A very interesting way of looking at business alternatives (and to analyse the value chain) is the Profit pool concept described by Gadiesh and Gilbert in the Harvard Business Review. Profit pools can be helpful to identify the business activities where the profit is made. Profit pools can be defined as the total profits earned in an industry or a company at all points along the industry’s or company’s value chain.
Although the concept is simple, the structure of a profit pool is usually quite complex. Segment profitability may, for example, vary widely by customer group, product category, geographic market or distribution channel.
The key of a profit pool analysis is the composition of a graph in which all relevant activities in the business value chain are plotted. It is up to the compiler of the pool to determine which business activities are to be included.
For each activity, revenue is plotted on the horizontal axis and profit margin is plotted on the vertical axis. The profit pool clearly shows the places where profit is being made. The example shows that for some economic activities the value creation is high, while the margin is low and vice versa.
Below, we provide a hypothetical profit pool analysis for a food delivery system. On the horizontal axis we have plotted the value addition along the chain of suppliers, on the vertical axis we have plotted the profit margins (as percentage).
Figure 1 hypothetical profit pool of the food delivery system
As discussed above different players in the chain may have different profit margins. Profit tends to be envisaged in three ways:
· Accounting profit,
· Return on investment,
· Cash-flow contribution.
A useful exercise is to map the estimated profit margins over the lifecycle, as is done in figure 1 above.
The four-step process of a profit pool analysis are presented below:
· 1 - Defining the pool’s boundaries
· 2 - Estimating the pool’s overall size
· 3 - Estimating the size of each value-chain activity in the pool
· 4 - Checking and reconciling the calculations
Step 1 - Define the pool
The first step is to identify the value-chain activities relevant to your own business. The question is: where, for the purposes of developing strategy, should the value chain be said to begin and to end?
At the conclusion of this step, you should have a clearly defined list of the individual value-chain activities that make up the profit pool.
The value chain should encompass all the activities that have meaningful influence on your ability to earn profits – not just today but in the future as well.
The exercise requires you to break down your business into discrete value-chain activities.
You should also look at the activities of your competitors to help you identify these value-chain activities, as there are so many ways to organise activities.
Questions to guide you:
- Might you have opportunities to perform new activities in your industry or in other industries?
Have other companies in your industry adopted business models that involve different sets of activities?
- Are there activities being performed in other industries that could displace or substitute for the activities you are performing?
- How would the customer define the life cycle of the product or service you produce?
These questions will help identify issues that you might consider peripherical but that could represent untapped potential.
Step 2 - Determine the size of the pool
In order to help you define the size of the pool, you should try to identify the total amount of profits being earned in all the value chain activities. At this stage, you should estimate roughly the total industry profits, to have a baseline against which to check reliability of the more detailed, activity-by-activity calculations. This information might not be available in a straightforward manner. You can try to build estimates of the total pool based on the profitability of individual companies, products, channels or regions.
Step 3 - Determine the distribution of profits
This is the core challenge of profit-pool mapping. There are two general analytical approaches to this task: aggregation and desegregation.
· If you are in an industry in which all companies focus on a single value-chain activity, you will calculate activity profitability by aggregating the profits of all pure players,
· If, by contrast, all the companies in your industry are vertically integrated “mixed players”, each performing many different activities, you will need to disaggregate each company’s financial data to arrive at estimates for a specific activity.
In reality, most industries are a combination of pure players and mixed players. For mixed players, this exercise will imply to disentangle your revenues and costs activity by activity.
Then you will need to examine the economics of other players in the industry. Although sources of company data will vary by industry, you will find common documents: annual reports, 10-K filings, and stock-analyst reports for public companies, as well as company profiles, reports by research organizations, reports by industry associations and trade magazines.
You should always look first at pure players. Once you know their revenues, costs and profits, you’ll have an economic yardstick for measuring the activity in which they specialize. You should focus on data collection on large companies (apply the 80/20 rule). You can then extrapolate for the rest.
When identifying profit pools, it is important to identify choke points such as the grating of a patent for a core component of a product, the establishment of an industry wide operating standard that all companies must obey, the consolidation of control over the customer interface. As an example, Intel’s dominance of microprocessors has become an important choke point in the computer sector.
Step 4 - Check and reconcile the calculations
As a check, you should add up the profit estimates for each activity, and you compare the total with the overall estimate of industry profits you developed earlier. If there are discrepancies, you need to go back and check your assumptions and calculations and, if necessary, collect additional data.