LIGHTHEARTED (AND IN SEARCH OF FOOTWEAR), WE TAKE TO THE OPEN ROAD
After an economics conference in Boston, the three of us—all business professors—had a bit of time to kill before our flights home, so we decided to hit the road. Mike had never set foot in Maine, so for kicks we drove an hour north on I-95, stopping for a wicked good lunch at Bob’s Clam Hut just over the state line. Figuring a walk might help us digest our deep-fried seafood, we wandered into a shoe store just across from the restaurant. We weren’t looking to buy shoes, but the sales staff insisted on asking us repeatedly whether we might want to try something on. Scott, who likes his solitude, asked a salesman why he was being so insistent even after having been told “no, thanks” a couple of times. The salesman, later joined by the manager and all of the rest of the store’s employees, proceeded to describe in amazing detail the store owner’s “secret shopper” program, in which employees can be marked down if they are not sufficiently persistent when working with customers. Paul and Mike soon wandered over, and the three of us began asking the shoe store’s team all sorts of questions about topics we teach to MBA students—sales incentives, relationships with suppliers, product differentiation, and competition. It was twice as educational as the conference we had just attended, and the conversation extended so long that we had to exceed the speed limit to get back to Boston for our flights. This chance conversation allowed a sneak peek into the workings of a small establishment, and, to us, it was thoroughly exhilarating.
We are economists and professors who have been teaching business strategy classes to MBA students for years. Paul Oyer, a professor at Stanford, is slim with thinning blond hair and could—in the movie version of our lives—be played by Police front man Sting, perhaps with makeup to make him a bit Jewish-looking. The oldest member of our group, Paul spent a few years in the so-called real world before starting work on his economics PhD, and he is also most likely to tell, and perhaps retell, a joke that isn’t very funny.
Scott Schaefer, a professor at the University of Utah, is not quite short but definitely not tall and has a full head of brown hair; imagine a casting of Jason Alexander (George from Seinfeld) in a bushy wig. Scott fancies himself a lovable curmudgeon, which Mike and Paul agree is about half right.
Mike Mazzeo, bespectacled with close-cropped hair and a quick sense of humor, is a professor at Northwestern University. Mike is the youngest and most impressionable of our group and has yet to meet a fad diet he was unwilling to try. As far as Paul and Scott can tell, Mike’s only character flaw is a lifelong devotion to the New York Yankees; think Ben Stiller with a Derek Jeter complex.
We all started our professorial careers at Northwestern University’s Kellogg School of Management; Scott arrived in 1995 after completing a PhD at Stanford, Paul a year later from Princeton, and Mike from Stanford in 1998. Finding many shared interests—baseball, beer, dogs (canines, not frankfurters), and, of course, economics—we became friends through our publish-or-perish days as assistant professors, and remained close even after Paul left for California in 2000 and Scott for Utah in 2005.
Over the years, we’ve taught thousands of MBAs at leading business schools. A majority of our students have gone on to work for (or consult with) large companies, so our classes have tended to focus on strategic issues facing big business. We’ve taught cases about Intel, Southwest Airlines, Procter & Gamble, Nordstrom . . . the list is pretty long.
Our unplanned visit to a Maine shoe store made us realize that the strategic challenges that small businesses face are just as rich and compelling as anything being discussed inside Six Sigma redoubts like General Electric. And the knife cuts both ways: the MBA tactics and tenets we teach would, we think, be just as valuable in the hands of a small business owner as they are in the hands of a Kraft brand manager or a Bain consultant.
To us, this meant just one thing . . .
Fast-forward a year: Mike’s and Paul’s marriages had just ended, and Scott’s—unbeknownst to him at the time—wasn’t going well.
“Hey guys, I have an idea I want to bounce off you,” Scott began the conference call. “Remember last December, when we went to that shoe store in Maine?”
“How could I forget? I learned more there than I did in five years of graduate school,” said Mike, always the quipper.
“I keep wishing I could go back and get data on their compensation plans,” Paul added. (And yes, this is exactly the sort of thing economists lie awake at night thinking about.) “I probably discussed fi examples from that shoe store when I was teaching a Strategic Human Resources Management course this year.”
“I know, I can’t stop thinking about it either,” Scott said, with a passion he normally reserves for occasional anti-Yankee diatribes. “Suppose we try to do that again, and again, and again. How do you think your courses would be different if you had examples from ten or fifteen businesses like that?”
“That could be interesting,” Mike said, “but we only see each other at conferences once or twice a year.”
“Right,” Scott said. “So we take a road trip, just for this. Suppose we find a week this summer where neither of you has your kids and hit the road in search of interesting small businesses?” “This is either the best idea you’ve ever had, or the worst,” Paul commented. “I’m not sure which. How do you think we’ll find interesting businesses, and how do we get them to talk to us about strategic challenges?”
“Well, I’m not exactly sure,” Scott admitted. “But look at it this way—if the businesses are boring or we can’t get people to open up, at least you get a road trip out of the deal. What states haven’t you been to?”
Paul religiously tracks which states he’s visited (which a lot of people do) and also states where he’s spent the night (which is a little weird). “I’ve never spent the night in Missouri or North Dakota.”
“Missouri it is,” Scott asserted, having spent a few too many uncomfortable nights on the couches of his North Dakota extended family.
“Guys, there might be a book to be written here,” Mike interjected. “We collect examples from the road of interesting strategic problems facing small businesses, then show how the frameworks we teach in our MBA classes apply. I bet the average small business owner could really benefit from a dose of strategic reasoning; it’d be a great introduction for business owners who haven’t done an MBA, and a solid refresher for those who have.”
“Like Economics of Strategy, but applied to small business?” Scott said, shamelessly plugging the textbook he co-authored.
“Uhhhh, sure,” said Mike, “but maybe not so heavy on the math?”
“We’ll call it The Roadside MBA!” Paul exclaimed.
“OK, I’ll check about taking a week away from my family this summer, and you guys check your parenting schedules. Compare notes in a week?” Scott said.
“Sounds good,” Mike responded.
“If we take US Highway 59, we can go from Missouri to Dakota!” Paul exclaimed, glancing up from Google Maps. “You’re on your own for North Dakota, pal,” Scott replied. And our project was born.
What Do Three Egghead Economists Know About Running a Business, Anyway?
Why, given our backgrounds as economics PhDs, would leading business schools ask us to teach classes on strategy? Isn’t economics all that stuff about money supply and inflation and where the stock market is going? And what does that have to do with business strategy?
We three are what’s known in the trade as micro-economists. We get down in the nitty-gritty. We don’t forecast economic growth or future unemployment trends; instead, we apply economic reasoning to the study of companies, individuals, and markets. Mike’s PhD dissertation, a data-driven study of how rural interstate motels differentiate themselves from local competition, grew out of his own on-the-road observations when driving from New York State to California to begin graduate school. Paul’s thesis on how quota-based employee compensation plans contribute to the seasonality of corporate earnings stemmed from his post-college jobs at 3Com and Booz Allen. While working in the real world, he was often frustrated with coworkers and clients who were more focused on quarterly targets than on long-term value. And Scott’s dissertation, which examined the forces that make organizational change so difficult, foreshadowed his own later attempts to re-engineer the University of Utah’s School of Business while serving as associate dean. With just those three topics—one study of how companies compete in product markets, one looking at how companies structure pay for employees, and another of how companies can organize for success—we’ve covered much of what keeps business people up at night.
Our years of applying economic reasoning to strategic questions have led us to a pretty simple philosophy of business strategy, one that Mike has so repeatedly emphasized in his classes that we named it after him.
The answer to every strategic question is “It depends.”
The trick is knowing what it depends on.
If the answer to a question isn’t “It depends,” then it’s not a strategic question.
To illustrate what we mean, consider the question of whether a small business entering a new market should try to offer a high-quality or a low-quality product (relative to competitors). While one might reflexively answer “high quality is better,” it’s certainly not the case that companies selling higher-quality products are always more successful. To draw a familiar example from the Fortune 100: Walmart doesn’t compete on quality, they compete on price, and they’ve identified a huge market of price-sensitive consumers who are very receptive to their offerings. Apple Inc.’s success story is the polar opposite—their products are never at the low end of the price spectrum, but Apple became the world’s most valuable company by offering the highest available quality in the user experience. So, to a small business owner—should you act like a mini Walmart or a mini Apple? The answer, says Mazzeo’s Law, is that it depends on the particulars of your company and its market.
In the chapters to come, we describe many interesting strategies that we heard about on the road, but we caution against simply copying the ones that worked. We think it’s never enough to know that something worked; you need also to understand why it worked. Only then can you unpack the “it depends” and figure out if it will work for you. If that sounds complicated, well, we suppose it is. But none of the small business owners we talked to would describe their challenges as simple. The economic frameworks taught in leading MBA programs can help structure your thinking in the face of this complexity, and guide you to better decisions.
One final note about economics: If you took a high school or college economics class, and don’t remember loving it . . . don’t worry. We followed Mike’s advice and took out all the math. (No graphs, either!)
The Division of Labor
What is it like to drive across America in a rental car with economists for the better part of a week? We hear you groaning, but it’s really not that bad. After shifting roles a bit early on, we settled into a good routine by our third trip. Scott (the mopheaded George) drives while Paul (the kosher Sting) rides shotgun. The two bicker like an old married couple, with most fights breaking out over Paul’s navigational skills. Somehow we manage to get lost quite a bit despite planning our routes carefully months in advance and having three GPS-equipped smartphones in the car. Paul blames Scott and Scott blames Paul, and Mike (Ben Stiller in a Yankees cap) secretly agrees with each when the other is out of earshot.
Mike rides in the back and has taken the role of audio technician. As Scott drives to our next company visit, Mike transfers the sound file from our last interview to his laptop, which gives him a good excuse to tune out the argument in the front seat. (Scott: Where the heck are we now, Magellan?)
To Paul’s frequent delight and Mike’s constant chagrin, Scott as driver controls the radio, which we turn up on our evening city-to-city drives after rehashing the day’s meetings. Boston, Kansas, and Sweet Home Alabama are more than just words on a highway sign to Scott. He and Paul are known, at times, to sing along with the likes of Journey and Foreigner, and argue about whether that last track was Boz Scaggs, Eddie Money, or Billy Squier. Mike, whose musical tastes are less refined, puts on headphones and tries to stream the Yankees game.
Planning a Roadside MBA trip is a group activity. We confer four or five months in advance to find a week when we’re all free of various obligations. Then we negotiate over a good route, with each of us making proposals until a consensus winner emerges. Guided by Mike’s desire to revisit some of the motels from his dissertation research and Scott’s interest in offthe-beaten-path travel writers like William Least Heat-Moon, Neil Peart, and Dayton Duncan, we decided early on to stay (mostly) out of the big cities. So a good proposal involves two airports with four small cities or big towns in between.
Plan agreed upon, we gather at the first airport Sunday afternoon, motor that evening to our first town, meet with businesspeople all day Monday, then drive, usually around 150 miles, to the next town. Restaurant decisions rotate through the group, and dinner frequently consists of beer and something fried that our ex-wives would have discouraged us from eating back when we were married. For lodging, Mike and Paul often try to outdo each other by finding something with charm or character. Scott, however, actively dislikes both charm and character, preferring Holiday Inn Express. Scott has vetoed the entire bed-and-breakfast segment ever since an unsuspecting B&B owner in Ohio tried to engage him in conversation before he had finished his coffee. We hope she’s OK.
But hey, enough of our yakkin’ . . . Let’s hit the road!
Scaling a Business
Paul’s concerns about whether we’d be able to find interesting small businesses vanished right at the start of our first trip. We met in Memphis, Tennessee, on a summer Sunday morning, and spent the day being tourists. We re-enacted the classic Spinal Tap scene at Elvis’s grave, watched a hazy sunset with the ducks atop the Peabody Hotel, and popped Prilosec at
10:00 p.m. to counteract the horrifically bad BBQ platter we’d shared at a tourist trap on Beale Street.
We woke Monday to bright sunshine and grabbed a quick Holiday Inn Express breakfast. Hopping in our rented Dodge Charger, we headed northwest on US 63 to Jonesboro, Arkansas. Perched on Crowley’s Ridge, a narrow band of hills rising above the flat and humid Mississippi River plain, Jonesboro boasts a population near 70,000. Arkansas State University, with plenty of newish academic buildings and dormitories, dominates the east side of town, and Stadium Boulevard was alive with dozens of newly constructed strip malls to serve a growing student population. Main Street, quieter with upscale restaurants in old brick buildings, sat a mile west of campus.
We were so excited to be out on the road that Paul and Scott were a little surprised when Mike suggested we stop for more coffee. “You didn’t get enough brew at the hotel breakfast nook?” Scott asked, pointedly.
“Look, we have forty-five minutes until our next meeting. You’d rather just sit in the car?” Mike replied.
Paul navigated to the nearby Starbucks, where we resisted a strong urge to pepper the cashier and barista with business questions while ordering. Paul grabbed his tall coffee and waded through the late-morning crowd to a tiny round table near the front window. “Shouldn’t we be at a hip independent coffee shop?” he asked after we had gathered. “I thought we were professors in search of small business stories.”
“I’d say ‘hip’ is not a word that suits us,” Mike quipped. “We’re probably better off here.”
“Cool people make me uncomfortable,” Scott added, nodding.
The conversation quickly turned back to business (and away from our personal insecurities) as we contemplated how Starbucks has done it. It was, after all, a hip independent coffee shop at one time—one that grew to tens of thousands of outlets worldwide. This kind of success represents the promise and possibility of small business with aspirations for growth, and the Starbucks story began to frame our thinking about the companies we were planning to visit. Does this business have what it takes to expand, or are there factors present that will inherently limit its growth? What can companies do to grow effectively, and what pitfalls should they try to avoid? While it’s not clear that we ever met with the next Starbucks, we did find many interesting companies that scaled up in creative ways. Others, however, struggled to grow despite having considerable success at a limited scale. An important Mazzeo’s Law question for any small business owner is this: What does successful growth depend on?
BRACES BY BURRIS DENTAL PRACTICE
Expand by Centralizing Common Activities to Lower Costs
Suitably caffeinated, we finished our crosstown Jonesboro jaunt and arrived at Braces by Burris, where we met with office manager Shawna Starnes. We were initially confused: The address indicated a white building in a small strip mall that appeared much larger than necessary for an orthodontist’s office. When we went inside, we didn’t see a lobby with nervous preteens waiting for their appointments as we had expected. Instead, there was a vast glassed-in area with cubicles surrounded by small offices.
“Welcome to the mother ship!” Shawna announced in greeting. Tall, slender, and wearing a stylish white pants suit, Shawna would fit right in as a recurring character on the hit TV show Nashville. We settled into her office for our interview, about to get a lesson in Arkansas geography.
“In addition to this, we have a practice in West Memphis that was purchased from an orthodontist there who was retiring,” Shawna began in an energetic drawl. “We also opened a location in Forrest City. We have opened a practice in Blytheville. All these are about sixty miles from Jonesboro.”
This list continued throughout the first fifteen minutes or so of our interview with Shawna. Over the past several years, Dr. Burris had increased the size of the practice by opening locations in new geographic areas and by opportunistically purchasing practices from doctors in other cities.
“Dr. Burris also bought a practice in 2007 from a doctor in Hot Springs, and that’s our Central Arkansas practice. We have since opened three locations there as well.”
By the time she was finished, Shawna had reeled off a total of eleven individual towns where the Burris team of orthodontists was present. It turned out that the Braces by Burris establishment we were visiting was the company’s main location and the centralized hub that was coordinating activities throughout the region. Most of the towns that Burris has expanded into are relatively small, and the locations do not need to be open every day.
“We travel to the other locations on a rotating schedule,” Shawna continued. “We’re actually in the process of transitioning from two to three traveling teams—each team has two assistants along with someone to greet patients. We’ll have different orthodontists rotating into each of the different locations with different teams.
“Some of our days are long. Everything operates out of the Jonesboro location. We do have some equipment and tools on site, but for the most part we travel with our supplies. So, we load up in vans, and everyone leaves from here to go to our other sites. When we go to West Memphis or Blytheville or any of those locations, we’ll start up at 7:15 and we might not get back ’til 6:15 or 6:30.”
“And what happens here?” Mike asked.
“This location is our administrative office,” Shawna replied. “Accounting, IT, HR. Billing, payments, and our call center are here. We have five people who answer the phones fulltime. There are local numbers, but everything rings here. All the phones are answered the same way.”
The Burris team grew by recognizing that while people don’t want to travel too far to visit their orthodontist, the task of providing care requires little more than a small reception area and a couple of rooms where patients are seen. These stripped-down offices are very inexpensive to operate. The key to making a collection of satellite locations run smoothly is an efficient centralized hub that handles all of the support services for every location. Since billing and insurance are centralized, Braces by Burris saves a substantial amount by not employing someone at each individual office to manage these tasks. The practice has grown, in part, through serving state-funded Medicaid patients—Arkansas is one of the few states where Medicaid pays for orthodonture. Reimbursement requires state licensure and much navigating of bureaucratic red tape, which Burris’s centralized system is well equipped to handle.
By utilizing its central office function across many satellite locations, Braces by Burris is employing the first principle of profitable growth: identifying and exploiting “economies of scale.” Economies of scale exist if a company becomes more efficient as its unit volume (that is, its scale) increases. Three cost definitions are critical to understanding this concept. The first is average cost, which is simply the company’s total cost divided by the number of units that it produces. Second is fixed cost, which are those costs a company incurs no matter how much it sells. Fixed costs typically include things like the rent on a building, the cost of equipment, and the price of a business license obtained from the state. The activities performed in the central office in Jonesboro largely represent fixed costs for Burris. Variable costs, our third definition, are those costs that a company must incur when it wants to produce additional output. At many businesses, inputs are important variable costs—an automobile manufacturer has to purchase four more tires for every car it sells. However, in some companies, variable costs can be quite low; Microsoft, for example, incurs very little additional cost when it sells another copy of the Office software package. Because it can utilize all the administrative functions in the central office, Burris’s variable costs of operating its satellite locations are low.
It is precisely when fixed costs are high relative to variable costs that economies of scale are likely to be present. The logic is simple division: Total fixed costs remain constant as quantity increases, so the fixed cost per unit quantity falls. And when economies of scale are strong, growth leads to higher profits for two reasons: Quantity goes up and average costs go down. Imagine a scenario where you can increase your company’s unit volume and earn a higher margin on each unit; any small business would jump on an opportunity like that.
Braces by Burris exploits economies of scale by centralizing back-office activities, and also in how it holds and tracks inventory—the metal brackets and wires that orthodontists implant in the mouth to straighten a patient’s teeth. Shawna explained: “It is cost effective to keep the brackets and wires together in a single, central location. There’s any number of different sizes of brackets—literally hundreds of inventory items. And we wouldn’t want to stock every one of those hundreds of items in each location. It wouldn’t be efficient to keep up with that inventory at every remote site where we go.”
Over time, Braces by Burris has built up a system whereby it can effectively grow by expanding its practice into new locations without incurring too much in the way of additional costs. This allows the company to spread fixed costs over a larger and larger customer base and leads to powerful economies of scale.
Paul wondered aloud how far the Burris orthodontics empire might expand.
“One of our practices, in fact, is located about four hours from here,” Shawna replied. “It is so small that we only go there once a month. We load up our plane and head down . . .”
It took Scott a minute to catch up. “Wait, did you say a plane? As in . . . airplane?”
“Yes. Dr. Burris himself flies. Once a month the team heads down to Central Arkansas on our plane. It’s nice. It’s very nice!!”
We certainly had not anticipated talking to an orthodontist’s office with a corporate airplane!
Centralizing operations and sharing fixed costs are very important for Braces by Burris: By using the satellite office system, the Burris team can profitably operate in locations where a stand-alone orthodontist would fail. At the same time, the patients at these additional locations add up, ultimately producing greater overall efficiencies and growth for the business.
Denver, North Carolina
STEELE RUBBER PRODUCTS, INC.
Ensure That Revenue Opportunity Exceeds Fixed Costs
On a subsequent trip, we visited the community of Hickory, North Carolina, in the Piedmont region about an hour northwest of Charlotte. For many years, economic activity in Hickory centered on furniture manufacturing, taking advantage of the thick forests and ample transportation nearby. Though a good portion of that manufacturing has moved overseas, the city still draws over half a million visitors per year to its massive four-level Furniture Mart, with over one hundred showrooms and outlets. The local economy has diversified and now hosts a broad range of manufacturing and corporate employers, along with massive data centers from Apple, Google, and Facebook. After a lovely drive through winding forested hills from Hickory proper to the neighboring town of Denver (North Carolina), we met Matt Agosta, the president of Steele Rubber Products, Inc. We sat down at a small conference table in the office adjacent to the factory floor to talk to Matt, a sturdy man in his early sixties who wore a gray goatee and a maroon work shirt bearing the company logo.
Steele began in 1958 just outside Detroit, Michigan. Matt’s father-in-law founded the company, which focused mainly on tool making to support the local automobile industry. He was also a vintage car collector and used the tools in his shop to make molds that could be used to fashion rubber parts and weather stripping. This is important to collectors because rubber parts become brittle as cars age. Over time, in partnership with a nearby rubber manufacturer, he produced these specialized rubber parts for friends in his vintage car clubs and eventually started offering them for sale to the public. With the oil crisis of the 1970s, demand for automotive tooling dried up, but the need for restoration parts grew. Steele decided to focus on the latter, making the move to North Carolina to take advantage of the warmer weather and a friendlier business climate. This is where Matt would eventually take over the business.
“When you look at a car,” Matt explained, “it’s amazing how many rubber pieces there are. You’ve got rubber parts that go around the glass to seal it, rubber that goes on a running board, rubber mounts for the engine to sit on . . . Just about anywhere you have a light assembly sitting on a fender, there’s a pad.” As cars became more complex through history, the number of rubber parts increased substantially. Matt estimated that there were only about a dozen rubber parts on a classic Ford Model T, but, on a 1941 Cadillac, there might be three to four thousand dollars’ worth of rubber pieces.
In describing the business—and the choices Matt needs to make to run the business effectively—one phrase came up over and over: “All the cost in the business is up front.”
In other words, the company can’t generate new streams of income without substantial initial investment.
This economic reality is the consequence of how Steele manufactures the replacement rubber parts. The process begins with a very important decision: Which particular model of classic car is Steele going to start manufacturing and selling rubber parts for?
“We are making parts for Pintos—that’s probably one of the most unusual ones.”
Mike had an extended flashback to his own childhood, being crammed along with his three sisters into his father’s car. “We had a Pinto growing up. A red hatchback,” Mike volunteered. “I can’t really imagine anyone restoring and collecting one of those.”
Paul laughed. “Didn’t the Pinto have problems with fires and explosions?”
“Yes.” Matt nodded. “And people ask, ‘Why do you make parts for Pintos?’ But they have a very strong club.”
Once Steele has decided to provide parts for a particular car model, they’ve got to learn what rubber parts are inside the car. “We went and bought a Pinto,” Matt described. “Found it at a local auction. Stripped the parts off of it and reverse engineered them. And then we made the parts to make sure that they’d fit. Tools have to be made for whatever we are trying to copy. Some parts are more than just rubber—they might have metal clips in the ends. They can get pretty complex.”
The tooling process generates a metal mold for each of the 12,000 parts that Steele lists for sale in its catalog across hundreds of makes of car. The custom piece is the mold itself, which then fits into a machine where the rubber is vulcanized by applying heat and pressure to the dense raw material in the mold, forming the finished part. Touring Steele’s facility, we saw a wide-open area where a few workers were quietly but diligently operating the machine tools and forming the new rubber parts. This work zone was lined by a series of tall shelves, which contained the company’s extensive collection of molds that had been fashioned in the past and would be used to produce the actual rubber versions of the replacement parts to sell. Steele keeps a small inventory of the most popular parts on hand, but most parts are made to order. “We can’t do it the mass-produced kind of way,” Matt said, “since everything we do is in small numbers. But if I have the mold, I can make it pretty quick.”
Making the mold represents the fixed cost of producing the part—the up-front investment on which the company will make its future earnings. And for Steele, these costs are substantial; the company must purchase the car, disassemble it, tool up the metal molds, manufacture rubber prototypes, and test fit. Once the molds are made, however, making rubber parts is relatively inexpensive. The additional cost is just the rubber, and these variable costs of producing additional output are small compared to the fixed costs. Strong economies of scale are present, so once Steele has made a mold, it benefits tremendously when more people buy these particular parts.
Since any set of molds can produce rubber parts for only a specific make and model of classic automobile, the decision to add a car to the product line represents a serious commitment. Unlike Braces by Burris, where fixed central-office costs don’t need to be duplicated when satellite locations are opened, Steele incurs substantial new fixed costs when it adds a car to its catalog. Making this decision correctly requires a careful comparison of the costs of producing the molds and the potential market for sales of that car’s parts in the future. To be successful, the company does a good deal of research to estimate what the size of the future restoration market might be before committing to produce a mold.
“We do research and see how many of those cars were made. How well do they sell? And do they have anything else that makes them unusual or collectable or something that people like?” Matt explained. In the case of the Pinto, for example, Matt reported that Ford sold more than two million vehicles in the 1970s, and that demand from collectors remains strong, in spite of (or perhaps because of) the car’s reputation as something of a lemon. If Steele’s research indicates that the potential market is large enough, then a reasonable price can be set to cover the large fixed costs of making the molds and still generate a healthy profit.
The insight here is that to grow profitably, a company needs more than just economies of scale. Along with this feature— which really comes from the underlying manner in which the product or service is produced—it is critical that there is enough demand for that product or service. How much is enough? That depends on the level of the fixed costs. The benefits of economies of scale come from spreading those fixed costs over more sales, so the higher the fixed costs, the more sales you will need. If you build it (and pay the fixed costs of doing so) and they (the customers) don’t come, the efficiencies never materialize.
SILK ESPRESSO CAFÉ
Expand Only Where Resources Can Be Shared
In our previous examples, we have seen the powerful effect that economies of scale can have on profits as businesses grow.
Mazzeo’s Law, however, suggests that some companies will be better able to exploit economies of scale to expand their businesses than others. We saw two wonderful examples of the “it depends” of growth and scale when visiting a pair of seemingly similar food service operations—an Oregon coffee shop and a grill and bar headquartered in Mississippi. Their different experiences highlight the challenges associated with growth and can help guide your thinking on when expansion is a good idea.
While Mike was a coffee enthusiast during our day in Jonesboro, Arkansas, he had quit his six-cups-a-day habit— cold turkey—by the time of a subsequent trip to the Pacific Northwest. “I bought a juicer,” Mike explained excitedly. “You guys should try celery juice with carrots, beets, and kale. It’s amazing.”
Paul and Scott stared open-mouthed as if Mike had said he was giving up his urbane Chicago apartment to live in a yurt. This was but one of several forays into “healthy eating” for Mike, who always seemed to be on some regimen or another. On one trip, he stuffed his briefcase with small Ziploc bags full of nuts and carrots that he ate instead of lunch. Another trip featured a detox plan called “The Clean.” But coffee? This was as important a fuel as gasoline on Roadside MBA trips, and Paul and Scott soon determined that they didn’t necessarily prefer the decaf version of Mike.
It was no help that we had scheduled a visit with an independent coffee shop. On a late afternoon in Gresham, Oregon, we pulled into a nondescript strip mall where we met with Silk Espresso owner and coffee aficionado Leah McMahon. A former varsity basketball player at Oregon State, Leah was now in her thirties but, with her straight brown hair and large silver leaf-shaped earrings, she would not have looked out of place on a college campus.
Though Leah told us that Gresham was part of the more rough-and-tumble “Eastside” of the Portland metro area, the atmosphere in the coffee shop belied that image. The décor was welcoming, and the Food Network was playing on the flat-screen television hanging on the wall. Both the clientele and the staff were very professional in their appearance and manner.
“We named the company based on what we wanted the end-user experience to be. We didn’t just call it ‘Cotton Espresso’ or any other textile. It’s silk. It’s high level. It’s upper echelon. We want the experience to be beyond what you were expecting.”
True enough, Leah proudly reported that Silk Espresso had won a string of awards from the local press during the six years she had been in business. “I think we’re up to seven awards now—Best Espresso, Best Café . . .” After having been, in her words, “spit out of the corporate world,” Leah had certainly found her calling in the high-quality segment of the coffee market.
As we discussed the retail coffee business further, it became obvious that business survival requires dealing with the competition, specifically “the green giant up the road,” as Leah put it. “If we can come up with ways to be cool and relevant for a particular generation, the green giant isn’t so powerful. We are thankful for them because their marketing affects us positively. We want to piggyback on that and say to customers, ‘If you want award-winning, locally made, locally owned, locally operated coffee, we’re right up the road.’ We focus on questions like ‘Are we worthy of Best Espresso?’ and ‘Are we worthy of Best Barista?’ And we’ve been fortunate to be recognized.”
While not quibbling with results, we were still puzzled. Mike pressed Leah for details: “What are the concrete steps you take to beat Starbucks on quality?”
“Are you coffee drinkers?” Leah asked impatiently, clearly a bit flummoxed by our ignorance and unaware of Mike’s recent conversion. We were about to get a lesson in fine coffee from a pro’s pro.
“OK, let me explain a little bit about coffee to you,” she began.
Leah proceeded to describe a long list of factors that could affect the quality of an espresso drink. “Coffee has different things that can change it. Drastically. Some of the catalysts are temperature, humidity, and weather. The preparation of it— whether you’re putting the espresso in the cup within fifteen seconds of its coming out of the machine. Are your beans coming from the right place? Are they stored properly? Are they ground properly? Is the temperature of your water correct? Are you double-filtering it?”
Silently, Paul and Scott wished that one-one-hundredth of this level of effort had been put into the motel coffee they had drunk earlier, while Mike wondered how temperature and humidity might be affecting his juicer.
“If all those hoops have been jumped through, then the finished product is good.”
“OK, so how do you make it all happen?” Scott asked.
“The training is a big part of it,” Leah replied. “It starts out with the fact that I am almost always here. There’s always someone here who has the passion of an owner, who’s hand-on. The end result is the highest quality.”
“How much of your time is spent here at the store?” Paul asked.
Leah thought for a moment. “This is our lifestyle. I’m the opener, and my days go best if I get here at 4:45 a.m. On a good day I go home around 4:00 p.m., on a bad day, maybe sixish. I’m always on.”
With so many steps necessary to produce the highest level of quality, it’s important that Silk Espresso’s owner is capable of incredible attention to detail. Indeed, Leah was among the most dedicated, hands-on owners that we visited on all of our road trips, and her extreme involvement is necessary, given the value proposition to consumers and how difficult it is to accomplish.
This is the kind of business model that, while very successful at a small scale, faces strict limits to growth. Silk Espresso had a large following of devotees and a great brand name in the community, so you might think these facts could support the opening of several outlets across Portland’s Eastside suburbs. And in fact, Silk Espresso had grown to as many as four locations at one point.
But that put a huge burden on Leah since she needed to closely supervise operations at all four outlets to be successful. It was, of course, nearly impossible to do this effectively, and Leah was overwhelmed by trying to be everywhere at once. She likened a four-store chain of espresso cafés to an “empire.” And so she scaled back. Silk Espresso is now back down to the single location in Gresham that we visited.
A key point here is that Leah’s direct involvement is an essential resource for business success at Silk Espresso. Growth is inhibited because, unfortunately, Leah is not a resource that can be easily shared across multiple locations. In contrast, Braces by Burris did find ways to share key resources across locations, by leveraging centralized inventory control, billing, and expertise in Medicaid reimbursement across its various dispersed practices.
MUGSHOTS GRILL AND BAR
Seize Growth Opportunities You Can Monitor Remotely
Since Leah’s struggle with adding Silk Espresso locations was connected to the challenges of scaling up high-quality monitoring, Mazzeo’s Law suggests that successful scaling would be more likely in situations where quality isn’t quite as important or where monitoring isn’t as difficult. This contrast struck us immediately when we visited with Ron Savelle, the fast-talking, sharp-witted owner of a chain of Mugshots restaurants based in Hattiesburg, Mississippi. Ron tended bar at a local outlet of the national dining chain, Chili’s, while a student at the nearby University of Southern Mississippi, and with his friendly manner and dimpled chin, it’s easy to imagine him as the favorite barkeep of every sorority girl in town. We sat with Ron at an outdoor patio, and during our visit he frequently stopped midsentence to chat up a passing customer. He seemed as relaxed as Leah was intense.
After college—Ron said he graduated “a little late”—he and a friend went to Hawaii for six months “to goof off and chase women and have fun.” “Out there,” he continued, “we got the dream to open our own bar. The next January, we bought Mugshots. It was a night venue, crappy building, old and rundown, but it was ours and we loved it. We had made a name for ourselves on the night scene at Chili’s, so people just followed us over, and we were a big hit right off the bat.
“My parents helped us buy the place, but we paid it off in four months,” Ron said. “In August that year, I went up to Starkville, where Mississippi State is located, to see some friends. We went out to a bar, but it was closed and nobody could figure out why. So, five and a half weeks later we started out on our second Mugshots.”
“Five and a half weeks?!?” Paul asked, as Mike and Scott chuckled.
“Yeah, I turned it around fast and within eight months of opening we had our second location,” Ron added. “The Hattiesburg location was doing great, so we were just able to write a check to get it going in Starkville. We thought we’d go up there and do a night business like in Hattiesburg, but it turned into huge lunches and dinners. It was wild. The Starkville restaurant business took off, so we’ve opened every one of them since then as a restaurant. We opened Tuscaloosa the next year. We just finished our ninth year, and we have nine locations now.”
Mike shook his head in disbelief at Ron’s story. “Wait a minute . . . you open a restaurant, and it’s a raging success. You open another one, and it’s a raging success. This is not common.”
“Being in college towns really helped us. When we got to Jackson,” he said in rapid-fire speech, “you’d think it would have taken us forever to build our brand. But so many people in Jackson went to Mississippi State or Southern Miss or Alabama, or their kids went there, or they go there for football games on the weekends . . . Our name was branded very easily. I’ve probably got more money in my pocket right now than I’ve ever spent on advertising.
“If you’re from Mississippi and you don’t know Mugshots,” Ron added, “well, you need to get out more.”
While Mugshots’ market is competitive with many national casual-dining chains such as Applebee’s or Chili’s, Ron has carved out a niche at a somewhat lower price point—which college kids probably appreciate. “Applebee’s PPA (per person average) is probably $12 to $16, and we’re more like $9 to $11. A place like that or Chili’s, they have steaks and ribs. We try to keep it simple, use our hamburger patty and chicken breast as much as we can on sandwiches and salads. We get creative with ingredients, but with not a lot of stock in the back. We came up with the Peanut Butter Burger out on the tailgate of a truck while we were doing a catering job. We had a big jar of peanut butter and just put it on there, and it turned out to be awesome. Peanut Butter Burgers—you want smooth or crunchy?—they’re in every restaurant we got. We sell a couple thousand a week.
“After a few years, my business partner and I decided to split up. I was married by then and starting to have babies, and we had some different ideas on how to do business,” Ron said. “He took the locations in Starkville and Tuscaloosa, and he’s been franchising other locations since. I took Hattiesburg and Jackson, and a year and half later I opened Biloxi and then Baton Rouge. I own all of my four locations.”
“It’s, what, 150 miles to Baton Rouge?” Paul noted, showing a mastery of geography not heretofore seen in our travels. “How do you keep tabs on things? Who makes decisions?”
“I hired Callie. She was my General Manager at Chili’s when I worked there, and I hired her to work under me as an area manager. She goes around to all my stores and keeps an eye on them. She’s in every store every week. Every day she’s on the road, in a different store. She puts in six or seven good hours there.
“So what is Callie doing when she’s on site?” Mike asked. “We have a three-page checklist that Callie goes through.
Picture frames, fans, floors, baseboards, cutting boards, knives, lettuce, down to everything, cooler space. The general manager has the list. Callie mixes up her schedule so they don’t know when it’s coming, but they know it’s coming.”
Ron supplements his checklist with other monitoring technologies that helped him scale Mugshots more efficiently. Operating at a lower price point, it’s critical to keep costs down for Mugshots, and, as it turns out, one of the biggest costs of operating a bar is “beer shrinkage.” Bartenders who take draws off the taps for pretty girls or their buddies (or themselves) can end up putting a large dent in your bottom line. Ron employs a technological solution that allows him to easily monitor this critical activity without being in any one of the restaurants.
“I get alerts on my phone if there’s any suspicious activity. At all my stores we have between 18 and 33 beers on draft. There are microchips in each one of the taps and it tells me on my phone how many ounces of beer they just poured. It’ll tell me if they poured 12 ounces and charged for a 10-ounce beer; it’ll tell me if they poured a 22-ounce Foster’s and charged for a Pabst. It tells me everything.”
Sometimes employees make mistakes, so having this system helps the bartenders stay focused, according to Ron. They know that if they fill a pitcher but don’t ring it up, they will be charged for it. In cases of outright theft, Ron has the information to discipline the offender.
“We had a guy from our monthly pest control. They do it overnight and at five in the morning an alert popped up on my phone. He poured himself a ten-ounce beer. It got him fired.”
The monitoring technology and checklist epitomize why Ron is able to add locations to Mugshots more easily than Leah could for Silk Espresso. Recall that Ron has positioned Mugshots below main competitors like Chili’s and Applebee’s in terms of price point and quality, whereas Silk Espresso needed to maintain higher standards than Starbucks to attract customers. As a consequence, the items that need monitoring at remote locations are simpler and less nuanced—clean floors and crisp lettuce are enough to keep his customers happy. Because these items are straightforward, Ron can put them on a list and send a trusted employee with a clipboard on the road to make sure things are going reasonably well. Plus, if a restaurant runs out of chunky peanut butter and has to use smooth for a couple of days, the college kids looking for cheap burgers and beer probably won’t be disappointed enough to take their business elsewhere.
Leah, on the other hand, devotes hours to training her baristas and needs to keep a close watch on their activities. Pulling an espresso shot is a subtle skill that cannot be easily quantified, unlike the number of ounces of beer drawn from a tap. In economic terms, direct monitoring of activities by someone with a hands-on owner’s mentality is an essential resource for success at Silk Espresso, and she cannot spread this resource across multiple locations as easily as Ron can.
This does not mean, however, that Leah cannot grow her business. Instead, it means she should seek growth opportunities that take advantage of the monitoring activity she is already doing at the flagship Silk Espresso location. Indeed, Leah did grow her business by supplementing coffee with pastries and sandwiches. Not surprisingly, given her attention to detail, she immediately began winning awards for these, too!
“I’ve been very committed to finding a quality product and making sure that it is something that I would serve my family and eat myself. It speaks to how meticulous we are about getting good things in here,” Leah concluded. Her meticulous attention is difficult to extend outside one café, but she is able to manage multiple high-quality services so long as she can keep her eye on them directly.
As we pulled out of the parking lot at Mugshots, our conversation quickly turned to the comparison with Silk Espresso. After covering the deeper economic issues, we got to the menu. “I wonder if Leah’s devotees would go for a peanut butter burger?” Paul joked.
“No way,” Mike asserted. “It would have to be some kind of ‘foodie’ combination. Maybe a peanut butter, portobello, and goat cheese panini?”
“That sounds horrible,” Scott said. “I’d prefer celery juice with beets and quail.”
“Oh, sorry. What’s that?”
Scaling a Business Profitably: What It Depends On
- Economies of Scale: The businesses in this chapter have been able to grow successfully by figuring out how to effectively spread out fixed costs when the business expands. On the surface, there are few notable similarities among these unique businesses, but they all have certain fixed costs that can be shared.
- Adding Low Variable Cost Activities: If the ratio of your fixed costs to variable costs in your business is high, you are in position to grow profitably. The clerical and inventory-related activities that Burris centralized in Jonesboro had sufficient capacity to accommodate even more practices without additional fixed expenditure and with minimal new variable costs.
- Demand: Even with a scalable model on the cost side, it is critical to have enough demand to offset the fixed costs needed to get the business up and running. Steele’s costs of adding a car to its catalog are mainly up front, but they carefully research the market for potential collectors to ensure that they will sell enough rubber parts to cover the costs of making the molds.
- Quality and Monitoring: Silk Espresso’s economies of scale don’t extend to additional locations because high quality was necessary to compete successfully; and maintaining high quality required detailed, passionate supervision. Since Mugshots was competing at a lower price point, procedures and technology could effectively assist with monitoring, and Ron Savelle could profitably operate more locations in his growing chain.
Excerpted from The Roadside MBA by Michael Mazzeo, Paul Oyer and Scott Schaefer. Copyright © 2014 by Michael Mazzeo, Paul Oyer, and Scott Schaefer.
First published 2014 in the US as Roadside MBA by Business Plus, an imprint of Grand Central Publishing. First published in the UK 2014 by Macmillan, an imprint of Pan Macmillan, a division of Macmillan Publishers Limited, 20 New Wharf Road, London N1 9RR, Basingstoke and Oxford. Associated companies throughout the world http://www.panmacmillan.com.
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