Computing Profitability with GroupOn – Relevant Costs and Cognitive Bias

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

Utpal Dholakia, Marketing professor at Rice published his results from his study, “How effective are GroupOn promotions“.  A key finding from the study is, 66% of the businesses that used GroupOn promotions reported the promotions were profitable. Let us note that (and the paper clearly points that out as well) this was measured based on survey response of business owners.

The reality could be much different from this, not just due to sampling error but due to incorrect relevant cost estimation and cognitive biases of these business owners. Note: Spreadsheet link at the end of the post.

Relevant Costs: In my previous articles (and here) I wrote about the different cost components of running a GroupOn promotion. These are not only specific to GroupOn but are true for any new promotion that is being considered. The promotion must deliver incremental profit over all its relevant costs and this profit must be better than any other option available to the business. In general, most small businesses without rigorous cost accounting are most likely to ignore:

  1. Opportunity costs: This is forgone profits  from other means to drive revenues-  including price realization, increasing customer margin, new product introduction and  other promotions.
  2. Lost profits: These are the lost profits from sales not made to current and new full price customers. Businesses may forgo these sales because their capacity is all consumed in serving the promotion traffic.
  3. Incremental costs: These are the costs incurred to add people and capacity just to serve the new traffic

Of these costs, the first two do not incur any cash outflow and hence are most likely to be ignored, “if we did not have it or spend it then we did not lose it”. But these costs are very relevant to evaluating the profitability of running the promotion and hence must be covered only by the revenues from the promotion.

In my email conversation with Utpal, he mentioned that the study did not take into account these costs (quoted with permission)

all of the things you mentioned are definitely true.. since we asked them only whether the promotion was profitable or not, they might or might not have factored in these more subtle aspects of costs

Cognitive Dissonance and Commitment Bias

You may have seen this on TV reality game shows or post-game interviews of players of losing teams.  They take huge risk but come out with very little to show for. A common quote from people who do not make it to the next round is, “It is great coming this far. We did not think we would be here when we started this. I would not exchange this for anything else”.

What is going on here is that losing team suffers from cognitive dissonance – the conflict between what we want vs. the real outcome. We take an action expecting one type of results but the reality turned out to be different. Since we can’t change the reality we change our mind by saying, “this is great, this is what actually we wanted, we are in fact better than what we thought we would be”.

In the case of business owners who reported the promotion was profitable, they may very well be addressing their cognitive dissonance. They made a conscious decision to run a GroupOn promotion. To say now that the move was not profitable is admitting their original decision to run the promotion was a mistake.

After the fact, people significantly understate their original target. Compared to the reduced targets, any revenue from a 50% promotion may look like a success.

There is also the mental compulsion to continue to act in accordance with our previous action. Psychologists call this, Commitment Bias. Once they run one promotion, the businesses are more likely to repeat the promotion because they are compelled to act in line with their previous action.

This is not to say no business made a profit but only to point out that the number 66% has more than sampling error in it.

When is GroupOn promotion profitable?

  • You have a product with high contribution margin (price less marginal cost)
  • Have excess capacity (with sunk costs and no other way to monetize it)
  • There exists 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)
  • There exists a segment of customers with low willingness to pay that you cannot reach through any other way
  • You can serve these low willingness to pay customers without the full price customers knowing about it (third degree price discrimination)

If any of these are not true you have hard math in front of you (Spreadsheet).