The Math of Daily Deals: Could Groupons Actually Be Profitable For Businesses?

September 14, 2011

With rumblings of the forthcoming Groupon IPO, no one has been shy about discussing every aspect of Groupon’s business: success rates, sustainability, accounting, growth, valuations, and whether the company is posed for collapse. Amongst the noise, merchants keep using Groupon, and customers keep buying them.

Ultimately, Groupon’s fortune will follow the fortunes of the small businesses they profess to help. Therefore, to understand Groupon, it makes sense to work to understand the factors that drive profitability (or unprofitability) for businesses using daily deals.

The Math of the Daily Deal

The New York Times ran a nice piece highlighting the math of daily deals, but going through each factor in their calculations in a bit more detail will help shed light on the key assumptions that impact profitability for businesses. We also include a few additional factors that the paper overlooked.

NYTimes Factors:

Incremental Cost of Sales - How much does a business need to spend for each incremental customer (someone they would not otherwise have sold to)?

For a half full plane, incremental customers cost almost nothing (save the cost of fuel and a soda or two). Restaurants have food costs to cover, which generally hover around 30-40% (but remember, restaurants can control staffing amounts, so these costs could be considered non-fixed with enough knowledge of expected traffic)

Average Ticket Size - What will the average deal customer spend when they come in?

The danger here is expecting a daily deal customer to spend like a normal customer. While this may be true, coupon clippers do not exactly have a reputation for being big spenders, and there is no incentive for them to spend more than the coupon’s value.

Redemption Percentage - How many of the coupons sold are being used?

This has actually changed quite a bit since the article was written. While 85% of customers are estimated to use their Groupons, lawsuits have begun to spring up challenging the expiration of these coupons. Businesses simply cannot depend on this leakage for profitability, and may have to at least redeem to coupons at cost.

Groupons Sold to Regulars - How many full paying customers are buying your coupons?

The hidden killer. If you are selling product for 75% off (50% off plus Groupon’s 25% cut), and the customer was going to pay full price, you have lost out of quite a bit of money.

I have purchased 3 daily deals - an Amazon gift card, a Whole Foods gift card, and a beerfest ticket. All three were cannibalized sales - 75% losses if you will. Purchases I would have made otherwise. Why are Little Star Pizza (625 review for “wait”) and Ike’s Place (1701 reviews for “wait”) selling coupons when they can’t even serve all the customers that want to pay full price?

This is likely the hardest input for local businesses to quantify. As we see more and more research on daily deals, the negative impact of cannibalization will become more and more obvious. Just remember, when a restaurant sells a discount dinner for $25 that they could have sold for $75, they are really losing $50, not making $25. Really.

Retention/New-Customer Rate - How many customers eat with a coupon and then return to your store to eat again for full price? Or see your deal and miss the coupon, but come to the store anyways?

Because customer tracking and analytics for local businesses are still developing, quantifying this number is extremely difficult. That said, remember that Groupon buyers are coupon clippers, so the retention rates are going to be lower than typical walk-ins (the users are likely moving on to the next Groupon deal instead).

Advertising Value - What is the value of having thousands of people see your Groupon ad?

This is another number that has likely changed significantly since the New York Times piece. The key here is context.

When a business uses a Groupon, they are sending a negative brand signal - discounting. A billboard that one million people see may be worth quite a but, but no one wants their business associated with discounted goods.

Full restaurants don’t need to (and shouldn’t) run Groupons. Consider the impact on potential customers that see your business running a Groupon? Are they going to wait for the next deal on Living Social? Or are they now going to come pay full price when they didn’t want to eat for 50% off?

To the NYTimes List, we would add a few major factors that were left out of the discussion:

Turnaways - How many full paying customers are you turning away because you have a discounted customer using your service?

Remember that cannibalization can appear in two ways: normal customers now paying half price and normal customers you are forced to turn away in lieu of different, half-off customers.

The New York Times mentions the first type (though they ignore them in their calculations). But what happens when your restaurant is full of Groupon customers and another regular that didn’t buy a coupon walks in? This is more money out the door that is hard to quantify but painful for merchants.

Brand Impact - How does the Groupon impact your brand moving forwards?

This is similar to the advertising value, but on the other side of the coin if you will. Recent studies indicate that Groupons may lead to a decline in the quality of your reviews. Yelp reviews drive sales, so these negative reviews may actually have a significant impact on long-term revenue and profitability - a non-trivial future-value destroyer.

Pulling It All Together

Once we start looking at all of these factors in concert, we can start to understand who Groupons might work for and where Groupons will never work. We will stick with the New York Times assumptions.

Coupons Sold: 3000
Coupon Terms: $35 for $75 of food
Incremental Cost of Sales: 40%, Incremental costs are likely substantially higher given the checklist that Groupon itself offers to local businesses (and I quote: “Have you scheduled double the number of employees as there are phone lines for reception on the day of your feature, and have you staffed all employees for you the first day your feature is valid and 85-90% the entire week after”). That doesn’t sound like only food cost only to me, and that doesn’t even get into training, additional phone lines, etc.
Average Ticket Size: $85, We’ll use the same 10% over and above the coupon.
Redemption Percentage: 85%, But remember, the other 15% are probably real liabilities, not free money.
Coupons Sold to Regulars: 40%, Again, we will use the NYTimes assumption.
Coupons Sold: 3000, From the article (but we’ll be nice and say every single one is a different person).
Retention Rate: 10%, This is always going to be difficult to quantify, and probably varied widely, but we will use the article again.
Turnaways: 100, Take a look at the graph Groupon provides businesses on redemption. If businesses are inundated with discount customers for entire months, how will their full-paying customers be able to visit comfortably. It is difficult to quantify this number, but a loss of 100 full paying customers during the Groupon period seems reasonable.
Advertising Value: Like brand value below, we will leave this blank and simply consider it at the end.
Brand Impact: This metric is nearly impossible to quantify, given the value of ratings themselves are not even clear to businesses, so we will just say that businesses can expect lots more ratings, but generally lower scores.

Redoing The Math (Correctly):

Marginal Revenue

Groupon Revenue = 3000 coupons * $35 per coupon * 50% cut = $52,500 (note Groupon takes $52,500 here too, nice)
Additional Revenue = 3000 coupons * 85% redemption rate * ($85 - $75) additional revenue = $25,500
Total Revenue = $52,500 + $25,500 = $78,000

Marginal Expenses

Food Costs = 3000 coupons * 85% redemption rate * $85 retail value * 40% incremental costs = $86,700 (and remember, this ignores the major staffing increases)

Lost Revenue

Groupons Sold to Regulars = 3000 coupons * 40% cannibalized customer * $85 * 76% money given to the customers and Groupon = $78,200 in lost revenue
Regulars Turned Away = 100 people turned away * $85 * 76% money lost because you are selling to a Groupon customer instead = $6,500k
Opportunity Cost = $78,200 + $6,500 = $84,700

Final Cost

Our Restaurant spent $78,000-$86,700 = $8,700 to run this Groupon, ignoring any additional costs beyond food. Full paying customers missed out on spending an additional $82,875. Our restaurant has $93,400 less than they would have.

What did they get in return? They have ~150 new regulars (3000 coupons * 85% redemption * 60% non-regulars * 10% retention). They have more reviews that are probably worse. They have ‘advertised’ with a Groupon to the entire city. So rather than NYTimes estimate of $114 per new customer, taking into account opportunity cost, the restaurant has spent at least $600 per new customer. If there is any brand hit, or expectation of future discounting, or additional costs over and above the 40% food costs, or if the ‘expired’ coupons become real liabilities, the restaurant cold easily be paying $1000 per new customer!!

For thoroughness, we also tested how sensitive the cost per customer is to each of the assumptions we used above (with the NYTimes value in red):

Note that cost is insensitive to redemption rate and upsell amount, but the retention rate, the incremental cost, and the number of coupons sold to current customers are extremely important factors to judging the cost of a Groupon. If many of the factors are tweaked together, the Groupon can actually turn into positive revenue, but the incremental costs need to be extremely low and coupons cannot be sold to many current customers. Follow this link to play with our model (you’ll probably have to download it) and test your own assumptions, and if you would like to play with our Excel model including sensitivity tables, let me know.

How To Make Groupon Work

Not all is lost for Groupon. What working through the calculations does is help show where the Groupon model works best. The real killer cost for Groupon is not the discounted customers walking in the door paying 25%, it is selling the coupons to current customers and paying for the marginal costs of each sale that are most expensive.

In our model, each new customer costs around $600 and the restaurant spent a total of ~$90,000 (good luck earning that back). Notice what happens, however, when we drop the marginal cost to 10% and the cannibalization rate to 10%. The cost drops from $90,000 to net gain of $36,000 dollars! The Groupon is now profitable even taking opportunity cost into account.

So who should be using Groupons? And how?

New businesses: There are no sales to cannibalize and advertising value may be much higher as people are not aware of your business.
Zero variable cost businesses: If you give boat tours and Groupon can fill up your boat with customers that wouldn’t come otherwise, without forcing full-paying customers out, you are golden.
Under the radar businesses: I honestly did not know I could take acrobat classes or that there are scavenger hunts across San Francisco. The advertising value here is probably large enough that is can offset the costs and consumers have less pricing instincts to latch on to.

Quick Wrap

To answer the question posed in the title, the answer is yes, Groupons can actually make small businesses money, but only in very limited circumstances. Hidden expenses and massive opportunity costs are hurdle that most local businesses will not be able to overcome. Before you run a daily deal, sit down and figure out which assumptions are correct for your business, or shoot us a quick email and maybe we can help you out.

Colin and the Rushrez Team

9:47am | URL: http://tmblr.co/ZPXAbx9WHBtr
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(Notes: 12)