Over at the New York Times You’re the Boss blog, Jay Goltz provides a great example of economic reasoning (ht: Jack B). His topic: how should small businesses think about the costs and benefits of participating in daily coupon sites like Groupon? Participants can see big spikes in traffic, at the expense of slashed margins. Is it worth it?
Goltz deploys many of the standard concepts we professor types teach our microeconomics students: distinguishing variable and fixed costs, the importance of thinking incrementally (i.e., at the margin), etc. But, frankly, he does it in a more entertaining way.
Here’s his basic set-up (but check out the whole article for how this calculation works out):
There are eight key calculations you need to consider to determine whether this is a better advertising vehicle than something else you may already be doing
1. Your incremental cost of sales — that is, the actual cost percentage for a new customer. If you are giving boat tours and have empty seats, your incremental costs for an additional customer are next to nothing. If you are selling clothes, your incremental costs might be 50 percent of the sale price. Food might be 40 percent. In any case, don’t include fixed costs that you would be incurring any way.
2. The amount of the average sale. If the coupon is for $75, will the customers spend more that that? I have seen more than one retailer complain that nobody spends more than the value of the coupon. That’s unlikely but I am sure it can feel that way, and that is my point: Keep track.
3. Redemption percentage. You don’t really know until the end, but from my experience and from what I have heard, 85 percent is a good guess.
4. Percentage of your coupon users who are already your customers. I’m sure this number varies tremendously depending on the size of your city, how long you have been around, and the type of business.
5. How many coupons does each customer buy? (The more they buy, the fewer people are exposed to your product or service.)
6. What percentage of coupon customers will turn into regular customers? Again, it can seem as if they are all bargain shoppers who will never return without a discount, but that’s almost impossible. Is it possible 90 percent won’t return? Sure.
7. What is the advertising value of having your business promoted to 900,000 people — that’s the number on Groupon’s Chicago list — even if they don’t buy a coupon?
8. How much does it normally cost you to acquire a customer through advertising? Everything is relative.
Goltz’ methodology is fundamentally incorrect and will often support the wrong decision, because it implicitly asks the wrong question. It implicitly asks: “Would we make a profit on the sales we make via Groupon (directly via the initial incremental business and indirectly via repeat business)?” The question should be: “What impact would using Groupon have on the bottom line for our total business?”
Goltz’ methodology ignores a critical factor: cannibalization of revenue and margin among existing customers who now buy with the coupon. The existing customers who would use the coupon would have otherwise paid full price, yielding higher revenue and margin, but that revenue and margin are forgone if they use the coupon instead.
To illustrate, let’s make the following assumptions, and please note that I’m making some unrealistic assumptions just to illustrate the point without adding distractions from extraneous variables and calculations:
1,000 coupons would be sold.
$400 face value.
$300 price of coupon.
$200 The business’ share of that $300 (Groupon gets the other $100).
100% redemption.
$400 average spend (“average ticket”) i.e., no one spends more than the face value.
20% variable cost (20% of face value)
1 coupon per customer
ok, now let’s apply Goltz’ methodology.
Revenue: $200,000 (the check from Groupon)
Expenses: 20% X $400 X 1,000 = $80,000
Contribution to Profit: $120,000 + more from any repeat business and any additional new customers resulting from increased awareness generated by Groupon’s email blast.
Per Goltz’ methodology, it sounds like a no-brainer to use Groupon.
But that’s misleading, because we don’t really have any idea of the impact on the total bottom line of the business until we factor in the degree of cannibalization of purchases that would occur at full price if we don’t use Groupon — i.e., the addition revenue and margin we forgo by shifting people who would have paid full price over to buying with the coupon.
Let’s assume that 70% of the coupons would be used by existing customers (so 700 of the 1,000 would be existing customers) and 30% by new (incremental) customers (300 of the 1,000). And I’m assuming that when we say “existing customers” we mean people who would have bought anyway within a given time period even without a Groupon coupon, and who would purchase the same amount with or without the coupon. In other words, they are part of our base business (our baseline).
That means that without Groupon we would miss out on the 300 incremental customers, but here’s what we’d get from those 700 existing customers:
Revenue: 700 X $400 = $280,000
Expenses: 20% X $400 X 700 = $56,000
Contribution to Profit: $224,000
So in terms of direct impact, using Groupon lowers our total business bottom line by $104,000, since we are forgoing $224,000 to get $120,000. So Groupon lowers our bottom line unless we can make up the difference via the indirect impact — repeat business from that incremental 300 and additional incremental business from those made aware of your business via the Groupon email blast.
Another problem with Goltz’ methodology: Overlooking the degree to which using Groupon may inadvertently train existing customers to “buy on sale” more often (or always). If the business is considering using Groupon regularly, to what degree will existing customers using Groupon shift their purchases to when they have a Groupon, meaning we forgo some full-price purchases from them?
And this applies in B2B (e.g., manufacturer sales to retailers) as well as retail sales. I recall back in my brand management days, sales (shipments to retailers) were very disproportionately high during the several “Off Invoice” periods (part of “trade promotion”) of a couple of weeks each several times over the course of the year. This concentration of sales wasn’t primarily because of incremental sales for the year driven by those O.I. periods, but rather because some retailers would significantly concentrate their purchases during the O.I. periods (“forward buying”), which they knew or anticipated were coming. For them, the O.I. discount was worth more than the cost of carrying the extra inventory.
(I’m not saying none of it was incremental; for example, some retailers would pass through some of the discount to consumers and combine it with displays or other store-level (POS) promotion.)
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