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