The Framework That Changes How You Analyze Any Business

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This week's newsletter is an adaptation from my recent YouTube video on The Consumer Hierarchy of Preferences.

Today, we are going to talk about one of the most powerful frameworks for analyzing a business.

If you understand this framework, I think you will understand how to analyze a business better than 99% of all analysts out there.

The problem is that a lot of times when you are analyzing a business, you're doing it from the business's perspective.

In fact, that is what is usually taught in business school.

You're taught Porter's Five Forces, competitive analysis.

What is the competitor offering?

All of these different things do not get at the crux of why a consumer buys a certain product or service.

And understanding that is critical because that is what is going to dictate whether or not it is a great company ultimately.

It's not because they have moats.

This framework is really focused on the consumer side.

It is focused on why a customer actually buys something.

Because a lot of the time, people are very focused on the value prop, which is what a business offers.

But the real question is: What does the customer want?

This framework helps you analyze what the customer wants with much more detail.

It is called the Consumer Hierarchy of Preferences, and we're going to get into exactly what it is in this newsletter!

Sol Price, Costco, and Rethinking Retail.

First, though, I want to tell a little story to help exemplify why thinking from the customer's perspective is so much more powerful than from the business's perspective.

So for many years, if we rewind 70, 80 years, retail was very different.

It was thought that it was actually important that there was a store clerk there that would give you service and would actually hand you the items, and self-service wasn't the norm by any means.

In addition to that, it was thought that it was critical that the store looks good.

And in fact, there was one entrepreneur who changed a lot of this and changed the way people thought about retail.

That person was Sol Price, who maybe you've heard of his company FedMart and then later Price Club, which was sort of a predecessor to Costco.

One of his great insights, though, was that customers care the most about low prices and getting good quality products, and they're willing to trade off on all sorts of things in order to get those preferences filled.

And so if we fast-forward today and think about Costco, you have stores that are usually pretty far out of the way, usually 30-minute drives, sometimes longer.

You have parking lots that are packed and very crowded.

And then when you get there, the store is entirely barren.

You're literally walking into a warehouse.

The ceiling is not done at all.

The store aisles have pallets of goods on them.

People don't help you pull stuff off the shelf and put it in your cart.

And if you were to describe this sort of store to someone 80 years ago, they would have laughed at you.

They were wrong. They were dead wrong.

In fact, Costco is one of the most popular retailers to shop at, and customers, unlike many other retailers, actually love Costco.

So we have to ask the question, why is that?

Sol Price and later Jim Sinegal with Costco figured out what preferences mattered the most to customers, which in this case was low prices and high-quality goods.

What they were willing to trade off to get those was drive far away, deal with an unfinished store, and even being willing to buy in bulk.

But that is a trade-off people are willing to make if it is low enough priced.

Applying Maslow's Hierarchy to Consumers.

Now, if you know anything about psychology, you maybe have heard of Maslow's hierarchy of needs.

This was a framework created by Abraham Maslow and was designed to help understand human motivational behavior.

It's very often depicted as this pyramid, and there are different lower order desires and higher order ones.

For instance, the first thing that you want in life is food.

Next, you want to socialize.

For example, no one who is really hungry and doesn't have a place to live is that concerned about whether or not they have a vibrant social life.

I took the same idea and just applied it to consumers, to the way people actually purchase things.

What ends up happening when you are buying something is you have a list of all of these preferences that you need to get out of a certain product or service, and once you get a sufficient number of these preferences met, then you purchase the item.

For example, let's say that you are going out to a party tonight and you need a nice shirt.

You go into your closet, you don't have anything that will work at all.

So you go out to a store and you're going to look for a shirt.

Now, you have many preferences that must be fulfilled in order for you to buy that shirt: 1) It has to be in-stock, 2) the shirt needs to look good, 3) it needs to be a dress shirt, 4) the shirt needs to fit, and 5) the shirt needs to be under $100.

So if you find any shirt that meets these five criteria, these five preferences, that store is going to get a sale.

Consumer Surplus.

You may have preferences beyond these five that can or cannot be fulfilled.

So as a sixth preference, maybe you really want it to be machine washable, so you never need to go to a dry cleaner.

Maybe you have a seventh preference too, where if it's a humane brand and they care a lot about the environment and they say that they're zero emission or something, then I'll like the shirt even more.

So you could have multiple preferences beyond what is necessary in order to get you to purchase that item.

But if it turned out that that shirt wasn't $100 and it was really $50 and it was machine washable, then you may really like this brand.

And what we would say is that consumer surplus was created because now you are getting more preferences fulfilled than you would've bought otherwise.

That is roughly what the consumer hierarchy of preferences is.

Competing Desires and Trade-Offs.

Now, your preferences and desires, though, there could be trade-offs in them.

Abraham Maslow never actually depicted his hierarchy of needs with a pyramid because he was cognizant of the fact that there's a lot of trade-offs in the things that you might want.

Let's say you're at some discount outlet, and there's a store with a lot of luxury goods in there.

There might be a jacket that is from Louis Vuitton, and it's a really expensive jacket, usually $8,000, and it doesn't fit your wife quite perfectly, but she may still want it anyway because it's 80% off.

She is willing in this transaction to trade off the fact that it doesn't fit quite perfectly.

It had to be kind of close, and then the style had to more than make up for that.

I sometimes like to think of it as a Thanksgiving plate.

It is a lot like a Thanksgiving dinner plate, where maybe you first go, you get your turkey, you put a little bit of gravy on your plate, you add some mashed potatoes, and you add some yams.

And then you realize your gravy to mashed potato ratio is off, so you grab more gravy.

Then you find out the turkey is really dry, so you go back up and add some more gravy to the plate, and now you're sufficiently satisfied with what you have going on here.

This is kind of more how our internal motivations, our internal desires, move and shift a lot.

So back to the example of the clothing, the person who needs a shirt for tonight, he may be willing to trade off: this is a little bit out of my budget, but I'm willing to go a little bit higher if the style and fit is a little bit better.

Amazon vs Etsy Consumer Preferences.

Now, the critical thing to look for as a business analyst is what preferences are being fulfilled from that product.

If we think about Amazon, Jeff Bezos' insight was that we are going to focus on customer selection, delivery speed, and price.

These are the three preferences we can say that they are most focused on.

He was very explicit with this in his very early investor letters.

Now, we could think about this, though: what if this wasn't the case?

What if it turned out that customers really cared a lot about specialized goods and homemade goods, and they didn't want all of their stuff to be just purchased from China or made by some manufacturer?

Well, that would really be a problem for Amazon, but it'd be a big benefit for Etsy, because Etsy is a marketplace of a lot of handmade goods.

One of the preferences they're fulfilling when people purchase on their site is handmade.

Now, that's not the way history went, of course, because it turns out people don't actually care that much about whether or not something is handmade.

Josh Silverman, who was the CEO of Etsy, kind of figured that out when he took over the business.

Whereas before, they used to brand themselves a lot as being handmade, once he took over, he started transitioning that to being a special sort of purchase occasion.

So what are special purchase occasions?

Well, that could be you're buying gifts for people.

That was them trying to change basically what their value prop was to customers.

Now, ultimately, though, it doesn't just matter what a company offers, which is their value prop.

It matters what the customer wants, the preferences that they're fulfilling.

And it turned out for Etsy, unfortunately, for most purchases, customers do not care about it being special, and they care a lot about delivery speed, and it wasn't good on Etsy.

Etsy cannot fulfill lowest price.

They cannot fulfill fast delivery, and they may have a lot of selection, but selection doesn't matter that much if it's not cheap and the delivery isn't fast.

Chipotle and the E. coli Crisis.

Another example is if we look at Chipotle.

We could say that the preferences Chipotle is fulfilling is something like 1) relatively healthy food, 2) pretty fast, and 3) relatively cheap too.

These are very high order preferences that a lot of people have for lunch.

And that's why Chipotle has done very well.

But if you remember, several years back, they had an E. coli outbreak, and several people got sick from eating their food.

As a result, a lot of people were scared off from eating Chipotle because of this.

At the time, what was kind of apparent is that there is a preference consumers have, an obvious one when you're getting food, which is that the food isn't going to make me sick.

As a result, though, instead of really addressing this core claim, saying, we now totally cleaned out our stores, and if you ever get sick eating Chipotle, we'll give you a million dollars cash because it's just not going to happen with E. coli anymore, instead of doing something like that, what they did instead was they offered two-for-one burritos to everyone.

People were not concerned with getting massive amounts of food for their money.

Chipotle was already seen as a decent money-for-value play for a lot of people.

Instead, they were concerned about food safety, and this campaign did not address that food safety whatsoever.

In fact, it could make people feel even worse about that, because it's like: “I'll get two E. coli burritos for the same price, thanks!”

Whereas a campaign that more directly went right at the crux of the food safety issue could have been better received, in my opinion.

The Jobs to Be Done Framework.

Now, if you are familiar with a lot of business philosophy, you've probably come across Clay Christensen, who, in my opinion, has one of the most brilliant frameworks for thinking about a very similar concept.

Why do customers buy certain products versus other products?

Very typically, people talk about product market fit, and this, in my opinion, is just not a very good framework to think about it, because you may buy a product that you don't love.

Clay Christensen kind of went to another level above this, and his whole framework is the jobs to be done framework.

He would say, "What job did you hire this product for?"

One of the examples always given is that a customer never goes to Home Depot to buy a drill.

Instead, what they're really buying is the hole in the wall.

They ultimately want to use the drill to get the hole in the wall, so the hole in the wall is the job to be done.

He observed that a lot of people were buying milkshakes in the morning at McDonald's, a lot, and they couldn't understand why milkshake traffic was so high early in the morning.

Now, if you ask a regular business analyst, maybe you would say, oh, the morning dessert TAM is a lot bigger than people thought.

Clay Christensen wanted to really understand this.

So he talked to a lot of these customers, and the thing he figured out was the job to be done for a lot of these customers was they were driving to work, so they wanted something that was very easy to eat in the car.

They wanted something that was quick, cheap, and fast.

From this jobs to be done framework, he could also note that the real competitive set wasn't other milkshake makers.

Instead, it was a banana, which it turned out didn't fill people up enough in the morning, or a bagel with cream cheese, which was a bit too hard to eat in the car.

Ultimately, they arrived at the milkshake.

From this jobs to be done framework, he was able to go to McDonald's and say: "Don't try to compete in the dessert market, instead look at these preferences that are being fulfilled by these customers, and maybe introduce other preferences like hitting higher order ones, such as, for instance, make it a little healthier."

His framework is the jobs to be done one.

The consumer hierarchy of preferences is the framework I came up with, and I think it basically helps make the job to be done a little bit more granular.

This can also help you see what could be disruptive competition to them.

Someone opening up a cake store next door to McDonald's, on the old analysis, you might have thought that could have been disruptive.

But no, that's not ultimately what people cared about.

But maybe if it's a very viscous smoothie store that opens up nearby, then that could turn out to be a much more formidable competitor to the milkshake.

Buffett’s Investment in See’s Candies.

If we're talking about Warren Buffett and his See's Candy investment, we could run a similar analysis.

In a 1998 Florida speech, Warren Buffett was talking about why people buy See's Candy, and he noted that very often it is purchased as a gift for someone else.

The reason why, in my opinion, that See's has such pricing power and has been able to maintain that for so long is because they're hitting a very high order preference.

The preference they're not fulfilling is tasty chocolate, or relatively cheap, or convenient.

It may be all of that, but that's not the preference they are focused on fulfilling.

That is a preference for the gift to convey care and love.

In this speech, Warren Buffett is talking about what would happen if instead of buying See's Candy, which your wife gets every year on Valentine's Day and loves the chocolate and really knows the brand.

Instead, you go and you pick up some unmarked generic chocolate box, and your wife is going to get that and say: what is this, why'd you give me this, you couldn't bother to get me See's Candy.

All of these things are kind of conveyed and get tied up in certain brands.

You can really build a brand, though, and associate yourself with some of these harder to fulfill psychological concepts.

If we're thinking about Coca-Cola, the way they would advertise is they just put Coca-Cola in a commercial with people being happy, and then they run that commercial a million times over to try to create in you an association between happiness and Coca-Cola.

The way a company markets themselves and the way the brand appears to the consumer is just as important as the actual preferences they are fulfilling.

Seek to Fulfill Consumer Preferences.

The big takeaway I want you to get from this is that customers only purchase something after it fulfills a sufficient number of preferences.

Once it fulfills any preferences beyond that, you're building surplus with the customer.

That means your customer is going to really love your product.

The benefit to that is that they're much less likely to ever leave.

They're also more likely to proselytize about your product.

It makes sense very often for a great company to leave consumer surplus.

Costco is a classic example of a company that leaves consumer surplus on the table.

They have a 3% operating margin.

I promise you there would be a very inconsequential impact to volume if they raised prices across the board 1%, which would flow to the bottom line and increase margins 33%, right?

But they won't do it, by and large, because they want to leave that consumer surplus on the table.

They're very loyal to Costco, and on top of that, they're going to tell everyone how much they love Costco.

Now, if you ask Jim Sinegal himself, the real reason why he doesn't want to raise prices is because he feels like once you do it a little bit, you kind of can't stop.

It just permeates the culture, and it becomes the focus of the business: how much more money can I extract from these customers, instead of how can I provide a better value for these customers?

And doing the latter is what a great business ultimately does.

For more on The Consumer Hierarchy of Preferences, check out the video below.

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