The "Wash my Ferrari" Problem: A Meditation on Risk

http://theothereight.wordpress.com/2012/09/08/the-wash-my-ferrari-problem-a-meditation-on-risk/

by URSpider94 • 14 years ago

198 50 14 years ago

theothereight.wordpress.com

CodeCube• 14 years ago

Wow, great discussion on risk. The only thing I would add to the discussion is that before you try to model risk, you should read 'The Flaw of Averages', by Sam Savage - http://flawofaverages.com/

Put simply, any real risk model should probably avoid being a 'single number', but a range of probabilities. This models the distribution of possibilities much better and helps you make better decisions.

robodale2• 14 years ago

Thank you for this link.

TheCowboy• 14 years ago

'Fooled by Randomness' by Nassim Nicholas Taleb is also a good book I frequently recommend to people trying to comprehend probability or randomness.

chime2• 14 years ago

I have seen two predominant forms of risks factored in by the larger incumbents waiting to be disrupted. One is, like the author puts it, the risk due to breakage. Be very mindful of this risk and insure against it if possible or change something to avoid/lower the risk (sorry, we don't wash Luxury cars).

The other risk factor is pure CYA. Nobody wants to prepare a costing worksheet for a customer quote where your cost is too low because you didn't factor in the various overheads. Only after the annual financial statements are made will you find out if you lost money on the product or not. Do you want to be the guy who buys at $10 and sells for $20 only to find out before bonus-time that overhead was $90 per unit? So you factor in the cost of capital, inventory hold charges, shipping delays, warehouse pallet transfer cost, foreign exchange currency buffer, and tons of other charges. This makes it appear that your cost is high and so it is only natural to charge more for the product. Boeing isn't going to sell an Arduino + LED light for $100. It will be $500 because of risk of breakage and be $5000 by the time all the CYA risks have been tacked on by six levels of middle-managers.

The wonderful thing about CYA risk factors is that they help justify your high prices and if you are able to be lean, they give you a terrific margin. THIS is what you want to disrupt. You can charge less than the incumbents because they are playing it way too safe as nobody wants to lose their neck for selling a product at a loss. But don't charge so low that risk of breakage ends your business. The good thing is that the risk of breakage is not as large as the CYA risks in most every costing sheet that I have seen. YMMV depending on the industry/product.

Retric• 14 years ago

Another large factor is high overhead industrys is customer acquisition. In a world of CYA people often take multiple detailed bids, but that means you need to charge for not just that bid but all the failed bids. Say a bid is 2% of total costs, and 1/5 bids win now that's an extra 10% overhead.

delano• 14 years ago

Just a side note for people like me: CYA is cover your ass.

DeepDuh• 14 years ago

Thanks. I always thought it's 'cover your assets' but I was wondering about the 'a' all along ;).

gav• 14 years ago

Not to nitpick but managing supply-chain risk is a lot more complicated than insurance.

In most cases insurance is going to be more expensive than simply eating the cost of breakages, it's really something you have to protect against rare-and-expensive events.

If you are high volume/low cost or low volume/high cost this can be a very different situation than medium volume/medium cost in terms of impact.

chime2• 14 years ago

> Not to nitpick but managing supply-chain risk is a lot more complicated than insurance.

I agree. I manage an ERP system at a pharma-manufacturer. I added a YMMV precisely because of the different situation - different impact reasons. My main point was:

    Incumbent Sales Price SP1 = Cost of (Base + Risk + CYA-buffers) + Predetermined Margin
    Incumbent Profits     PR1 = SP1 - Total Actual Cost

    Startups Sales Price  SP2 = Cost of (Base + Risk) + Predetermined Margin
    Startups Profits      PR2 = SP2 - Total Actual Cost

If you assume Cost of (Base + Risk) to be relatively on-par then SP1 > SP2 because SP1 includes CYA-buffers. The problem is that when incumbents become lean and shave off overhead, they can continue to command high prices due to entrenched contracts and make a much larger profits. This reinforces their position in the industry, making it harder for startups to compete.

Sidenote: While in a perfectly competitive market, the sales price should be determined by the intersection of supply and demand curves, instead of being a predetermined markup based on cost, in most contract manufacturing environments, all the costs are known, markups are expected, and thoroughly negotiated.

dfghsfjhfjxfxf• 14 years ago

garbage article

monochromatic2• 14 years ago

Garbage comment; garbage account.

ComputerGuru• 14 years ago

The best thing you can do for comments like that (esp. when they're made by "green" accounts) is to just downvote and ignore. They'll be downvoted to grey, then deleted. The accounts will be hellbanned in time (comments autmotically deleted, posts only visible to poster). Replying only clutters the discussion.

khet• 14 years ago

Just curious, how much of this risk can be mitigated by contracts (terms of service) between the buyer and seller?

dbot• 14 years ago

Agreed. I would be interested to hear thoughts on this as well. As an example, if Coca-Cola uploaded its secret formula to a Dropbox, the damages resulting from a data breach would seem to be immeasurable. But I'm sure Dropbox's TOS limits damages to cost of the service (no extraordinary, consequential, etc.) Is this amount what's at issue here, or is there something I'm missing?

lsc• 14 years ago

eh, yeah, but you need to set expectations. I mean, people that will lose thousands of dollars every minute you are down have... rather different hosting expectations from people that are making a thousand dollars a month.

I mean, which would you rather have, assuming they were paying you the same money (and using the same capital resources, e.g. both of them use a full low-power dedicated server that costs $1,200 up front in parts and $20/month in power. Both use about as much bandwidth.)

Customer A. who is hosting email, web and ftp for his family, and maybe has a dev setup so she can test out the new webapp she's developing.

Customer B. who is running a website with $10,000 per day worth of sales.

Assuming they both have my phone number and can wake me up at 4am and yell at me, I can tell you that I am going to want a lot more money to give customer B the same service as customer A, because first, customer A isn't going to call me at 4am very often, and if I do flub something up, I can give customer A a free month, an apology and an explanation of what happened, and she is going to think I'm okay.

Customer B? man, customer B is going to wake me up every time there is even a little networking blip. And if I screw it up? they are going to have reason to be really angry, and possibly sue me for a bunch of money. a free month is unlikely to mollify them.

(also note, insurance might cover the payout if I get sued, but they certainly won't cover the time and aggravation, even in the best case.)

So yeah, I can see how hosting customer B would be exciting, but I'd want a whole hell of a lot more money to deal with those increased expectations.

If we want to go to the car wash example, when I was driving my maxima with unrepaired body damage? my neighbour caved in the rear passenger door with her land rover. "Don't worry about it," I said, "You did not significantly lower the utility or value of my car." - I mean, the whole thing was probably worth about as much as the bumper on her land rover.

If she had done the same to the new M3 in the next space over? you can bet her insurance would be making it just perfect, for a price that could have bought my jalopy several times over.

That's the thing. Nobody reads the legal bullshit until the knives are fully out and the lawyers are at the table. When you think about it, it doesn't make sense to spend the effort until then. I mean, you're talking about thousands of dollars of effort to understand a contract, and that doesn't make any sense on a contract that is worth two hundred bucks. Setting expectations is an important part of avoiding the situation where the lawyers need to come out and understand the contracts.

(Of course, this is why most contracts are as one sided as legally possible; there is no advantage to giving quarter, as the counterparty won't really read it until the relationship has soured and they are actively hostile.)

OllieJones• 14 years ago

The issue in IT doesn't arise around the Coke formula on Dropbox, unless Coke could somehow sue Dropbox for damages. The issue arises around large quantities of sensitive information. What if those Red Box video rental machines could be stolen to get the credit card data inside (they can't, the data aren't in there).

The issue hits hard in medical record IT. Losing control of 500 or more folks' medical records gets your name in lights here, and you're required to try to notify everybody who might be affected. http://www.hhs.gov/ocr/privacy/hipaa/administrative/breachno...

What kind of insurance could possibly cover a startup against the reputation cost of this? Not insurance that any startup could afford. Plus, the liabilities for misuse of the leaked data (identity theft, employment blacklisting of sick people, you name it) are unlimited.

So, a business that holds medical records for people is inherently a Ferrari car wash, unless the entrepreneurs can somehow persuade their hospital customers to bear the reputation risk. That's very hard.

nemilar• 14 years ago

I realize that the post is making an analogy, but it's based on fact. I worked in a car shop for a few months, and we charged a premium for "exotic" cars - something like 2x the cost of normal service. The reason was entirely on the insurance costs for handling those customers' vehicles.

zwischenzug• 14 years ago

I've seen this happen first hand. I joined a lean startup full of smart hackers building software in a fast-growing industry. It was great, and we made a load of money. Then problems started happening, and we blamed people: incompetent, tired, one-offs, whatever.

Then our customers started getting serious and regarded these events as unacceptable, just as they became statistically certain, and impossible to manage out. So costs have gone up, processes multiplies, checks increased. And now lean startups are nipping at our heels...

Think medicine.

robodale2• 14 years ago

This was a very good article. I have never thought about or considered looking at potential costs this way. Thanks.

jiggy2011• 14 years ago

I vaguely know somebody through work who is involved in high end legal services.

Around a year ago he hired a webdesigner to redesign his website, apparently the cost paid was around $20,000. Now bare in mind that this was for website design only (logo etc already existed).

The website itself was a relatively bog standard wordpress setup with about 10 pages of copy, a basic WP template and a handful of stock art images, no custom code at all as far as I could tell; I could have done a better job myself over a weekend most likely.

After hearing about this price I was curious as to who had been lucky enough to get hired for such a contract, turns out it was a designer who had been referred to him by others in the legal business.

So the question is, has whoever did this found a goldmine of customers who are willing to pay such huge sums of money just because frankly $20K isn't a lot to these people.

Or was it more to do with the risk of providing services to somebody who specialises in suing the crap out of people?

dkokelley4• 14 years ago

From what I (think I) know about the web development business, I'm guessing it had more to due with the fact that this developer found a goldmine of customers. Then again, maybe the developer is very concerned about clients from hell so he can quote princely sums to clients he or she isn't sure are worth the hassle. I suppose that's still a measure of risk. Not risk that you will be sued, but risk that a demanding client will require special treatment and hand-holding.

dkokelley4• 14 years ago

An interesting discussion on risk. Here's another consideration, you can self-insure to an extent by changing processes to minimize risks. If you must charge $10 to wash a Ferrari because your risk model says that it will cost you $5 in mistakes, use a different process to lower mistakes. Let's say that instead of the standard wash process you use for regular cars, you take extra time on the Ferrari, using your best washers and new materials. Now, the risk goes down from 1 in 2,000, your risk is 1 in 10,000. Now you can charge more for the special, risk-averse treatment and only a $1 risk surcharge on top of that.

Effective risk management doesn't just mean that you protect yourself against "bad things". The ability to manage risks better than your competitors is a competitive advantage. I heard it best described as the brakes on a sports car. Good brakes let you take corners faster.

sukuriant2• 14 years ago

Just a nitpick, 'cause it was on my mind. 5$ might have been that "different process to lower mistakes". I was wondering how it could still just be $5 to manage risk of damaging a ferarri, myself.

dkokelley4• 14 years ago

I'm having a difficult time parsing your comment. The $5 from the article was the cost of paying out $10,000 1 in 2000 times. If a different process costs $5 to implement, then they might as well accept the risk as is.

pacaro• 14 years ago

To the list of industries where there is a built in x10 on all quotes add Weddings...

mcherm• 14 years ago

But that is for a different reason... it's not increased pricing because of increased risk, it's increased pricing because of increased willingness to pay combined with a sense of "more costly must be more valuable".

kgermino• 14 years ago

I would think that risk could be a part of it (or at least risk mitigation)...

If I were a photagrapher, I would likely want to charge more for a wedding then say the engagement pictures (or other portraits) which have a similiar amount of effort. If I have a problem with a portrait I might need to call them back in to reshoot. If theres a problem with the wedding pictures I'm stuck.

The workaround is better preparation, more people, more equipment, etc. All this costs money.

fotbr• 14 years ago

I've shot weddings before. You're partially right, wedding parties are willing to pay, and pay well. The flip side of it is that they can be some of the absolute worst clients possible, and you only have one chance to get it right. So a lot of the "wedding markup", at least in regards to photography, comes down to "how much do I have to get to make the headache and stress worth it?"

noonespecial• 14 years ago

I always figured this was one of the "grey" advantages startups have. For a very short time, a startup has so few assets that an entire class of risks exist that will simply put it out of business. When you're brand new, it doesn't matter if you damage a Honda or a Ferrari, either way, you're done. This gives you a slightly evil and transient advantage that let's you temporarily undercut the established players by just ignoring those risks altogether.

sopooneo• 14 years ago

But couldn't knowledge of this fact by your potential customers make them wary of giving you much business, thus canceling out your advantage?

stickfigure• 14 years ago

Yes and yes, but not necessarily. Customers do not have perfect information about the market, and especially not about the inner workings of your company.

turbulents• 14 years ago

Last weekend, I was a little irritated when Southwest Airlines charged me an extra $5 to get a glass jar in my luggage bubble-wrapped when I would have preferred to save the $5 and take the risk of it breaking/leaking. The Southwest agent's explanation boiled down to more or less the same point as this article's. Kudos to her.

brandoncapecci4• 14 years ago

The price of a car wash should take into account the aggregate probability for any car to get damaged. The idea that one would price discriminate via the exact make and model is absurd and when I stopped reading...

sonnyhe20023• 14 years ago

brandon, you are right. This article is just flawed.

brandoncapecci4• 14 years ago

Why am I getting downvoted for this? I am not making any commentary on price discrimination but instead, saying that the artificially created scenario could at least be more approachable for readers.

sonnyhe20023• 14 years ago

Mr. car washer. By your argument, McDonalds should charge twice as much for a big mac to fat people because they are more likely to get health problems and sue McDonalds.

I think this model is just wrong and charging any customers more due to profiling should not be practiced by any company. Assuming that your formula is correct. Don't raise the price because of the probability and risk. You should train your employees and improve your quality of service, so that the probability is low enough, now you charge back the same $5 for a fararri carwash.

nazgulnarsil• 14 years ago

the idea that discriminating against a riskier class of people is morally wrong is responsible for much of our financial woes.

callmeed• 14 years ago

>> Mr. car washer. By your argument, McDonalds should charge twice as much for a big mac to fat people because they are more likely to get health problems and sue McDonalds.

No, The consequences of faulty equipment or service are fairly acute–i.e. someone dies or something is damaged right away. I think long-term consumer risks like obesity and lung cancer are different than what the author is referring to.

Also, most class actions suits against McDonalds have been thrown out [1]. Malpractice lawsuits and the like are very numerous, on the other hand.

* >> I think this model is just wrong and charging any customers more due to profiling should not be practiced by any company*

That's absurd. The entire insurance industry is based on this. As is any financial product that takes your credit score into account.

[1] http://www.bloomberg.com/news/2010-10-27/mcdonald-s-obesity-...

sonnyhe20023• 14 years ago

The McDonalds was just an example. Your points about lawsuits to being thrown away against McDonald, is irrelevant. Whether people successfully sue McDs or not, is not the point, McDs should not charge more to certain people. Do you agree? Yes, the insurance industry do charge more depending on the person. But my point still remain, The model is Bad. Besides if you have a SET price, you should not change it because of probability or risk per person.

Tycho• 14 years ago

When people talk about risk (and return) I always feel like there's something I'm missing, something I don't get. Can never quite put my finger on it.

I guess it's something to do with wilfully gambling vs. relying on your own abilities. They seem like very different things but somehow get classified together.

The "Wash my Ferrari" Problem: A Meditation on Risk

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