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Analyzing Groupon Profitability: 7 Factors for Group Buying Success

October 17th, 2010 · 1 Comment · All Posts, SamDecker

I’ve had a lot of conversations lately about the strategy of group buying sites (or daily deals, flash sales, etc.). Groupon is the leader in this space…so much the word is becoming a verb. The questions I often hear are: How do you know if Groupon (and group buying deals) are right for a type of business? What are the factors that make Groupon a profitable strategy?

How do you evaluate and analyze the profitability of Groupon?

Already there are a lot of competitors with Groupon, and several more that are headed toward even more niche group buying capabilities, focused by interest, small city, or people groups. The group buying strategy will continue, and so will the conversation about this. But the model of giving a significant (50%+) discount on goods and services has its dangers. So it piqued my curiosity to analyze this from an economic perspective.

On the plus side, this is a pay-for-performance approach to customer acquisitions. And it’s a sudden and (mostly) predictable burst of new customers and revenue.

On the cautionary side, you’re paying for that acquisition with negative margin. Do business owners really know (or at least rationally evaluate) the complete profitability of these customers? If I were doing this, I’d look as much as possible at the total economic impact, as there are some overlooked aspects to this type of promotion.

A fascinating study on Groupon effectiveness by Utpal Dholakia of Rice University cited that 66% of small business owners report Groupon to be profitable. In discussing this with him, that figure is a self-reported, which is valud to understand how the owners think about the outcome. It is natural for an owner to believe and report they made a profitable decision. But this is not to say that 66% of Groupon promotions actually are profitable. I would assert most small business owners were not instrumented or had taken the time to fully analyze profitability.

Utpal and I agree that the analysis for full profitability may not be possible for the average small business owner. Epsecially at the detail I’m about to outline. However, if I were running a business, I’d at least want to logically think through the assumptions of profitability and measure what I could…otherwise, I would be headed down a slippery slope.

This kind of customer acquisition can become a ‘drug’ to a business looking for revenue, and yet the total P&L impact may not be understood. Groupon reports that 95% of businesses would run Groupon again, though Utpal’s study suggests it’s more like 68%. Both are self reported figures. How many actually DID use Groupon again? I digress.

Let’s use a fictitious example to walk through what the “ideal” analysis would include.

Assume you’re the owner of a spa salon and you offer a coupon of $50 for $100 of spa services (to make it easy), and you sell 1,000 of them.

You get $25 from each sale (because typically 50% of the $50 goes to the group buying site). If you had 50% margin on the $100 list price, then you’re losing $25 on each deal and 1,000 of these coupons is costing you $25,000 in negative margin.

On the plus side you’ve acquired 1,000 new customers. However, how many of those actually are ‘new’? This is the first key assumption and the maturity and visibility of your company will be important in determining this value. Let’s assume 20% of those who received the coupon would’ve bought at full price. That’s 200 customers that would’ve given you $10k in margin, but instead cost you $5,000.

That’s a $15k net swing.

The remaining customers are new, 800 customers that cost you $20k in negative margin But, how many will buy again at full price over the year? This is another key assumption and the type of business you have an the kind of service or product you provide have impact on the lifetime value calculation. For this exercise let’s assume 20% of the 800 new customers will come back and spend $100 in services again three more times in the year. That’s 160 customers driving $150/yr in margin (3x $50 margin) = $24k in margin.

Here’s the margin math so far:

200 existing customers in lost margin = -$15k

640 customers who won’t come back = -$16k

160 customers with 3x 1yr full margin value = +$24k

It’s unprofitable so far. Ah, but we’re not done!

How many of the 1,000 customers never redeemed the coupon? Let’s assume 10% don’t execute on the coupon before it expires. That’s 100 coupon purchases where you get $25 each with no cost of goods, $2,500 in positive margin.

Now, how many of the 900 customers who DO redeem buy something else when they turn in the coupon? Let’s assume 30% of those customers spend 30% more. that’s 180 customers spending $30 in full margin ($15) = $2,700 positive margin.

And, what’s the brand recognition worth of the campaign itself? This is the most difficult to measure and understand. Yet it’s probably the assumption Groupon wants you to believe in the most, which is one of the reasons they invest in great copywriting for their offers. There are a lot of assumptions to think through on this…how many are seeing the promotion, how well is your company marketed, how many of the audience already knew about your business, what’s the acquisition opportunity of this kind of awareness-building, etc.? For the sake of this exercise, let’s just assume that 25,000 people see this promotion and 1% of that audience will visit you at full price, assuming the same $100 of service they purchase 4x a year. That’s 250 new customers spending $400 ($200 in margin) = $50,000 in margin.

Ok, so let’s net out the total economic impact:

200 existing customers in lost margin = -$15k

640 coupon customers who won’t come back = -$16k

160 customers with 3x 1yr full margin value = +$24k

100 coupons not redeemed = $2,500

180 customers buy more on site = $2,700

250 new full margin customers from campaign awareness = $50,000

Total margin impact for year: $48,200

I haven’t touched on the possible word of mouth impact from customers that experience the product/service (see my Mashable article) or value of acquiring customer data, or value of learning something from these customers.

Now, there are a ton of assumptions in this exercise you can argue. I just made these numbers up. If the awareness didn’t bring any customers in after the coupon, the example is not profitable. The point is to illustrate the factors to think through and debate with yourself.

Also, every business is different, every group buying site campaign is different, and you could do it at different times of the year which would all effect the economic outcome. The one-year value of doing a group buy coupon could be negative margin as much as it could be positive margin in this exercise.

For example, when Groupon did the Gap promotion, perhaps the % of customers that would’ve bought from them anyway is much higher. Everyone is aware of Gap, so I doubt they got as much upside on the awareness building from the campaign. If anything, they may have told customers that it’s possible to get a better deal at Gap if you look for a coupon or wait, so perhaps they lost a higher percentage of full margin customers. The turnout for Gap may have been very bad from a one-year margin calculation and a brand impact. Or, perhaps the majority of people who redeemed coupon spent twice as much at full margin and therefore they didn’t lose money. Though I still question the incremental lifetime value opportunity from these customers. In my experience coupon users are discount shoppers. The thrill is in getting the best possible deal, so money spent beyond the coupon is not a deal.

The point is there are a lot of factors that go into the determination if this is a good strategy for one business vs. another. Here are some factors I would consider if I were a small business considering if a group buying strategy was worthwhile:

  1. Awareness – if your company already has high awareness in your market then the awareness building benefit of the group buying campaign is less positive. Further, if you have high awareness, than the % of existing customers who buy with a coupon could be high.
  2. Repeat Business – Do you have a business that has repeat customers? 50% off a vehicle registration service is not as good as 50% off a haircut. If you have repeat business, then you have a higher likelihood (and of calculating) for lifetime value of a customer acquired.
  3. Differentiation – How differentiated is your business, product and/or service. If you’re a burger joint as good as many others, than customers may take you up on your coupon, but go to the next burger joint with a coupon next time.
  4. Word of Mouth – Related to repeat business, what is the likelihood that someone who experiences your business at a discount will be delighted, and how word-of-mouth-worthy is your experience. Interestingly, Certain types of businesses or products can have a higher word of mouth quotient than others. A zip line company has more WOM than a nail salon. And customer experience matters. Uptal’s research reports that if employees were happy with the incoming customers, the owner was more likely to believe the promotion was profitable. Things like group-buying sites will require businesses to create better products and services, otherwise you will lose the LTV benefits of acquiring customers. See my Mashable article.
  5. Upsells – What’s the likelihood people who come in with a coupon will buy more at full price? The type of product and service will make a difference, as much as how upsells are executed. According to Utpal’s study.
  6. Breakage – what is the likelihood people will not execute on the coupon? Are you far away; is the dollar amount small, is scheduling involved?
  7. Data – How much data can you capture about the customer? That enables you to remarket (assuming you do so) and raise the return business assumption. And what is your ability to capture and analyze the measurements above? This doesn’t change the outcome, but it does better inform you if you should do it again. Otherwise, it may be too tempting to do something like this again that could put you out of business.

Of course, I didn’t calculate your time and opportunity cost to evaluate, execute and analyze all this to determine if you should do a group discount. Add that to the mix as well!

Again, I don’t assume small business owners can or will go to this level of detail in analysis. The point is to consider the characteristics above, to go through a rational decision making process, and then measure what you can to determine how to use group buying.

Sam Decker

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