Profit Pool AnalysisProfit Pool Mapping

© K.E. Homa

Proprietary Material

Professor Ken HomaGeorgetown University

Incomplete Without Extensive Oral Elaboration

Profit Pool AnalysisGuiding Principle

The starting point for industry analysis is a very simple question: What is the level of profitability in an industry and what determines it? Grant, Contemporary Strategy Analysis

Profit Pool Analysis is how to answer the question.

Profit Pool Analysis

1. Estimate aggregate industry profits

2. Disaggregate profits into components

3. Visualize (display) the results

Three sequential activities:

Profit Pool Maps are the end-product of the process …

Profit Pool MapsKey Elements

Sources of Profitability• Value Chain Steps• Products / Markets• Customer Segments• Distribution Channels

Profit Pool MapsKey Elements

Profitability• ROS• ROI

Sources of Profitability• Value Chain Steps• Products / Markets• Customer Segments• Distribution Channels

Profit Pool MapsKey Elements

Profitability• ROS• ROI

Sources of Profitability

Scale of ParticipationRevenue, Capital Deployed

• Value Chain Steps• Products / Markets• Customer Segments• Distribution Channels

Profit Pool MapsKey Elements

Profitability• ROS• ROI

Sources of Profitability

Scale of ParticipationRevenue, Capital Deployed

Note: By def’n. thebox areas = Profits

• Value Chain Steps• Products / Markets• Customer Segments• Distribution Channels

Profit Pool MapsKey Elements

Profitability• ROS• ROI

Sources of Profitability

Scale of ParticipationRevenue, Capital Deployed

Note: By def’n. thebox areas = Profits

• Value Chain Steps• Products / Markets• Customer Segments• Distribution Channels

See Appendix for Examples

Profit Pool MapsThe Gold Standard

Strategy guru Michael Porter argues that:

• Organizations are supposed to use all resources effectively … by producing goods or services whose value exceeds the sum of the costs of all the inputs

• So, he best financial measure that is return on invested capital since ROIC since it weighs the profits a company generates versus all the funds invested in it.

Source: Margretta, Understanding Michael Porter

ROIC

Sources of Profitability

Capital Deployed

Profit Pool MapsThe Gold Standard

• Value Chain Steps• Products / Markets• Customer Segments• Distribution Channels

See Appendix for Examples

The Gold Standard – relating capital deployed to ROIC – is often difficult to derive because of accounting complexity and data limitations …

More typically, the profitability metric used is return on sales (ROS) and revenue is used as a measure of scale…

ROS

Sources of Profitability

Revenue

Profit Pool MapsTypical Application

• Value Chain Steps• Products / Markets• Customer Segments• Distribution Channels

See Appendix for Examples

Profit Pool Mapping: Why bother?

Profit Pool MapsDerived Benefits

• Adds depth of understanding re: industry structure and competitive dynamics

• Reveals location and size of profit concentrations within an industry

• Identifies and isolates the most critical drivers of future industry profitability

Profit Pool Mapping:An under-used tool …

Profit Pool MapsAn Under-used Tool

• Managers unaware of implications

• Financial data unavailable or inconsistently reported

• Requires extensive time, effortand analytical dexterity

Profit Pool MapsThe Process

Source: How to Map Profit Pools

Profit Pool MapsTricks of the Trade

• Start by mining government and analyst reports

• If compiling from scratch, start with direct competitors, especially “pure plays” that report profit by segments

• Extrapolate from data-rich competitors to others

• Take several views – split by multiple profit sources.

• Don’t get bogged down … think 80-20 … better to be directionally right than precisely wrong.

• Profit Pools are the ultimate metric of industry attractiveness

• Strong ties to Porter’s Five Forces and Value Chain Analysis

• Profit Pools can be split along several dimensions: business segment, competitors, products, regions, value chain stage

• Profit metrics applied range from ROS % (most typical) to ROCE (conceptually, the most pure)

• Often, multiple views are required to get a full industry perspective.

Profit Pool AnalysisTakeaways

Appendix

Profit Pool MapsExamples

Industry-level Profit Pools can be split into different categories …

Often, multiple views are needed to get a complete perspective on the industry.

Examples

U.S. PC Industry Profit Pool -- Late 1990s

Source: Profit Pools: New Look at Strategy

1. Profits split by product categories… horizontally sequenced by activity stage – parts, finished goods, etc.

2. Width of each bar is proportionalto the all categories’ total

3. Profit is stated relative sales (i.e. ROS %)

4. Area of each bar representsproportion of total profits

U.S. Auto Industry Profit Pool -- Late 1990s

Source: Grant, Strategic Analysis from Profit Pools: New Look at Strategy

Profits split by business segment … horizontally sequenced by activity stage – make, sell, service, etc.

Source: Breakthrough Imperative

Profits split by value chain stages

http://www.bain.com/publications/articles/healthcare-2020.aspx

Profits split by business segment

The prior examples all calibrated profitability based on ROS (return on sales), but …

Strategy guru Michael Porter argues that:

• Organizations are supposed to use all resources effectively … by producing goods or services whose value exceeds the sum of the costs of all the inputs

• So, he best financial measure that is return on invested capital since ROIC since it weighs the profits a company generates versus all the funds invested in it.

Source: Margretta, Understanding Michael Porter

Some economists and financial analysts follow Porter’s guidance and use some variant of ROIC in their profit pool maps …

For example, Credit Suisse analysts calculate a net cash flow ROI (over the firm’s WACC), and relate it to relative levels of net investment (not revenues).

Examples

http://analystreports.som.yale.edu/internal/F2013/MJ/Measuring%20the%20Moat.pdf

3. Width of each bar is proportional tothe industry’s total net investment

2. Profit is stated based on net ROIC (over the WACC)

1. Profits split by industry sector

http://analystreports.som.yale.edu/internal/F2013/MJ/Measuring%20the%20Moat.pdf

Profits are split by company

http://analystreports.som.yale.edu/internal/F2013/MJ/Measuring%20the%20Moat.pdf

Profits are split by business segment

1. Profits are split byvalue chain stage

2. Profit is stated based on net ROCE

3. Note that axes are mismatchedso areas do not equal profits Revenues x ROCE ≠ Profits

Profit Pool AnalysisProfit Pool Mapping

© K.E. Homa

Proprietary Material

Professor Ken HomaGeorgetown University