase features that may benefit consumers but erode profits industry-wide. Nowhere is this balance more difficult than when competition involves technology. The fundamental strategic question in the Internet era is, “How can I possibly compete when everyone can copy my technology and the competition is just a click away?” Put that way, the pursuit of sustainable competitive advantage seems like a lost cause.

But there are winners—big, consistent winners—empowered through their use of technology. How do they do it? In order to think about how to achieve sustainable advantage, it’s useful to start with two concepts defined by Michael Porter. A professor at the Harvard Business School and father of the value chain and the five forces concepts (see the sections later in this chapter), Porter is justifiably considered one of the leading strategic thinkers of our time.

According to Porter, the reason so many firms suffer aggressive, margin-eroding competition is because they’ve defined themselves according to operational effectiveness rather than strategic positioning. Operational effectivenessPerforming the same tasks better than rivals perform them. refers to performing the same tasks better than rivals perform them. Everyone wants to be better, but the danger in operational effectiveness is “sameness.” This risk is particularly acute in firms that rely on technology for competitiveness. After all, technology can be easily acquired. Buy the same stuff as your rivals, hire students from the same schools, copy the look and feel of competitor Web sites, reverse engineer their products, and you can match them. The fast follower problemExists when savvy rivals watch a pioneer’s efforts, learn from their successes and missteps, then enter the market quickly with a comparable or superior product at a lower cost before the first mover can dominate. exists when savvy rivals watch a pioneer’s efforts, learn from their successes and missteps, then enter the market quickly with a comparable or superior product at a lower cost.

Since tech can be copied so quickly, followers can be fast, indeed. Several years ago while studying the Web portal industry (Yahoo! and its competitors), a colleague and I found that when a firm introduced an innovative feature, at least one of its three major rivals would match that feature in, on average, only one and a half months.J. Gallaugher and C. Downing, “Portal Combat: An Empirical Study of Competition in the Web Portal Industry,” Journal of Information Technology Management 11, no. 1–2 (2000): 13–24. When technology can be matched so quickly, it is rarely a source of competitive advantage. And this phenomenon isn’t limited to the Web.

Tech giant EMC saw its stock price appreciate more than any other firm during the decade of the 1990s. However, when IBM and Hitachi entered the high-end storage market with products comparable to EMC’s Symmetrix unit, prices plunged 60 percent the first year and another 35 percent the next.P. Engardio and F. F. Keenan, “The Copycat Economy,” BusinessWeek, August 26, 2002. Needless to say, EMC’s stock price took a comparable beating. TiVo is another example. At first blush, it looks like this first mover should be a winner since it seems to have established a leading brand; TiVo is now a verb for digitally recording TV broadcasts. But despite this, TiVo has largely been a money loser, going years without posting an annual profit. And while 1.5 million TiVos have been sold, there are over thirty million digital video recorders (DVRs) in use.N. DiMeo, “TiVo’s Goal with New DVR: Become the Google of TV,” Morning Edition, National Public Radio, April 7, 2010. Rival devices offered by cable and satellite companies appear the same to consumers, and are offered along with pay television subscriptions—a critical distribution channel for reaching customers that TiVo doesn’t control.

Operational effectiveness is critical. Firms must invest in techniques to improve quality, lower cost, and generate design-efficient customer experiences. But for the most part, these efforts can be matched. Because of this, operational effectiveness is usually not sufficient enough to yield sustainable dominance over the competition. In contrast to operational effectiveness, strategic positioningPerforming different tasks than rivals, or the same tasks in a different way. refers to performing different activities from those of rivals, or the same activities in a different way. While technology itself is often very easy to replicate, technology is essential to creating and enabling novel approaches to business that are defensibly different from those of rivals and can be quite difficult for others to copy.

Different Is Good: FreshDirect Redefines the NYC Grocery Landscape

For an example of the relationship between technology and strategic positioning, consider FreshDirect. The New York City–based grocery firm focused on the two most pressing problems for Big Apple shoppers: selection is limited and prices are high. Both of these problems are a function of the high cost of real estate in New York. The solution? Use technology to craft an ultraefficient model that makes an end-run around stores.

The firm’s “storefront” is a Web site offering one-click menus, semiprepared specials like “meals in four minutes,” and the ability to pull up prior grocery lists for fast reorders—all features that appeal to the time-strapped Manhattanites who were the firm’s first customers. (The Web’s not the only channel to reach customers—the firm’s iPhone app was responsible for 2.5 percent of sales just weeks after launch.)R. M. Schneiderman, “FreshDirect Goes to Greenwich,” Wall Street Journal, April 6, 2010. Next-day deliveries are from a vast warehouse the size of five football fields located in a lower-rent industrial area of Queens. At that size, the firm can offer a fresh goods selection that’s over five times larger than local supermarkets. Area shoppers—many of whom don’t have cars or are keen to avoid the traffic-snarled streets of the city—were quick to embrace the model. The service is now so popular that apartment buildings in New York have begun to redesign common areas to include secure freezers that can accept FreshDirect deliveries, even when customers aren’t there.L. Croghan, “Food Latest Luxury Lure,” New York Daily News, March 12, 2006.

The FreshDirect model crushes costs that plague traditional grocers. Worker shifts are highly efficient, avoiding the downtime lulls and busy rush hour spikes of storefronts. The result? Labor costs that are 60 percent lower than at traditional grocers. FreshDirect buys and prepares what it sells, leading to less waste, an advantage that the firm claims is “worth 5 percentage points of total revenue in terms of savings.”P. Fox, “Interview with FreshDirect Co-Founder Jason Ackerman,” Bloomberg Television, June 17, 2009. Overall perishable inventory at FreshDirect turns 197 times a year versus 40 times a year at traditional grocers.E. Schonfeld, “The Big Cheese of Online Grocers Joe Fedele’s Inventory-Turning Ideas May Make FreshDirect the First Big Web Supermarket to Find Profits,” Business 2.0, January 1, 2004. Higher inventory turnsSometimes referred to as inventory turnover, stock turns, or stock turnover. It is the number of times inventory is sold or used during the course of a year. A higher figure means that a firm is selling products quickly. mean the firm is selling product faster, so it collects money quicker than its rivals do. And those goods are fresher since they’ve been in stock for less time, too. Consider that while the average grocer may have seven to nine days of seafood inventory, FreshDirect’s seafood stock turns each day. Stock is typically purchased direct from the docks in order to fulfill orders placed less than twenty-four hours earlier.T. Laseter, B. Berg, and M. Turner, “What FreshDirect Learned from Dell,” Strategy+Business, February 12, 2003.

Artificial intelligence software, coupled with some seven miles of fiber-optic cables linking systems and sensors, supports everything from baking the perfect baguette to verifying orders with 99.9 percent accuracy.J. Black, “Can FreshDirect Bring Home the Bacon?” BusinessWeek, September 24, 2002; S. Sieber and J. Mitchell, “FreshDirect: Online Grocery that Actually Delivers!” IESE Insight, 2007. Since it lacks the money-sucking open-air refrigerators of the competition, the firm even saves big on energy (instead, staff bundle up for shifts in climate-controlled cold rooms tailored to the specific needs of dairy, deli, and produce). And a new initiative uses recycled biodiesel fuel to cut down on delivery costs.

FreshDirect buys directly from suppliers, eliminating middlemen wherever possible. The firm also offers suppliers several benefits beyond traditional grocers, all in exchange for more favorable terms. These include offering to carry a greater selection of supplier products while eliminating the “slotting fees” (payments by suppliers for prime shelf space) common in traditional retail, cobranding products to help establish and strengthen supplier brand, paying partners in days rather than weeks, and sharing data to help improve supplier sales and operations. Add all these advantages together and the firm’s big, fresh selection is offered at prices that can undercut the competition by as much as 35 percent.H. Green, “FreshDirect,” BusinessWeek, November 24, 2003. And FreshDirect does it all with margins in the range of 20 percent (to as high as 45 percent on many semiprepared meals), easily dwarfing the razor-thin 1 percent margins earned by traditional grocers.S. Sieber and J. Mitchell, “FreshDirect: Online Grocery that Actually Delivers!” IESE Insight, 2007; D. Kirkpatrick, “The Online Grocer Version 2.0,” Fortune, November 25, 2002; P. Fox, “Interview with FreshDirect Co-Founder Jason Ackerman,” Bloomberg Television, June 17, 2009.

Today, FreshDirect serves a base of some 600,000 paying customers. That’s a population roughly the size of metro-Boston, serviced by a single grocer with no physical store. The privately held firm has been solidly profitable for several years. Even in recession-plagued 2009, the firm’s CEO described 2009 earnings as “pretty spectacular,”P. Fox, “Interview with FreshDirect Co-Founder Jason Ackerman,” Bloomberg Television, June 17, 2009. while 2010 revenues are estimated to grow to roughly $300 million.R. M. Schneiderman, “FreshDirect Goes to Greenwich,” Wall Street Journal, April 6, 2010.

Technology is critical to the FreshDirect model, but it’s the collective impact of the firm’s differences when compared to rivals, this tech-enabled strategic positioning, that delivers success. Operating for more than half a decade, the firm has also built up a set of strategic assets that not only address specific needs of a market but are now extremely difficult for any upstart to compete against. Traditional grocers can’t fully copy the firm’s delivery business because this would leave them straddlingAttempts to occupy more than one position, while failing to match the benefits of a more efficient, singularly focused rival. two markets (low-margin storefront and high-margin delivery), unable to gain optimal benefits from either. Entry costs for would-be competitors are also high (the firm spent over $75 million building infrastructure before it could serve a single customer), and the firm’s complex and highly customized software, which handles everything from delivery scheduling to orchestrating the preparation of thousands of recipes, continues to be refined and improved each year.C. Valerio, “Interview with FreshDirect Co-Founder Jason Ackerman,” Venture, Bloomberg Television, September 18, 2009. On top of all this comes years of customer data used to further refine processes, speed reorders, and make helpful recommendations. Competing against a firm with such a strong and tough-to-match strategic position can be brutal. Just five years after launch there were one-third fewer supermarkets in New York City than when FreshDirect first opened for business.R. Shulman, “Groceries Grow Elusive for Many in New York City,” Washington Post, February 19, 2008.

But What Kinds of Differences?

The principles of operational effectiveness and strategic positioning are deceptively simple. But while Porter claims strategy is “fundamentally about being different,”M. Porter, “What Is Strategy?” Harvard Business Review 74, no. 6 (November–December 1996): 61–78. how can you recognize whether your firm’s differences are special enough to yield sustainable competitive advantage?

An approach known as the resource-based view of competitive advantageThe strategic thinking approach suggesting that if a firm is to maintain sustainable competitive advantage, it must control an exploitable resource, or set of resources, that have four critical characteristics. These resources must be (1) valuable, (2) rare, (3) imperfectly imitable, and (4) nonsubstitutable. can help. The idea here is that if a firm is to maintain sustainable competitive advantage, it must control a set of exploitable resources that have four critical characteristics. These resources must be (1) valuable, (2) rare, (3) imperfectly imitable (tough to imitate), and (4) nonsubstitutable. Having all four characteristics is key. Miss value and no one cares what you’ve got. Without rareness, you don’t have something unique. If others can copy what you have, or others can replace it with a substitute, then any seemingly advantageous differences will be undercut.

Strategy isn’t just about recognizing opportunity and meeting demand. Resource-based thinking can help you avoid the trap of carelessly entering markets simply because growth is spotted. The telecommunications industry learned this lesson in a very hard and painful way. With the explosion of the Internet it was easy to see that demand to transport Web pages, e-mails, MP3s, video, and everything else you can turn into ones and zeros, was skyrocketing.

Most of what travels over the Internet is transferred over long-haul fiber-optic cables, so telecom firms began digging up the ground and laying webs of fiberglass to meet the growing demand. Problems resulted because firms laying long-haul fiber didn’t fully appreciate that their rivals and new upstart firms were doing the exact same thing. By one estimate there was enough fiber laid to stretch from the Earth to the moon some 280 times!L. Kahney, “Net Speed Ain’t Seen Nothin’ Yet,” Wired News, March 21, 2000. On top of that, a technology called dense wave division multiplexing (DWDM)A technology that increases the transmission capacity (and hence speed) of fiber-optic cable. Transmissions using fiber are accomplished by transmitting light inside “glass” cables. In DWDM, the light inside fiber is split into different wavelengths in a way similar to how a prism splits light into different colors. enabled existing fiber to carry more transmissions than ever before. The end result—these new assets weren’t rare and each day they seemed to be less valuable.

For some firms, the transmission prices they charged on newly laid cable collapsed by over 90 percent. Established firms struggled, upstarts went under, and WorldCom became the biggest bankruptcy in U.S. history. The impact was felt throughout all industries that supplied the telecom industry. Firms like Sun, Lucent, and Nortel, whose sales growth relied on big sales to telecom carriers, saw their value tumble as orders dried up. Estimates suggest that the telecommunications industry lost nearly $4 trillion in value in just three years,L. Endlich, Optical Illusions: Lucent and the Crash of Telecom (New York: Simon & Schuster, 2004). much of it due to executives that placed big bets on resources that weren’t strategic.

Imitation-Resistant Value Chains

While many of the resources below are considered in isolation, the strength of any advantage can be far more significant if firms are able to leverage several of these resources in a way that makes each stronger and makes the firm’s way of doing business more difficult for rivals to match. Firms that craft an imitation-resistant value chainA way of doing business that competitors struggle to replicate and that frequently involves technology in a key enabling role. have developed a way of doing business that others will struggle to replicate, and in nearly every successful effort of this kind, technology plays a key enabling role. The value chain is the set of interrelated activities that bring products or services to market (see below). When we compare FreshDirect’s value chain to traditional rivals, there are differences across every element. But most importantly, the elements in FreshDirect’s value chain work together to create and reinforce competitive advantages that others cannot easily copy. Incumbents would be straddled between two business models, unable to reap the full advantages of either. And late-moving pure-play rivals will struggle, as FreshDirect’s lead time allows the firm to develop brand, scale, data, and other advantages that newcomers lack (see below for more on these resources).

Brand

A firm’s brandThe symbolic embodiment of all the information connected with a product or service. is the symbolic embodiment of all the information connected with a product or service, and a strong brand can also be an exceptionally powerful resource for competitive advantage. Consumers use brands to lower search costs, so having a strong brand is particularly vital for firms hoping to be the first online stop for consumers. Want to buy a book online? Auction a product? Search for information? Which firm would you visit first? Almost certainly Amazon, eBay, or Google. But how do you build a strong brand? It’s not just about advertising and promotion. First and foremost, customer experience counts. A strong brand proxies quality and inspires trust, so if consumers can’t rely on a firm to deliver as promised, they’ll go elsewhere. As an upside, tech can play a critical role in rapidly and cost-effectively strengthening a brand. If a firm performs well, consumers can often be enlisted to promote a product or service (so-called viral marketingLeveraging consumers to promote a product or service.). Consider that while scores of dot-coms burned through money on Super Bowl ads and other costly promotional efforts, Google, Hotmail, Skype, eBay, MySpace, Facebook, Twitter, YouTube, and so many other dominant online properties built multimillion member followings before committing any significant spending to advertising.

Early customer accolades for a novel service often mean that positive press (a kind of free advertising) will also likely follow.

But show up late and you may end up paying much more to counter an incumbent’s place in the consumer psyche. In recent years, Amazon has spent no money on television advertising, while rivals Buy.com and Overstock.com spent millions. Google, another strong brand, has become a verb, and the cost to challenge it is astonishingly high. Yahoo! and Microsoft’s Bing each spent $100 million on Google-challenging branding campaigns, but the early results of these efforts seemed to do little to grow share at Google’s expense.J. Edwards, “JWT’s $100 Million Campaign for Microsoft’s Bing Is Failing,” BNET, July 16, 2009. Branding is difficult, but if done well, even complex tech products can establish themselves as killer brands. Consider that Intel has taken an ingredient product that most people don’t understand, the microprocessor, and built a quality-conveying name recognized by computer users worldwide.

Scale

Many firms gain advantages as they grow in size. Advantages related to a firm’s size are referred to as scale advantagesAdvantages related to size.. Businesses benefit from economies of scaleWhen costs can be spread across increasing units of production or in serving multiple customers. Businesses that have favorable economies of scale (like many Internet firms) are sometimes referred to as being highly scalable. when the cost of an investment can be spread across increasing units of production or in serving a growing customer base. Firms that benefit from scale economies as they grow are sometimes referred to as being scalable. Many Internet and tech-leveraging businesses are highly scalable since, as firms grow to serve more customers with their existing infrastructure investment, profit margins improve dramatically.

Consider that in just one year, the Internet firm BlueNile sold as many diamond rings with just 115 employees and one Web site as a traditional jewelry retailer would sell through 116 stores.T. Mullaney, “Jewelry Heist,” BusinessWeek, May 10, 2004. And with lower operating costs, BlueNile can sell at prices that brick-and-mortar stores can’t match, thereby attracting more customers and further fueling its scale advantages. Profit margins improve as the cost to run the firm’s single Web site and operate its one warehouse is spread across increasing jewelry sales.

A growing firm may also gain bargaining power with its suppliers or buyers. As Dell grew larger, the firm forced suppliers wanting in on Dell’s growing business to make concessions such as locating close to Dell plants. Similarly, for years eBay could raise auction fees because of the firm’s market dominance. Auction sellers who left eBay lost pricing power since fewer bidders on smaller, rival services meant lower prices.

The scale of technology investment required to run a business can also act as a barrier to entry, discouraging new, smaller competitors. Intel’s size allows the firm to pioneer cutting-edge manufacturing techniques and invest $7 billion on next-generation plants.J. Flatley, “Intel Invests $7 Billion in Stateside 32nm Manufacturing,” Engadget, February 10, 2009. And although Google was started by two Stanford students with borrowed computer equipment running in a dorm room, the firm today runs on an estimated 1.4 million servers.R. Katz, “Tech Titans Building Boom,” IEEE Spectrum 46, no. 2 (February 1, 2009): 40–43. The investments being made by Intel and Google would be cost-prohibitive for almost any newcomer to justify.

Switching Costs and Data

Switching costsThe cost a consumer incurs when moving from one product to another. It can involve actual money spent (e.g., buying a new product) as well as investments in time, any data loss, and so forth. exist when consumers incur an expense to move from one product or service to another. Tech firms often benefit from strong switching costs that cement customers to their firms. Users invest their time learning a product, entering data into a system, creating files, and buying supporting programs or manuals. These investments may make them reluctant to switch to a rival’s effort.

Similarly, firms that seem dominant but that don’t have high switching costs can be rapidly trumped by strong rivals. Netscape once controlled more than 80 percent of the market share in Web browsers, but when Microsoft began bundling Internet Explorer with the Windows operating system and (through an alliance) with America Online (AOL), Netscape’s market share plummeted. Customers migrated with a mouse click as part of an upgrade or installation. Learning a new browser was a breeze, and with the Web’s open standards, most customers noticed no difference when visiting their favorite Web sites with their new browser.

It is critical for challengers to realize that in order to win customers away from a rival, a new entrant must not only demonstrate to consumers that an offering provides more value than the incumbent, they have to ensure that their value added exceeds the incumbent’s value plus any perceived customer switching costs (see Figure 2.4). If it’s going to cost you and be inconvenient, there’s no way you’re going to leave unless the benefits are overwhelming.

Data can be a particularly strong switching cost for firms leveraging technology. A customer who enters her profile into Facebook, movie preferences into Netflix, or grocery list into FreshDirect may be unwilling to try rivals—even if these firms are cheaper—if moving to the new firm means she’ll lose information feeds, recommendations, and time savings provided by the firms that already know her well. Fueled by scale over time, firms that have more customers and have been in business longer can gather more data, and many can use this data to improve their value chain by offering more accurate demand forecasting or product recommendations.

Differentiation

Commodities are products or services that are nearly identically offered from multiple vendors. Consumers buying commodities are highly price-focused since they have so many similar choices. In order to break the commodity trap, many firms leverage technology to differentiate their goods and services. Dell gained attention from customers not only because of its low prices, but also because it was one of the first PC vendors to build computers based on customer choice. Want a bigger hard drive? Don’t need the fast graphics card? Dell will oblige.

Technology has allowed Lands’ End to take this concept to clothing. Now 40 percent of the firm’s chino and jeans orders are for custom products, and consumers pay a price markup of one-third or more for the tailored duds.J. Schlosser, “Cashing In on the New World of Me,” Fortune, December 1, 2004. This kind of tech-led differentiation creates and reinforces other assets. While rivals also offer custom products, Lands’ End has established a switching cost with its customers, since moving to rivals would require twenty minutes to reenter measurements and preferences versus two minutes to reorder from LandsEnd.com. The firm’s reorder rates are 40 to 60 percent on custom clothes, and Lands’ End also gains valuable information on more accurate sizing—critical because current clothes sizes provided across the U.S. apparel industry comfortably fit only about one-third of the population.

Data is not only a switching cost, it also plays a critical role in differentiation. Each time a visitor returns to Amazon, the firm uses browsing records, purchase patterns, and product ratings to present a custom home page featuring products that the firm hopes the visitor will like. Customers value the experience they receive at Amazon so much that the firm received the highest score ever recorded on the University of Michigan’s American Customer Satisfaction Index (ACSI). The score was not just the highest performance of any online firm, it was the highest ranking that any service firm in any industry had ever received.

Capital One has also used data to differentiate its offerings. The firm mines data and runs experiments to create risk models on potential customers. Because of this, the credit card firm aggressively pursued a set of customers that other lenders considered too risky based on simplistic credit scoring. Technology determined that these underserved customers not properly identified by conventional techniques were actually good bets. Finding profitable new markets that others ignored allowed Capital One to grow its EPS (earnings per share) 20 percent a year for seven years, a feat matched by less than 1 percent of public firms.T. Davenport and J. Harris, Competing on Analytics: The New Science of Winning (Boston: Harvard Business School Press, 2007).

Network Effects

AOL’s instant messaging client, AIM, has the majority of instant messaging users in the United States. Microsoft Windows has a 90 percent market share in operating systems. EBay has an 80 percent share of online auctions. Why are these firms so dominant? Largely due to the concept of network effectsAlso known as Metcalfe’s Law, or network externalities. When the value of a product or service increases as its number of users expands. (see Chapter 6 “Understanding Network Effects”). Network effects (sometimes called network externalities or Metcalfe’s Law) exist when a product or service becomes more valuable as more people use it. If you’re the first person with an AIM account, then AIM isn’t very valuable. But with each additional user, there’s one more person to chat with. A firm with a big network of users might also see value added by third parties. Sony’s PlayStation 2 dominated the prior generation of video game consoles in large part because it had more games than its rivals, and most of these games were provided by firms other than Sony. Third-party add-on products, books, magazines, or even skilled labor are all attracted to networks of the largest number of users, making dominant products more valuable.

Switching costs also play a role in determining the strength of network effects. Tech user investments often go far beyond simply the cost of acquiring a technology. Users spend time learning a product; they buy add-ons, create files, and enter preferences. Because no one wants to be stranded with an abandoned product and lose this additional investment, users may choose a technically inferior product simply because the product has a larger user base and is perceived as having a greater chance of being offered in the future. The virtuous cycle of network effectsA virtuous adoption cycle occurs when network effects exist that make a product or service more attractive (increases benefits, reduces costs) as the adopter base grows. doesn’t apply to all tech products, and it can be a particularly strong asset for firms that can control and leverage a leading standard (think Apple’s iPhone and iPad with their closed systems versus Netscape, which was almost entirely based on open standards), but in some cases where network effects are significant, they can create winners so dominant that firms with these advantages enjoy a near-monopoly hold on a market.

Distribution Channels

If no one sees your product, then it won’t even get considered by consumers. So distribution channelsThe path through which products or services get to customers.—the path through which products or services get to customers—can be critical to a firm’s success. Again, technology opens up opportunities for new ways to reach customers.

Users can be recruited to create new distribution channels for your products and services (usually for a cut of the take). You may have visited Web sites that promote books sold on Amazon.com. Web site operators do this because Amazon gives them a percentage of all purchases that come in through these links. Amazon now has over 1 million of these “associates” (the term the firm uses for its affiliatesThird parties that promote a product or service, typically in exchange for a cut of any sales.), yet it only pays them if a promotion gains a sale. Google similarly receives some 30 percent of its ad revenue not from search ads, but from advertisements distributed within third-party sites ranging from lowly blogs to the New York Times.Google Fourth Quarter 2008 Earnings Summary, http://investor.google.com/earnings.html.

In recent years, Google and Microsoft have engaged in bidding wars, trying to lock up distribution deals that would bundle software tools, advertising, or search capabilities with key partner offerings. Deals with partners such as Dell, MySpace, and Verizon Wireless have been valued at up to $1 billion each.N. Wingfield, “Microsoft Wins Key Search Deals,” Wall Street Journal, January 8, 2009.

The ability to distribute products by bundling them with existing offerings is a key Microsoft advantage. But beware—sometimes these distribution channels can provide firms with such an edge that international regulators have stepped in to try to provide a more level playing field. Microsoft was forced by European regulators to unbundle the Windows Media Player, for fear that it provided the firm with too great an advantage when competing with the likes of RealPlayer and Apple’s QuickTime (see Chapter 6 “Understanding Network Effects”).

What about Patents?

Intellectual property protection can be granted in the form of a patent for those innovations deemed to be useful, novel, and nonobvious. In the United States, technology and (more controversially) even business models can be patented, typically for periods of twenty years from the date of patent application. Firms that receive patents have some degree of protection from copycats that try to identically mimic their products and methods.

The patent system is often considered to be unfairly stacked against start-ups. U.S. litigation costs in a single patent case average about $5 million,B. Feld, “Why the Decks Are Stacked against Software Startups in Patent Litigation,” Technology Review, April 12, 2009. and a few months of patent litigation can be enough to sink an early stage firm. Large firms can also be victims. So-called patent trolls hold intellectual property not with the goal of bringing novel innovations to market but instead in hopes that they can sue or extort large settlements from others. BlackBerry maker Research in Motion’s $612 million settlement with the little-known holding company NTP is often highlighted as an example of the pain trolls can inflict.T. Wu, “Weapons of Business Destruction,” Slate, February 6, 2006; R. Kelley, “BlackBerry Maker, NTP Ink $612 Million Settlement,” CNN Money, March 3, 2006.

Even if an innovation is patentable, that doesn’t mean that a firm has bulletproof protection. Some patents have been nullified by the courts upon later review (usually because of a successful challenge to the uniqueness of the innovation). Software patents are also widely granted, but notoriously difficult to defend. In many cases, coders at competing firms can write substitute algorithms that aren’t the same, but accomplish similar tasks. For example, although Google’s PageRank search algorithms are fast and efficient, Microsoft, Yahoo! and others now offer their own noninfringing search that presents results with an accuracy that many would consider on par with PageRank. Patents do protect tech-enabled operations innovations at firms like Netflix and Harrah’s (casino hotels), and design innovations like the iPod click wheel. But in a study of the factors that were critical in enabling firms to profit from their innovations, Carnegie Mellon professor Wes Cohen found that patents were only the fifth most important factor. Secrecy, lead time, sales skills, and manufacturing all ranked higher.T. Mullaney and S. Ante, “InfoWars,” BusinessWeek, June 5, 2000.