Chasing Value or Chasing Costs

Groupon Chases Costs Not Value. Let me explain.

Groupon is the hot collective buying site that provides local merchants access to a massive audience. Local merchants contract with Groupon and advertise deals that are at least 50% off retail price. Then, Groupon advertises that deal to its millions of email subscribers in the relevant local city. The collective buying portion of the deal means that the deal becomes effective if and only if a certain number of offers are bought and, that number, is determined by the merchant at the creation of the deal.

As of this post (which is written on December 3, 2010 but will be published December 16, 2010) Groupon is rumored to be in talks with Google for an acquisition price of $6 Billion USD. That’s a nice price tag for a 2.5 year old company (Incidentally, Andrew Mason, the founder and CEO, and I went to the same college together – he dropped out and became a millionaire, I finished and am living from paycheck to paycheck. Go figure).

Here’s an example of the Groupon model:

For this particular merchant (a provider of photofacials), they are offering a 90% discount for a photofacial at their day spa. This deal for a photofacial becomes effective if and only if the minimum number of deals determined by the merchant are bought. At that minimum point, Groupon calls it a “tip” – or in other words, the “deal has tipped”.

Is it Working at Groupon?

That seems to be the case. For each deal, Groupon gets a percentage of the sales. So, from Groupon’s perspective, it’s to their advantage that deals tip, but if it doesn’t they don’t lose and neither does the merchant. So, it’s working for Groupon.

But, one has to ask: is Groupon fundamentally hurting local businesses?

Chasing Costs or Chasing Value

The following statement – “Can a local merchant afford to provide a 90% discount for their services?” – has three major assumptions:

1. Price is determined by the company.
2. Customers will chase low-cost services and products.
3. Businesses don’t have much control over their costs (also called cost plus model).

Perspective of Lean Manufacturing

The traditional corporate finance model looks like this:

Profit = (Sales Price Cost) x Volume

But, the perspective of costs and value in lean manufacturing is that costs are controllable, but the price the customer is willing to pay for is not entirely controllable by the merchant – price is determined by the market and by the customer.

Profit = (Sales Price Cost)

In the model informed by Lean Manufacturing, the belief and emphasis are the following:

1. Costs are controllable and can be reduced through the application of lean manufacturing methods
2. Sales Price is determined by what customers are willing to pay, not by company profitability policies or targets (EBITDA Goals)

The Lean Thinking model might be illustrated like this:

Mathematically, both equations are identical, but the difference in assumptions and emphasis have a significant impact on company behavior, actions in the market, marketing, and the impact on employees and customers.

For example, following the cost-plus or the traditional corporate finance model can lead too pricing products or services above what customers are will to pay or way below what they are willing to pay (such as 90% off retail price), leading to early irrelevance in the market; not to mention, almost completely antithetical to common sense economics.

Groupon is doing really well and this model is working for Groupon. But, fundamentally, local merchants need to view their business from the perspective of value and cost. Chasing one without concern for the other will lead to early demise.