Profit Pools: An Industry Level Strategic Framework!
I recently came across a podcast by Matrix Partners India, which shed light on Profit Pools. I was intrigued by this fancy term. It made me wonder what it is and whether it is different from Profit Margins. It was initially mentioned in an HBR article by Orit Gadiesh and James L. Gilbert in 1998.
What is a Profit Pool?
- It is a strategy model that can help managers or companies focus on profits rather than revenue growth.
- By definition, a profit pool is the total profit earned in an industry at all points in an industry’s value chain. A value chain is a business model that describes the full range of activities that are needed to create a product or service.
Is It Different From Profit Margins?
- Profit Pool is a type of framework that uses an industry’s financial history to help make strategic decisions for the future. Whereas, Profit margins are generally considered for a specific period.
- Profit Pools are usually industry-specific, and Profit Margins are specific to organizations.
Profit Pool Mapping:
Profit Pool mapping is done by using value chain analysis for a particular industry.
- This framework analyzes how profits are distributed among the various activities that form a value chain of an industry.
- Profit Pools prove that the highest revenue does not always necessarily convert to the highest profits.
- Below is the framework, initially explained by Orit Gadiesh and James L. Gilbert in their HBR article.
Profit Pool Charts:
- Profit Pool charts are mapped in the following manner:
- X-axis: % Share of revenue of different components in a value chain of an industry
- Y-axis: % of Operating margins of the same components
Here, operating profit margins are the ones gained after paying variable costs for respective components.
Let’s consider a hypothetical example of the Fitness Industry consisting of the following elements in the value-chain:
- Food Supplements
- Fitness Consulting
- Gym Memberships
- Live Classes’ Subscription
- The gyms tend to have variable costs like real estate rental, electricity bills, staff salaries, timely maintenance of equipment on the gym floor. These costs shrink the operating profit margins.
- A startup that purely runs on subscriptions for live classes does not have overhead costs like huge real estate investment. The instructor can take sessions from anywhere, which helps cut down the variable costs and yield more profit margins.
- The above chart shows that, from a revenue perspective, ‘Gym Memberships’ and ‘Food Supplements’ have a larger share (more than 50%) in the value chain.
- On the other hand, the operating margins (operating profit margins) are lower for both of them than that of ‘Subscriptions for Live Classes’
- From the above data, we can say that a leading Gym Chain will make a lesser profit (in %) than an online live fitness coaching platform that runs on a subscription basis.
- This analysis can help the Gym Chains decide the strategy and roadmap to invest in a live subscription business model to improve profit margins.
Below is one real-time example of Profit Pool Mapping:
- Profit Pool mapping helps in finding the location and size of profit concentrations within an industry.
- It gives an in-depth analysis of the industry structure and competitive dynamics.
- It also identifies the most critical components of the industry that will yield more profitability in the future.
- For mapping profit pools, access to accurate financial data points is a must.
- It is an intensive calculation process.
- Profit Pool mapping for an industry with a complex value chain can get more complicated.
My Two Cents:
- Startups looking forward to disrupting various industries can use this framework to figure out which component of an industry’s value chain should be targeted.
- It will also give startups a competitive advantage over others in terms of hitting profitability early.