Groupon: Goldmine, Tar Pit, or Niche Solution

Since its launch in 2008, Groupon has generated a storm interest.  13 million users have signed up to participate in collective bargaining through Groupon earning Groupon an expected $400 million in revenue for 2010.  With dramatic growth, Groupon has been positively featured in numerous news articles, news broadcasts, and even a few academic postings.

With glowing statements from business owners regarding the use of Groupon to create and capture new profitable customers, many might perceive Groupon to be a goldmine of an opportunity.  However, not every business working with Groupon reports satisfaction.  Some complain of high expenses and few new customers.  For these firms, the Groupon experience felt more like a tar pit to struggle against as they climbed out of the challenges created by Groupon.

So which is Groupon: goldmine, tar pit, or some niche in between?

In this article, I evaluate the breakeven incremental unit sales per redemption (BISR) for two different small businesses to demonstrate the value of Groupon for driving profits.  Furthermore, I compare the distribution of coupons through Groupon with that of a more typical newspaper distribution, such as the Chicago Sun Times.  From this analysis, we conclude that Groupon is a niche solution to driving profitable revenue for businesses.  Some businesses should increase their activity with Groupon, others should avoid it altogether.

Promotional Campaign Metrics

In evaluating any coupon promotional campaign, executives must examine both the incremental costs and incremental profits associated in order to identify the three key performance metrics (1) costs / buyer, (2) the return on investment (ROI), and (3) the breakeven incremental unit sales per redemption (BISR).  Of these three metrics, the first describes cost but fails to describe value of couponing, the second describes overall value but fails to properly identify the differential value in comparison to doing no couponing, and the third alone describes the incremental value of the coupon promotional campaign to the firm.

Many of the customers that purchased with a coupon (deal customers) would have purchased without the coupon.  The BISR defines the fraction of these deal customers which must be incremental customers, customers that wouldn’t have purchased in the absence of the coupon, in order for the promotion to improve profits.

Deriving the BISR is relatively straightforward.  Executives desire the fraction of campaign profits associated with incremental sales to exceed the campaign costs.  Rearranging this conditional reveals that the BISR is the ratio of the campaign costs to campaign profits.

The BISR defines the fraction of campaign sales that must be derived from customers that wouldn’t have purchased in the absence of the campaign.  If the fraction of campaign sales related to customers that wouldn’t have purchased in the absence of the campaign exceeds the BISR, then the campaign improved profits.  Otherwise, the promotional campaign harmed profits because too many of the deal customers would have purchased anyway and the coupon would represent an unnecessary price concession to customers that otherwise are willing to pay full price.

Spring Restaurant, Chicago

Spring Restaurant on the north side of Chicago is delighted with Groupon.  Fletcher Harrison, General Manager of Spring Restaurant, reports that most of the Groupon customers were new customer, fit the demographic of their target market, and many have become repeat customers since their initial visit.

Yet how do the economics work out?  Was Groupon a good price promotion for Spring Restaurant?  Would a targeted coupon distribution through the Friday – Weekend Chicago Sun Times to the north side have been more profitable?

Spring Restaurant is an upper-end fish restaurant with a Zagat rated average price per customer of $59, making the average tab for a couple of diners to be $118.  While the fixed costs of running a restaurant are substantial, the food costs relevant for calculating the actual marginal costs to serving one more customer are low.  From conversations with chefs and a review of hospitality texts, it is reasonable to estimate the profit margin for most restaurants is around 85%.

Groupon Costs

While Groupon doesn’t charge businesses directly for distributing coupons, the coupon promotion still has costs associated.  In the case of Spring Restaurant, 2,873 coupons were distributed with a face value of $75 each.  Not all coupons purchased through Groupon were redeemed.  Based on the experience of other Groupon using businesses, we can estimate that only 70% of the coupons were actually redeemed and the remaining 30% of coupons were forfeited. All together, the cost of Spring Restaurant’s Groupon Promotion would have been $151,000.

Groupon Profits

Groupon generates profits for its business clients through two mechanisms.  One, the client business profits from the sale of its items.  Two, the client business profits from the sale of coupons.  For Spring Restaurant, the profits generated through restaurant sales would have been $202,000 and the revenue generated through the sale of coupons at $35 each would have been $50,000. (Groupon keeps 50% of the coupon sales proceeds). Overall, the campaign profits would have been quite substantial at $252,000.

Groupon Metrics

The costs per buyer for Spring Restaurant through Groupon are $75.  Each coupon purchased from Groupon and redeemed at the restaurant costs the restaurant $75 in revenue.

Spending $151,000 on coupon redemptions generated incremental profits of $252,000, yielding a strong campaign ROI of 67% for Spring Restaurant through Groupon.   For every dollar spent on the campaign, Spring Restaurant earned $1.67 in profits.

Yet ROI alone does not indicate value for Spring Restaurant.  Of the incremental profits, not all of it can be attributed to incremental sales.  The BISR for Spring Restaurant’s campaign is 60%.  If more than three-fifths (60%) of the revenue associated with the campaign is derived from incremental customers, where incremental customers means customers that wouldn’t have purchased in the absence of the coupon promotion, then the campaign immediately increases profits.

From Mr. Harrison’s comments, we should suspect that fraction of Groupon customers that were incremental customers to Spring Restaurant exceeded the BISR, hence the executives should be pleased with the Groupon campaign results.  We also see that his ROI was positive.  Hence, it is little surprise that Spring Restaurant is a glowing reference for Groupon.

Newspaper Coupon Costs

Of course, Spring Restaurant could have chosen an alternative media outlet for their distribution of coupons.  From a purely explicit costing economic viewpoint, asking customers to pay $35 to Groupon for a $75 coupon would be similar to handing customers a $40 coupon in a more typical media.  How would traditional newspaper distributed coupons fare in comparison to Groupon distributed coupons?

The Chicago Sun Times reports distribution of 312,655 newspapers daily, of which 24% can be estimated to be distributed within their north side zone.  Running a one-time 6 inch one-column advertisement within the north side zone alone can be estimated to cost $950, reaching 75,000 households, at a cost of $13 per thousand households.

If 3% of those households clipped the newspaper coupons out and redeemed them at Spring Restaurant, executives would have noticed a relatively equal increase in their business but at a much lower overall campaign cost.  With 3% of the north side households redeeming the coupon, Spring Restaurant would have seen 2,250 coupon redemptions costing $90,000 to redeem and yielding a total campaign cost of $91,000, significantly cheaper than the costs associated with Groupon.

Newspaper Coupon Profits

Similarly, with 2,250 coupons redeemed, using the same average tab and profit margin, the profits generated from a potential newspaper coupon distribution would be relatively similar, at $226,000.

Newspaper Coupon Metrics

The cost per buyer for newspaper coupon distribution under these assumptions would have been relatively cheap, at $40.42.  Moreover, the campaign ROI would have been quite strong at 148%.  Furthermore, the BISR would have been lowered to 40%, implying that only two-fifths (40%) of the customers from a newspaper coupon distribution must be incremental customers in order for the campaign to have generated profits.

Under these assumptions, newspaper coupon distribution looks more attractive than Groupon.  However, these assumptions glaringly possess an overly optimistic expectation of coupon redemption.  Restaurants do not typically see a 3 in 100 redemption rate for newspapers ads, and may more typically see only 3 in 10,000 coupons being redeemed.  Under the assumption of a poor coupon response, we see the newspaper campaign costs per buyer climb to $82, above that associated with Groupon.  Moreover, the campaign ROI will drop to 22%, significantly below that associated with Groupon.  And, the BISR would climb to 82%, implying that four-fifths (80%) of the customers must be incremental.  It is doubtful more than four-fifths of the newspaper coupon redeeming customers would be new customers.  Hence, newspaper coupon distribution for Spring Restaurant would have failed to perform along a key metric, and may actually harm profits for Spring Restaurant.

Groupon vs. Newspaper for Spring Restaurant

For Spring Restaurant, we see from the above analysis that, under typical circumstances, Groupon does appear to be a more attractive media outlet for distributing coupons than newspapers.  Groupon delivers a strong ROI and has a surmountable BISR, making the promotional media profitable for businesses like Spring Restaurant.

Plus, there are other benefits.  Spring Restaurant executives report the customers generated from Groupon converted to repeat customers.  Since the purpose of couponing is to generate trial which converts to loyalty, we assumed in the above analysis that the benefits from generating new repeat customers were equal across both mediums.  This assumption is likely to be false for Spring Restaurant and other high-end outlets like itself.

Groupon users are social media users.  Groupon generates customers for client businesses by friends telling friends, presumably from a similar demographic and psychographic, of the benefits of patroning a particular establishment.  Because of the superiority of Groupon and social media in general over newspapers in aggregating specific demographic and psychographic market segments for businesses, it is likely that the Groupon redeemers are more likely to convert to repeat customers than a more typical newspaper redeemer.  Groupon is simply more likely to target like-minded customers that convert to loyalty than newspapers which garner a broader audience.

Moreover, because Groupon is a social media, the users of Groupon experience the internalization of a positive externality.  By only benefiting when buying in groups, Groupon users have an incentive to work together, enabling the external benefit of seeing others gain a discount be converted into an internal benefit of gaining a discount themselves.  This factor contributes to a higher coupon identification and use rate among Groupon users than other individuals from a similar demographic or psychographic segment.  Thus Groupon is simply more likely to generate interest in a high-end restaurant than newspaper advertisements which lack the additional direct benefit of internalizing a positive externality.

Chicago Bagel Authority, Chicago

Chicago Bagel Authority, also located on the north side of Chicago, is however very dissatisfied with Groupon.  Again, by examining the economics, we can see why.

When the Chicago Bagel Authority ran a Groupon, they offered an $8 coupon for $3 and garnered 10,000 coupon sales.  At first glance, this may imply a highly successful promotional effort.  However, as before, we must calculate the cost per by buyer, ROI, and BISR to identify the value of Groupon for Chicago Bagel Authority.

The Chicago Bagel Authority is a good quality sandwich shop.  From examining their menu, we can expect that the average tab per person including beverage is somewhere near $8.  A Groupon coupon for $8 redeemed by a single patron implies that patron paid nothing that day for their meal.

After making some approximations and analysis, we can conclude that Chicago Bagel Authority’s Groupon promotion was associated with an $8 campaign cost / buyer, yielded a paltry 12% ROI, a positive ROI only because not every patron redeems their coupons.  We can also calculate the BISR to be 90%, implying that more than nine out of ten customers must be incremental customers before the Groupon delivers positive results.

Based on comments from Greg Gibbs of the Chicago Bagel Authority, it is unlikely that more than nine out of ten of the Groupon users at the Chicago Bagel Authority were customers that wouldn’t have purchased in the absence of the coupon.  Many of the Groupon redeemers would have purchased a sandwich that day anyway.  As such, this campaign was a bust.

Moreover, if we examine a more typical promotion made by Chicago Bagel Authority though a newspaper such as a buy-one-get-one coupon (BOGO), we can see that newspaper coupons are likely to be more valuable for businesses like Chicago Bagel Authority than Groupon.

After making some estimates, approximations, and analysis, we can conclude that a more typical buy-one-get-one newspapers coupon promotion for Chicago Bagel Authority has a lower cost per buyer, a significantly higher ROI (profits which roughly double the campaign investment costs), and a lower BISR.  Thus, it would be easier for businesses like Chicago Bagel Authority to benefit from mainline newspaper advertisements than it would be from Groupon.

Perhaps this is why Greg Gibbs of the Chicago Bagel Authority felt Groupon used them to learn how to run their business, leaving him and others like him feeling more like they got stuck in a tar pit.

Spring Restaurant vs. Chicago Bagel Authority

The issues that drive the wedge between Spring Restaurant and Chicago Bagel Authority in their experience with Groupon arise from both coupon design and consumer behavior.

In the coupon design, Spring Restaurant’s Groupon offered customers to defray a portion of their tab associated with a visit to the establishment, while Chicago Bagel Authority’s Groupon offered to defray the entire tab.  A shallower offer from Chicago Bagel Authority would have enabled Groupon to be more profitable, but it also could have resulted in an insufficient incentive for customers to identify the coupon and purchase.

In terms of consumer behavior, Spring Restaurant is closer associated with social events than the Chicago Bagel Authority. Thus …

• The purchases at Spring Restaurant are more likely to be associated with sales to more than one person at a time while those at Chicago Bagel Authority are more likely to be associated with individual orders.  By increasing the average revenue per purchase, Spring Restaurant has more margin to work with than the Chicago Bagel Authority, and thus the deeper offers that must be made to gain socialization can be more easily afforded by Spring Restaurant than Chicago Bagel Authority.
• The act of patroning Spring Restaurant is more likely to be associated with a special event or the desire to spend time with a loved one in comparison to catching a sandwich at the Chicago Bagel Authority.  Thus, Groupon offers for Spring Restaurant lend themselves towards a more attractive topic for socializing through social media and generating increased incremental sales than an offer from Chicago Bagel Authority.
• And, for most customers, dining at Spring Restaurant will occur less frequently than dining at Chicago Bagel Authority.  Thus it is more likely that any coupon redemption at Spring Restaurant will be associated with incremental business, and therefore Spring Restaurant will find it easier to surpass any BISR hurdle than the Chicago Bagel Authority.

Groupon:  High-end Niche Solution

While generalizing from two simple case examinations is likely to miss some salient issues, some dimensions of success with Groupon have become overwhelmingly clear.  As this analysis demonstrates, Groupon is likely to be more profitable for high-end outlets than medium or low-end outlets.  Related to the issue of the average ticket price is the issue of consumer behavior.  Higher numbers of people involved in a single purchase occasion, social aspects of the purchase occasion, and infrequent category involvement all contributed to the success of Groupon for Spring Restaurant.  Movement in the opposite direction on these dimensions for Chicago Bagel Authority contributed to the profit destruction from their Groupon experience.

Which other businesses might enjoy a Groupon experience?  From these cases, we can extrapolate that other high-end restaurants, hotels, spas, and social-oriented service providers will do well.  High-end retailers may also benefit from Groupon, though care must be taken in coupon design due to their higher variable costs and consequently lower profit margins earned in goods markets over service markets.  For companies that fit the identified criteria, Groupon is likely to be a goldmine.  For all others, avoid the tar pit.   Groupon is a niche solution in the coupon promotion industry.  Fortunately, for Groupon executives and investors, their niche is significantly large and evolving.

References

• Ron May, “Briefly Noted,” The May Report, (September 10, 2010).
• The break-even incremental unit sales per redemption model (BISR) has been adopted from Scott A. Neslin, “A Market Response for Coupon Promotions,” Marketing Science 9, No. 2 (1990): 123-45.
• The 85% profit margin represents the margin earned in relationship to direct variable costs, or food costs in the case of restaurants, and does not represent the average monthly profitability of a restaurant which is significantly reduced through fixed costs of labor, rent, and other forms of overhead.
• Groupon’s receives 50% of the proceeds from the sales of Groupons to end customers.  See Ian Sherr, “Online Coupons Get Smarter — Groupon, Rivals Add Personalized Bargains, Staff as Some Merchants Gripe,” Wall Street Journal (August 25, 2010):  B.4.
• Xoom NYC Inc. reports 1300 Groupon Sales yielded 900 coupons redeemed, or a redemption rate of 70%.  See Ian Sherr, “Online Coupons Get Smarter — Groupon, Rivals Add Personalized Bargains, Staff as Some Merchants Gripe,” Wall Street Journal (August 25, 2010):  B.4.
• Chicago Sun Times advertising rates were identified from their 2009 General Rate Card.  Current rates may differ. http://www.suntimes.com/advertising/mediakit/pdfs/2009_General_Rate_Card_103009v20.pdf  (accessed on September 25, 2010)
• Comments from Spring Restaurant Executives were gleaned from a promotional video offered by Groupon.  http://www.grouponworks.com/ (accessed on September 25, 2010)
• By describing Groupon as a niche solution, we are not implying that is opportunity for meeting the needs of business is trivial, but rather drawing attention to the limitations of using Groupon to meet business needs.

Note:  At the time of writing, the author is not currently a direct consultant to nor investor in any of the firms listed in this article.