ANALYTICAL COMPETITION ‘Using Analytics to Builda Dietinatve Capebiite IN 1997, A THIRTY-SOMETHING man whose resume included software geek, education reformer, and movie buff rented Apollo 13 from the biggest video-rental chain on the block—Blockbuster—and got hit with $40 in late fees. That dent in his wallet got him thinking: why didn’t video stores workllike health clubs, where you paid a flat monthly fee to use the gym as much as you wanted? Because of this experience-and armed with the $750 million he received for selling his software company —Reed Hastings jumped into the frothy sea of the “new economy” and started Netilix, Inc. Pure folly, right? After all, Blockbuster was already drawing in revenues of more than $3 billion per year from its thousands of stores across America and in many other countries—and it wasn't the only competitor in this space. ‘Would people really order their movies online, wait for the U.S, Postal Service (increasingly being referred to as “snail mail” by the Iate 19908) to deliver them, and then go back to themailbox to return the films? Surely Netflix would go the route of the many Net-based companies that had a “business model” and a marketing pitch but no customers. ‘And yet we know that the story turned out differently, and a significant reason for Netflix’s success today is that itis an analytical competitor. The movie delivery company, ‘which has grown from $5 million in revenues in 1999 to about $1 billion in 2006, is @ prominent example of a firm that competes on the basis of its mathematical, statistical, and data management prowess. Netflix offers free shipping of DVDs to its roughly 6 million customers and provides a return shipping package, also free. Customers watch their cinematic choices at their leisure; there are nolate fees, When the DVDs are returned, customers select their next films. Besides the logistical expertise that Netflix needs to make this a profitable venture, Netflix employs analytics in two important ways, both driven by customer behavior and buying patterns. The first is a movie-recommendation “engine” called ‘Cinematch that's based on proprietary, algorithmically driven software, Netflix hired mathematicians ‘with programming experience to write the algorithms and code to define clusters of movies, connect customer movie rankings to the clusters, evaluate thousands of ratings per second, and factor in current Web site behavior—all to ensure personalized Web page for each visiting customer. ‘Netflix has also created a $1 million prize for quanitative analysts outside the company who can improve the cinematch algorithm by atleast 10 percent. Netilix CEO Reed Hastings notes, “If the Starbucks secret is a smile when you get your latte, ours is that the Web site adapts to the individual's taste." Netfix analyzes customers’ choices and ‘customer feedback on the movies they have rented—over 1 Billion reviews of movies they liked, loved, hated, and so forth—and recommends movies in a way that optimizes both the customer's taste and inventory conditions. Netflix will often recommend movies that fit the customer's preference profile but that aren't in high demand. In other words, its primary territory is in “the long tail—the outer limits of the normal curve where the most popular products and offerings donttreside."= Netflix also engages in a somewhat controversial, analytically driven practice called throttling. Throttling refers to how the company balances the distribution of shipping requests across frequent-use and infrequent-use customers. Infrequent-use customers are given priority in shipping over frequent-use customers, There are multiple reasons for this practice. Because shipping is free to customers and the monthly charge to the customer is fixed, infrequent-use customers are the most profitable to Netflix. Like all companies, Netilix wants to keep its most profitable customers satisfied and prevent them from leaving, And while frequent-use customers may feel they are being treated unfairly (there have been complaints by a small number of customers, according to Hastings), Netflix must distribute its shipping resources across its most and least profitable customers in a way that makes economic sense. Hastin, refers to the practice as a fairness algorithm. Netflix recentiysettled a class action suit involving the practice, because it hhad advertised that most movies were shipped in a day. Analytics also help Netfix decide what to pay for the distribution rights to DVDs. When the company bought the rights to Favela Rising, a documentary about musicians in Rio de Janeiro slums, Netflix executives were aware that a million customers had ordered from the company the 2003 movie City of God, a realistic drama set in the slums of Rio, It also knew that 500,000 customers had selected a somewhat related documentary about slum life in India, Born into Brothels, and 250,000 ordered both DVDs from Netflix. Therefore, the company’s buyers felt safe in paying for 250,000 rentals, If more are ordered, both Favela Rising’s producers and Netflix benefit. Like most analytical competitors, Netflix has a strong culture of analytics and a “test and learn” approach to its business. The chief product officer, Nell Hunt, notes, From product management all the way down to the engineering team, we have hired for ard have built a culture of quantitative tests. We typically have several hundred Variations of consumer experience experiments running at ‘once. For example, right now we're trying out the “Netflix ‘Screening Reom,” which lets customers see previews of movies they haven't seen, We have built four different versions of that for the test. We put 20,000 subscribers into each of four test cells, and we have a control group that doesn't get the screening room at all, We measure how long they spend viewing previews, what the completion rate is, how many movies they ‘add to their queue, how it affects ratings of movies they eventually order, anda variety of ther factors. The initial data is quite promising. ‘Netlix’s CEO, Hastings, has a master's in computer science from Stanford and is a former Peace Corps math ‘teacher. The company has introduced science into a notably artistic industry. As a BusinessWeek article put it, “Netflix uses data to make decisions moguls make by gut. The average user rates more than 200 films, and Netix crunches consumers’ rental history and film ratings to predict what they'll like. .. It's Moneyball for movies [referring to the Oakland Athletics’ usage of statistics in professional baseball), with geeks like Reed looking at movies as just another data problem,’ says Netfix board member Richard. Barton.” In its testing, Netflix employs a wide variety of quantitative and qualitative approaches, including primary user testing, concept development and ising testing, data mining, brand awareness studies, subscriber satisfaction, channel analysis, marketing mix optimization, segmentation research, and marketing material effectiveness. The testing pervades the culture and extends from marketing to operations to customer service, The company’s analytical orientation has already led to a high level of success and growth. But the company is also counting on analytics to drive it through a major technological shift It’s already clear that the distribution of movies will eventually move to electronic channels—the Internet, cable, or over the air. The exact mix and timing aren't clear, but the long-term future of the mailed DVD isn't bright. Netflix, however, is counting on its analytics tohelp it prosperin a virtual distribution world. If Netflix knows more than anyone else about what movies its customers want to see, the logic goes, customers will stay with the company no matter how the movies get to their screens. Netilix may’ seem unique, butin many ways itis typical of the companies and organizations—a small but rapidly growing number of them-that have recognized the potential of business analytics and have aggressively moved to realize it. ‘They can be found in a variety of industries (see figure 1-1). Some, like Netflix, are not widely known as analytical competitors. Others, like Harrah's Entertainment in the famingindustry or the Oatand in basbal, have alrexdy celebrated in books and articles. Some, such as Amazon.com, Yahoo!, and Google, are recent start-ups that have hamessed the power of the Internet to their analytical ‘engines. Others, such as Mars and Procter & Gamble, have ‘made familiar consumer goods for a century or more. These companies have only two things in common: they compete on the basis of their analytical capabilities, and they are highly successful in their industries. These two attributes, we believe, are not unrelated. Analytic competitors are found in a variety of industries esgaiy ans Soman rete enorme Bost 1M a immeaiine Soin en pe a aeWhat Are Analytics? ics we mean the extensive use of data, statistical and sis, explanatory and predictive models, and fact-based management to drive decisions and actions. ‘The analytics may be input for human decisions or may drive fully automated decisions. Analytics are a subset of what has come to be called business intelligence: a set of technologies and processes that use data to understand and analyze business performance. As figure 1-2 suggests, business intelligence indudes both data access and reporting, and ‘analytics. Each of these approaches addresses a rango of questions about an organization's business activities. The questions that analytics can answer represent the higher-value and more proactive end of this spectrum. In principle, analytics could be performed using paper, pencil, and perhaps ase rule but any sane person using analytics today would employ information technology. The range of analytical software goes from relatively: simple statistical and optimization tools in spreadsheets (Excel being the primary example, of course), to statistical software packages (¢.g., Minitab), to complex business intelligence Suites (SAS, Cognos, BusinessObjects), predictive industry applications (Fair Isaac), and the reporting and analytical modules of major enterprise systems (SAP and Oracle). And as well describe later in the book, good analytical capabilities also require good information management capabilities to integrate, extract, transform, and access business transaction ata. Some people, then, would simply equate analytics with analytical information technology. But this would be a huge mistake—as welll argue throughout this book, it’s the human land organizational aspects of analytical competition that are tly differentiating, Business intelligence and analytics Ves I Wopastepaiy? | womanctyarsneain | ecw tad ruta Noctua wear Papin ‘esr vente a Age nee at pataiy AE ae pom ‘Why Compete on Analytics? ‘Ata time when companies in many industries offer similar products and use comparable technology, high-performance business processes are among the last remaining points of differentiation. Many of the previous bases for competition are no longer available. Unique geographical advantage doesnt matter in global competition, and protective regulation is largely gone. Proprietary’ technologies are rapidly copied, and breakthrough innovation in products or services seems increasingly difficult to achieve. What's left as a basis for competition is to execute your business with maximum efficiency and eiectiveness, and to make the smartest business decisions possible. And analytical competitors wring every last drop of value from business processes and key decisions. ‘Analytics can support almost any’ organizations that want to be competitive must have some attribute at which they are better than anyone else in their industry—a distinctive capability. This usually involves zome sort of business process or some type of decision. Maybe you strive to make money by being better at identifying profitable and loyal customers than your competition, and charging them the optimal price for your product or service. Ifso, analyties are probably the answer to being the best at it. Perhaps you sell commodity products and need to have the lowest possible level of inventory while preventing your customer from being unable to find your