Profit Pools

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Profit PoolsAuthor: Dana Peck

Reviewer: Michael CollinsDecember 1998Copyright 1998 Bain & Company, Inc.

Profit Pools Agenda

Profit Pools Concept Applications

Profit Pool Steps Client Example Key Takeaways

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Profit Pools What are Profit Pools? Profit pools are the total profits earned in an industry at all points along the industrys value chain

Pattern of profit concentration in an industry is very different from the pattern of revenue concentration (see example) For example, profits and revenues in the automotive industry can be divided among many value chain activities - vehicle manufacturing, new and used car sales, gasoline retailing, insurance, after-sales service and parts, and lease financing - although car manufacturing and dealers account for almost 60% of industry revenue - auto leasing and financing are by far the most profitable businesses

Profit pools answer the question: Where and how is money being made?Source: Profit Pools: A Fresh Look at Strategy (May-June 1998): Orit Gadiesh and James L. GilbertCHI 3

Profit PoolsProfit can be defined in one of three ways:

What is Profit?

Accounting profit - represents companys earnings as formally reported - most commonly used as the basic profit measure - examples include net income or earnings per share calculations Return on investment - represents companys earnings after taking into account the cost of capital invested in the business. Two commonly used measures include: - ROC, accounting based Return on Capital (book value) - ROIC, accounting based Return on Invested Capital (book value) Cash-flow contribution - companys earnings before taking fixed-asset and capital costs into account (e.g. EBITDA) - represents the amount of cash left from a sale after subtracting the variable costs associated with that sale - used as a basis for decision-making in mature, high fixed cost and cyclical industries Be aware of differences in accounting standards when evaluating companies with profits spanning different industriesSource: How to Map Your Industrys Profit Pool (May-June 1998); Orit Gadiesh and James L. GilbertCHI 4

Profit Pools

Truck Manufacturing Business Example Revenue vs. Profit Split

The pattern of profit concentration in the truck manufacturing industry is very different from the pattern of revenue concentration.100%

$3,865MMTruck Finance Parts and ServiceBody Manufacturing and Truck Assembly

$600MMTruck Finance Parts and ServiceBody Manufacturing and Truck Assembly

80%

Percent of Total

60%

40%Chassis Manufacturing and Sales Chassis Manufacturing and Sales

20%

0%

Revenue Split by Activity

Profit Split by Activity

Source: PBIR Profile of the U.S. Truck Body Industry; R.L. Polk Registration Database; Literature Search; TEM Financials; Prior Bain PLP analysis (7/96); Bain estimates

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Profit PoolsCompanies that recognize the variability of profitability and can exploit the deepest pools will earn superior returns.Illustrate the Current State of the Industry Offer a view of the underlying industry structure Help illustrate the economic and competitive forces driving the industrys profit distribution Offer a different perspective on an industry Illustrate relationship between profit and revenues Highlights potential watchouts (choke points in the value chain) which can influence the profit flow in an industry Provide a Competitive Advantage to Your Client Help companies see what their rivals dont see Foster the potential to dictate the terms of competition within the industry Keep companies abreast of changes in rapidly changing (turbulent) industries - alert potential shifts in profit distribution along the value chain - illustrate potential change in profit sources from new entrants

Why Use Profit Pools?

Help to Develop Innovative Strategies

Help guide important decisions about a companys operation and strategy Encourage rethinking old decisions and pursuing counterintuitive initiatives to create and control profit pools Reduce the possibility of blind spots in a companys strategic vision - reduce potential to overlook attractive profit building opportunities - lesson potential to become trapped in areas of weak/ fading profitability Example applicationsCHI 6

Source: Profit Pools: A Fresh Look at Strategy (May-June 1998): Orit Gadiesh and James L. Gilbert

Profit Pools How Profit Pools Illustrate the State of the IndustryProfit pools provide a means to evaluate the competitive dynamics of an industry.

The varying concentrations of profit along the value chain (known as the shape of the profit pool) reflect the competitive dynamics of a business - profit concentrations result from the actions and interactions of companies and customers - profit pools form in areas where barriers to competition exist - profit pools exist in areas that have been overlooked by competitors Every market has an uneven distribution of profit between product categories, customer groups, geographic regions and/or distribution channels Profit pools are not stagnant - as power shifts among the players in an industry (competitors, suppliers, and customers), the structure of the profit pool changes

There are many different sources of profit in any businessSource: Profit Pools: A Fresh Look at Strategy (May-June 1998): Orit Gadiesh and James L. GilbertCHI 7

Profit Pools Profit Pool Watchouts (Computer Industry Example)Be aware of choke points - particular business activities that control the flow of profits throughout an industry.Microprocessors Other Components Personal Computers

Software*

Peripherals

Services

Examples: Intels dominance of microprocessorsImpact: Establishment of an industry wide standard that all companies must now obey

Microsofts dominance of Windows Consolidation of control over the customer interface

Control of a choke point can influence the distribution of profits among competitors and more distant value-chain participants*includes operating system and application software Source: Profit Pools: A Fresh Look at Strategy (May-June 1998): Orit Gadiesh and James L. GilbertCHI 8

Profit Pools Profit Pool Watchouts (Computer Industry Example Con.)Although choke points exist in the computer industry, it is still possible for companies to create and leverage new profit pools within this industry. 40% PC Industry Profit Pool

Operating Margin

30%

20%

Analyzing the profit pool has enabled Dell to be profitable in the least profitable personal computers segment (see example)

10%

Microprocessors

0%

Other Components

Personal Computers

Share of Industry Revenue

Soft- PeripheralsServices ware 100%

*includes operating system and application software Source: Profit Pools: A Fresh Look at Strategy (May-June 1998): Orit Gadiesh and James L. Gilbert

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Profit PoolsThe automotive industry encompasses many value-chain activities. The most profitable areas of the car business are not the ones that generate the biggest revenues. 25% 20% Operating Margin 15% 10% 5% 0% 100%

U.S. Auto Industry Example

Aftermarket parts

New car dealers

Auto loans Leasing Gasoline

Auto manufacturing

Used car dealers

Auto insurance

Share of Industry Revenue

Service repair

Auto rental

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Profit Pools Key Questions to Help Develop Innovative StrategiesBuilding an understanding of profit pools puts strategic thinking on a firm footing and prompts the following questions: Why have profit pools formed where they have? Are the forces that created those pools likely to change? Will new, more profitable business models emerge? How do some profit sources exert influence over others and shape competition? How do we gain a disproportionate share of industry profits?

Source: Profit Pools: A Fresh Look at Strategy (May-June 1998): Orit Gadiesh and James L. Gilbert

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Profit Pools Agenda

Profit Pools Concept Applications

Profit Pool Steps Client Example Key Takeaways

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Profit Pools Applications (1 of 2)Companies can use their understanding of profit pools in different ways: ExamplesIdentify New Sources of Profit Analyzing profit pools allowed U-Haul to identify a large untapped source of profit in the low margin truck rental business - seized the first mover advantage and entered accessory business at a low cost - reduced prices (and profits) in core truck rental business to attract customers for higher margin accessory business In anticipation of a potential reconfiguration of the profit pool from pharmacy-benefit managers (PBM), Merck and others vertically integrated the value chain and acquired PBMs - insulated themselves from new entrants and protected their existing sources of profits - gained greater access to patient information - increased the likelihood that the pool would evolve in a beneficial rather than destructive way

Chart Acquisition and Expansion Strategies

Source: Profit Pools: A Fresh Look at Strategy (May-June 1998): Orit Gadiesh and James L. Gilbert

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Profit Pools Applications (2 of 2)Develop Distribution Strategy Dell Computer Corp. utilizes the profit pool approach to evaluate which customers to pursue and which channels to use - direct sales approach allows Dell to keep a portion of dealers profits for itself and to share the rest with customers through lower prices - regular resegmentation of customer base enables them to identify the most profitable cust