Perils of being on the wrong side of asymmetric two-sided market

Plug for my book: To Group Coupon Or Not: Small Business Guide to Groupon, LivingSocial and Others is now available.

eBay, Craigslist, dating sites and GroupOn have one thing in common – these are two-sided markets that need two sides (producer-consumer, men-women, stores-deal seekers) to be present to succeed.  Buyers flock to such a market like eBay if they believe there is a wider selection of sellers and vice versa. Two sided markets succeed when there is net new value creation that all three (the two sides and the market maker) get to share in it.

When two-sided markets simply redistribute value from one side to other while taking its share we have asymmetry. If you get caught on  the wrong side of asymmetry, any advantage you get from participating in the two-sided market is wiped out.

Deal seekers score! Does your business too?

In case of group buying sites it is easy to build the buyer side. These people add no net value but they reap large consumer surpluses.

With a large population of deal seeking customers enabled by social media (like facebook connect) the demand side is almost  unlimited. As it has been pointed out by many during the Google-GroupOn acqusition days, the stickiness from social media connections create loyalty to these sites even though the business model can be easily copied.

The question is what do the sellers who give away 50% discounts get in return. Claims made by people like Sam Decker and Seth Godin state,

“Once the first timer experiences your astonishing product and service, they become your lifetime customer”

There is a difference between stating this as one of the possibilities with a level of uncertainty vs. this is the only expected outcome. These are no different than the claims of an adorable cartoon giraffe that, “Madagascar is indeed San Diego because it has white sandy beaches“.

Small businesses must call these rosy projections into question since they are the only ones who is adding value but not getting their fair share. They need to ask,

  1. What job is the deal seeking customer hiring the group buying site for? For discovery, thrill of getting discount or for maximizing their consumer surplus? Which one of these gives you long term advantage?
  2. If you were able to lure away someone else’s lifetime customer (who is also likely to have astonishing product and service) with your 50% coupon, what makes you think they will become your lifelong customer?
  3. What do you get in return to track the lifetime value of these customers?
  4. Where is data behind the claims of these gurus? Data from Utpal Dholakia point to very minimal if any repeat business or customer margin.
  5. What is the impact on reference price and value perception due to 50% off? My experiments show customers are likely to assign lesser value a product they bought at a discount than to a comparable product bought at full price.

To repurpose Omar Khayyam, “The deal seeker, having scored the deal moves on to the next deal. (Likely) no amount of astonishing product or service will bring them back to pay the full price”.

If you want to add a new channel to minimize deadweight loss, by all means do it. But do the math behind it and not base it on hope

  • Do you  have a product with high contribution margin (price less marginal cost)?
  • Do you have excess capacity (with sunk costs and no other way to monetize it)?
  • Is there a segment of customers with low willingness to pay but reducing the price to include them will deliver less profit than your current profit (even though it is still profitable)?
  • Is there a segment of customers with low willingness to pay that you cannot reach through any other way?
  • Can you serve these low willingness to pay customers through these group buying site without the full price customers knowing about it (third degree price discrimination)?

If  the answer to any of these questions is NO, you have hard math ahead of you (Spreadsheet).

Necessary and Sufficient Conditions for Choosing GroupOn

Read the book: To Group Coupon Or Not for Small Businesses

Let us say you sold cupcakes at $4 a unit. You sell 1000 a week at that price. You are considering using GroupOn to increase your sales. Here are the necessary and sufficient conditions
Necessary:  The Marginal Cost of each unit must be less than 25% of full price. If this is not true GroupOn recommended 50% off promotions and its 50% cut are not for you.
Sufficient: The incremental profit from serving the GroupOn delivered customers must be more than the incremental cost to serve them. A more restrictive requirement is, this net profit must be more than what is possible through other methods.

For the detailed  factors read on:
  1. Cost Calculation: The stories I read on GroupOn and other Small Business stories from Times indicate they are doing cost accounting wrong. For example, cupcake stores allocate a share of all the costs, from rent, insurance to bathroom cleaners to each unit sold. That is wrong! You need to compute the true marginal cost of SELLING one more cupcake and treat everything else as fixed costs. Let us assume it is $1 for your cupcake.
  2. Contribution Margin: Now that you know the true marginal cost (MC) of each cupcake, Price – MC,  gives its contribution margin (CM). In this case it is $4 – 1 = $3. The sum of CM from all cupcakes, $3000, go towards offsetting your fixed costs. If after covering all such costs you still have some CM left, that is your profit.
  3. Discount: From the vivid news stories described by small businesses and from a survey of GroupOn deals, the most common discount is 50% (or more). So the effective price drops to $2 and CM drops to  $2 -$1 = $1.
  4. GroupOn’s Cut: GroupOn gets 50% of the deal price . This may not look like additional cost but this is the cost to sell each additional unit.
  5. Contribution Margin of GroupOn Customer: After the 50% cut, the contribution margin further drops to  (P/2 – MC – P/4  = P/4  – MC). That is right, the new customer you acquire contribute much less than a regular customer. In the example we are using, the CM of a GroupOn customer is $1 – $1 = $0.
  6. Lifetime Value?: You might think you are getting the customer for life (or at least a few more times ). But there is nothing to support the claim other than hope. Sometimes it might take you years to serve these customers you acquired – either because it will take them time to visit you or because of sheer capacity limitations. If these customers are willing to buy your cupcake only because of its deal, are they likely to pay the full price? They are more likely busy searching other great deals.
  7. Incremental Costs: If you can serve all the new customers from the campaign with no additional investment (equipment, people, space), then it is not too bad. But if you need to hire more people, buy new oven etc, then all these costs be covered fully by the GroupOn customers. One common mistake is to distribute the new costs over all the cupcakes sold. The new costs are a direct result of these new customers and hence the CM from these customers alone must cover the costs.
  8. Opportunity Lost: Suppose the deal drove lots of customers to your stores and that ended up turning away some of your current and new (non GroupOn) high CM, customers.  That is opportunity lost.  Another aspect is, your business may already be growing albeit at very low rate due to previous marketing efforts,WoM and other reasons. These customers pay full price. If you cannot serve these new customers because you are busy handling promotion customers, that is opportunity lost. You need to calculate how many such full-price customers you are losing because of your focus on GroupOn customers.
  9. Opportunity Cost: This is the cost of alternative you did not take because you chose GroupOn – from time and resources you invest. Are there other channels that could have delivered you incremental sales?

So when should you consider with GroupOn?

  1. When   MC < 25% of current price (you are selling at high price premium)
  2. When there are low-value customers who are not willing to pay the current price but can be served at a price P1 > MC  (note P1 = P/2 according to GroupOn)
  3. When these customers are not easy to identify and reach
  4. When the incremental profit from these customers is more than the costs they incur you