Cannibalization, Breakage, and Exposure: Calculating the Value of a Groupon

4/14/11

The humble coupon has become the epicenter of an Internet startup mania, the height of which I believe we witnessed when Groupon rejected a $6 billion buyout offer from Google last December.

In the wake of Groupon’s vertiginous arc, a mob of copycats has followed. With names like Weforia, LivingSocial, Tippr, and LevelUp (SCVNGR), they have proliferated to the point where deal aggregators like DealGator and Yipit now have currency. Relatively well-established Web companies like Google and Facebook, for whom bargain shopping is hardly a core competency, have leapt into the melee. It is, by all accounts, a contemporary gold rush.

Yet, there remains an open question: how valuable is Groupon as a service? Let’s say you run a local retail outfit, or a hospitality venture; will you benefit by offering some kind of social buying deal? While Groupon claims 97 percent of its featured retailers would want to repeat the experience, an independent study conducted by Rice University professor Utpal Dholakia says that at least 30 percent of businesses surveyed thought the Groupon they ran was unprofitable.

It’s worth noting that the survey relied on self-reported yes/no responses, and while it seems churlish to suggest business owners don’t really know if they’re making money or not, I think it is reasonable to point out that many small to medium businesses don’t have the resources to do the kind of closed-loop analysis necessary to definitively calculate return on investment (ROI) on promotion efforts.

Having conducted such an analysis for a local hospitality venture, I thought I’d walk through some of the potential benefits—and dangers—attached to social buying deals, and conclude with a fairly simple but effective method for calculating the ROI of a social buying deal. For the sake of brevity, I’ll assume we all understand the basics of group buying.

Cash Up Front… Sort of

One of the attractive parts of the Groupon-style deal is that it delivers a substantial pile of cash up front, before anyone actually walks into your establishment demanding goods or services at ludicrously discounted rates. This will sound tremendously appealing to anyone who’s struggled with balancing cash flows. Of course, it’s not all upside. First, Groupon takes a 33-50 percent cut for itself off the top of all revenues gathered from the sale of the Groupon. Second, the company delivers the remaining revenue in thirds—immediately and then after 30 and 60 days.

Breakage

Another benefit, though one you won’t find on the public portion of the Groupon site, is breakage; that is to say, the rate at which consumers will buy a Groupon and then never redeem it. The company’s representatives claim a roughly 30 percent breakage rate on average. This can go a decent ways towards alleviating the pain of offering your wares at bone-crushing discounts.

Exposing Yourself

Groupon claims to deliver “huge exposure” for its featured business customers. One such customer reported approximately 250,000 impressions resulting from being featured on Groupon. To do a rough, back of the envelope style calculation, I looked up what Facebook would recommend you bid for 1,000 impressions to market to a local, relevant audience (in this case defined as people in Cambridge, MA, who like pizza)—about $0.50. So, we can theoretically set the advertising value of being featured at about $125. We could finesse this number further, but as an accounting professor of mine is fond of saying, it’s all “motherhood and apple pie” to a certain extent anyhow, so let’s leave it at that.

Cannibalization and Overcrowding

There are, however, tremendous potential downsides to riding the group-buying tiger. Foremost among these is cannibalization: the danger that your regular customers, your dearest and most profitable of constituents, will buy a Groupon. They would have happily bought your services or goods at the full premium anyway, so this functionally amounts to stuffing cash into a Cuisinart.

Happily, there is more one can do to deal with a second danger: overcrowding. For small restaurants and other venues, this is a serious concern. Presumably, one can only offer so many facial massages or bake so many pizzas in a day. A sudden rush of bargain-hungry social buyers can end up filling the capacity that would normally go to profitable regular customers, and possibly alienate those regulars in the process. Though Groupon does not offer this option to small clients, other social buying sites will allow you to restrict the use of coupons to certain days of the week. In this case, one could use the group-buying demand to fill out the capacity that would normally go spare on the slower days, such as the oft-bemoaned Monday and Tuesday crowds for restaurants.

The Dreadful Bargain Hunter

It’s hardly contentious to say that the best customer is the one that values your offering such that they’ll gladly and regularly pay the full price. Yet, the clientele that will be attracted by a deep discount will consist of an unusually high proportion of people who aren’t particularly attached to the good or service being offered, but rather enticed simply by the fact that it’s being offered at a deep discount (and they happen to be in the mood for a sandwich, a facial massage, whatever). As a result, you’ll be less likely to convert these bargain hunters into regular customers, as compared to other forms of marketing. This is especially damning in light of the fact that it’ll be hard to make any kind of margin on that first and only interaction when you’re offering the product at 50 percent off or worse.

Return on Investment

Thus, we arrive at the ultimate question: should you offer a group buying deal? I’ll outline a quick and dirty framework for answering that question below, using nothing more than basic arithmetic.

First, let’s calculate revenue from the deal. This is the total amount of cash you’d get up front.

Number of Groupons to be sold :                _______

Price of Groupons :                                  *  _______

Gross Revenue :                                      = _______

Groupon’s cut :                                         – _______

(Gross Revenue * a percentage between 33% and 50%)

Final Revenue : …………………….…….= _______


Next we have to consider breakage, the cost of cannibalization, and the likelihood of retaining repeat customers. We begin by establishing the value of an interaction with a customer.

Average Purchase Revenue :                 _______

Average Cost of Goods Sold :             –  _______

Average Profit of a Sale :                     = _______

Redemption Number :                             _______

(Number of Groupons sold * 70%, thanks to breakage!)

Opportunity Cost of Cannibals :            _______

(Redemption Number * 10% * Average Profit of a Sale. You may want to adjust the %.)

Value of New Regulars :                          _______

(Redemption Number * Average Profit of a Sale * Return Rate * Number of Returns)

According to Professor Dholakia’s research, the Return Rate can vary between 13 and 31 percent. For the number of returns, you’ll have to use your expected life of a customer relationship.

Lastly, very important to consider: what it cost you to offer the deal.

Cost to Offer :                                          _______

(Redemption number * average Cost of Goods Sold)


Whew, that’s a lot of math. Now for the grand finale!

Rough Estimate of What a Groupon Is Worth =

Final Revenue + Value of New Regulars – Cost to Offer – Opportunity Cost of Cannibals

You could throw in miscellaneous factors mentioned previously, like overcrowding or marketing value, but those will vary considerably across businesses and may stray into the realm of pure guesswork. (Of course, if you’d be interested in having a more sophisticated calculation done, with fancy MBA terminology like “net present value” and “discounted cash flows,” there are plenty of smart and talented folks at Babson who could do exactly that.)

What It All Means

After running this calculation for a local restaurant—1,000 Groupons sold at $10 for $20 face value, $18 average purchase with $9 average cost of goods sold, with new customers returning an average of twice—I found that running a Groupon deal was essentially a break-even proposition, plus or minus $500 depending on how optimistic I chose to be with the assumptions—hardly a runaway success. The most impactful factor is what I described as the Return Rate: while you won’t be able to get a majority of bargain hunters to return to your establishment, the difference between being able to capture 15 percent and 30 percent represents the difference between making money and losing money.

In essence, this demonstrates that a Groupon offering will do little to help a venue with an undifferentiated product, like the uninspiring pizza/sub/wings shops ubiquitous in the Boston metro area, while it could substantially expand the customer base for a more unique establishment that has a higher chance of luring customers back with a distinctive product or service, even when the next guy is offering a 70 percent off social coupon.

Ryan W. Cohen is an MBA candidate and graduate fellow at Babson College, where he studies information markets and digital strategy. Follow @

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