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Author: Dana Peck Reviewer: Michael Collins Profit Pools December 1998 Copyright© 1998 Bain & Company, Inc.

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Page 1: Profit Pools

Author: Dana Peck

Reviewer: Michael Collins

Profit Pools

December 1998Copyright© 1998 Bain & Company, Inc.

Page 2: Profit Pools

2CHI

Profit Pools

Agenda

• Profit Pools Concept

• Applications

• Profit Pool Steps

• Client Example

• Key Takeaways

Page 3: Profit Pools

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Profit Pools

• Profit pools are the total profits earned in an industry at all points along the industry’s value chain

• Pattern of profit concentration in an industry is very different from the pattern of revenue concentration (see example)

• For example, profits and revenues in the automotive industry can be divided among many value chain activities - vehicle manufacturing, new and used car sales, gasoline retailing, insurance, after-sales service and parts, and lease financing

- although car manufacturing and dealers account for almost 60% of industry revenue

- auto leasing and financing are by far the most profitable businesses

What are Profit Pools?

Profit pools answer the question: “Where and how is money being made?”

Source: Profit Pools: A Fresh Look at Strategy (May-June 1998): Orit Gadiesh and James L. Gilbert

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Profit Pools

What is Profit?

• Accounting profit - represents company’s earnings as formally reported

- most commonly used as the basic profit measure

- examples include net income or earnings per share calculations

• Return on investment - represents company’s earnings after taking into account the cost of capital invested in the business. Two commonly used measures include:

- ROC, accounting based Return on Capital (book value)

- ROIC, accounting based Return on Invested Capital (book value)

• Cash-flow contribution - company’s earnings before taking fixed-asset and capital costs into account (e.g. EBITDA)

- represents the amount of cash left from a sale after subtracting the variable costs associated with that sale

- used as a basis for decision-making in mature, high fixed cost and cyclical industries

Profit can be defined in one of three ways:

Be aware of differences in accounting standards when evaluating companies with

profits spanning different industries

Source: How to Map Your Industry’s Profit Pool (May-June 1998); Orit Gadiesh and James L. Gilbert

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Profit Pools

Revenue vs. Profit Split

Truck Finance

Parts and Service

Body Manufacturingand Truck Assembly

Chassis Manufacturingand Sales

Truck Finance

Parts and Service

Body Manufacturingand Truck Assembly

Chassis Manufacturingand Sales

Revenue Split by Activity Profit Split by Activity

$3,865MM $600MM

0%

20%

40%

60%

80%

100%

Per

cent

of

Tot

al

Source: PBIR Profile of the U.S. Truck Body Industry; R.L. Polk Registration Database; Literature Search; TEM Financials; Prior Bain PLP analysis (7/96); Bain estimates

The pattern of profit concentration in the truck manufacturing industry is very different from the pattern of revenue concentration.

Truck Manufacturing Business Example

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Profit Pools

Why Use Profit Pools?

• Offer a view of the underlying industry structure

• Help illustrate the economic and competitive forces driving the industry’s profit distribution

• Offer a different perspective on an industry

• Illustrate relationship between profit and revenues

• Highlights potential watchouts (choke points in the value chain) which can influence the profit flow in an industry

Illustrate the Current State of the Industry

Provide a Competitive Advantage to Your Client

Help to Develop Innovative Strategies

• Help companies see what their rivals don’t see

• Foster the potential to dictate the terms of competition within the industry

• Keep companies abreast of changes in rapidly changing (turbulent) industries

- alert potential shifts in profit distribution along the value chain

- illustrate potential change in profit sources from new entrants

• Help guide important decisions about a company’s operation and strategy

• Encourage rethinking old decisions and pursuing counterintuitive initiatives to create and control profit pools

• Reduce the possibility of blind spots in a company’s strategic vision

- reduce potential to overlook attractive profit building opportunities

- lesson potential to become trapped in areas of weak/ fading profitability

• Example applications

Companies that recognize the variability of profitability and can exploit the deepest pools will earn superior returns.

Source: Profit Pools: A Fresh Look at Strategy (May-June 1998): Orit Gadiesh and James L. Gilbert

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Profit Pools

How Profit Pools Illustrate the State of the Industry

• The varying concentrations of profit along the value chain (known as the shape of the profit pool) reflect the competitive dynamics of a business

- profit concentrations result from the actions and interactions of companies and customers

- profit pools form in areas where barriers to competition exist

- profit pools exist in areas that have been overlooked by competitors

• Every market has an uneven distribution of profit between product categories, customer groups, geographic regions and/or distribution channels

• Profit pools are not stagnant

- as power shifts among the players in an industry (competitors, suppliers, and customers), the structure of the profit pool changes

There are many different sources of profit in any business

Profit pools provide a means to evaluate the competitive dynamics of an industry.

Source: Profit Pools: A Fresh Look at Strategy (May-June 1998): Orit Gadiesh and James L. Gilbert

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Profit Pools

Profit Pool Watchouts (Computer Industry Example)

Examples:

Be aware of “choke points” - particular business activities that control the flow of profits throughout an industry.

Impact:

Control of a choke point can influence the distribution of profits among competitors and

more distant value-chain participants

• Intel’s dominance of microprocessors

• Establishment of an industry wide standard that all companies must now obey

• Microsoft’s dominance of Windows

• Consolidation of control over the customer interface

*includes operating system and application softwareSource: Profit Pools: A Fresh Look at Strategy (May-June 1998): Orit Gadiesh and James L. Gilbert

Micro-processors

Other Components

Personal Computers Software* Peripherals Services

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Profit Pools

Mic

ro-

proc

esso

rs Other Components

Personal Computers Soft-ware

PeripheralsServices0%

10%

20%

30%

40%

Ope

ratin

g M

argi

n

Share of Industry Revenue

Profit Pool Watchouts (Computer Industry Example Con.)

*includes operating system and application softwareSource: Profit Pools: A Fresh Look at Strategy (May-June 1998): Orit Gadiesh and James L. Gilbert

• Analyzing the profit pool has enabled Dell to be profitable in the least profitable personal computers segment (see example)

Although choke points exist in the computer industry, it is still possible for companies to create and leverage new profit pools within this industry.

PC Industry Profit Pool

100%

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Profit Pools

0%

5%

10%

15%

20%

25%

Ope

ratin

g M

argi

n

The automotive industry encompasses many value-chain activities. The most profitable areas of the car business are not the ones that generate the biggest revenues.

Auto manufacturing

New

car

de

aler

s Used car dealers

Aut

o lo

ans

Leas

ing

Gas

olin

e Auto insurance

Ser

vice

rep

air

Afte

rmar

ket

part

s

Aut

o re

ntal

Share of Industry Revenue

100%

U.S. Auto Industry Example

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Profit Pools

Key Questions to Help Develop Innovative Strategies

• Why have profit pools formed where they have?

• Are the forces that created those pools likely to change?

• Will new, more profitable business models emerge?

• How do some profit sources exert influence over others and shape competition?

• How do we gain a disproportionate share of industry profits?

Building an understanding of profit pools puts strategic thinking on a firm footing and prompts the following questions:

Source: Profit Pools: A Fresh Look at Strategy (May-June 1998): Orit Gadiesh and James L. Gilbert

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Profit Pools

Agenda

• Profit Pools Concept

• Applications

• Profit Pool Steps

• Client Example

• Key Takeaways

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Profit Pools

Applications (1 of 2)

• Analyzing profit pools allowed U-Haul to identify a large untapped source of profit in the low margin truck rental business

- seized the first mover advantage and entered accessory business at a low cost- reduced prices (and profits) in core truck rental business to attract customers for higher margin

accessory business

• In anticipation of a potential reconfiguration of the profit pool from pharmacy-benefit managers (PBM), Merck and others vertically integrated the value chain and acquired PBMs

- insulated themselves from new entrants and protected their existing sources of profits- gained greater access to patient information- increased the likelihood that the pool would evolve in a beneficial rather than destructive way

Companies can use their understanding of profit pools in different ways:

Identify New Sources of Profit

Chart Acquisition and Expansion Strategies

Examples

Source: Profit Pools: A Fresh Look at Strategy (May-June 1998): Orit Gadiesh and James L. Gilbert

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Profit Pools

Applications (2 of 2)

• Dell Computer Corp. utilizes the profit pool approach to evaluate which customers to pursue and which channels to use - direct sales approach allows Dell to keep a portion of dealer’s profits for itself and to share the rest with customers

through lower prices- regular resegmentation of customer base enables them to identify the most profitable customers and react quickly to

new sources of profit

• After recognizing that the industry’s profit pool was driven by the premium beer segments, Anheuser Bush refocused their strategy to expand their share of the premium segment

- gained dominance of the premium segment through increased marketing of premium brands and by managing the price differentials between premium and discount brands

- vertical integration into can production raised competitive barriers around the pool by cutting manufacturing and distribution cost

Develop Distribution Strategy

Guide Pricing, Product and

Operating Decisions

The company that sees what others do not will be best prepared to capture a

disproportionate share of industry profits

Source: Profit Pools: A Fresh Look at Strategy (May-June 1998): Orit Gadiesh and James L. Gilbert

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Profit Pools

Agenda

• Profit Pools Concept

• Applications

• Profit Pool Steps

• Client Example

• Key Takeaways

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Profit Pools

Mapping a Profit PoolMapping a profit pool involves four steps.

Define the PoolDetermine the

Size of the Pool

Estimate the Distribution of

Profits

Reconcile the Estimates

Tasks: • Identify which value chain activities influence the industry’s ability to generate current and future profits

• Develop a baseline estimate of the profits generated by all profit pool activities within the value chain

• Determine the profits generated by each activity within the value chain

• Compare the results of step 2 and 3, and reconcile the numbers

• List of value chain activities in profit pool (in sequential order)

• Estimate of total profit pools (maybe a range)

• Point estimates of profit for each value chain activity

• Final estimates of activity and total pool profits

Output:

Step 1: Step 2: Step 3: Step 4:

Source: How to Map Your Industry’s Profit Pool (May-June 1998); Orit Gadiesh and James L. Gilbert

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Profit Pools

Guidelines (Defining the Pool)Defining the pool involves identifying value chain activities relevant to the business.

• Take a broad view of the value chain - look beyond traditional industry definitions

• Examine the industry from 3 perspectives- client- competitors- customers

• Talk to industry players and analysis to uncover new or emerging business models

• Don’t disaggregate activities more than necessary

• Consider parallels from other industries- are there activities that could substitute for activities in this industry?

The way you define your profit pool is unlikely to coincide with any traditional industry

definition

Source: How to Map Your Industry’s Profit Pool (May-June 1998); Orit Gadiesh and James L. Gilbert

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Profit Pools

Guidelines (Determining the Size of the Pool)

Determining the size of the pool involves developing a rough, but accurate baseline estimate based on the available data.

• Take the easiest analytical routes available

• Focus on the largest components first- large companies

start with the biggest players who account for a large portion of the industry’s profits

gauge the profits of the smaller players by adjusting the leader’s margins to account for the smaller player’s competitive advantages or disadvantages

add the profits together

- high volume products

• Consider building estimates using two different methodologies (e.g. company level vs. product level) so you can compare answers to see if you are in the ball park range

Source: How to Map Your Industry’s Profit Pool (May-June 1998); Orit Gadiesh and James L. Gilbert

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Profit Pools

Guidelines (Estimating the Distribution of Profits)

Estimating the profits for each value chain involves creative thinking.

• Go where the data is (e.g. products, customers, channels, companies, or regions, etc.)

- use proxies if relevant data is unavailable

• Prioritize focus - look at client economics, then large pure players, large mixed players, then a sample of smaller players

- use the 80/20 rule - in most cases 20% of the companies constitute 80% of the revenues

• Shift between aggregation and disaggregation in analysis

- aggregations - use in industries where most of the players focus on one value chain activity “Pure players”

- disaggregation - you will need to disaggregate company’s financial data if the industry’s players are vertically integrated “mixed players”

Source: How to Map Your Industry’s Profit Pool (May-June 1998); Orit Gadiesh and James L. Gilbert

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Profit Pools

Guidelines (Reconciling the Estimates)Developing final estimates of activity and total profits can be an iterative process.

Compare the estimate of total profit pools (top-down approach) with estimates calculated for each value

chain activity (bottoms-up approach)

Check assumptions and calculations if the numbers don’t add up

Collect additional data if necessary

Resolve inconsistencies

Source: How to Map Your Industry’s Profit Pool (May-June 1998); Orit Gadiesh and James L. Gilbert

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Profit Pools

Agenda

• Profit Pools Concept

• Applications

• Profit Pool Steps

• Client Example

• Key Takeaways

Page 22: Profit Pools

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Profit Pools

Truck Manufacturing Business Example

Activities:

Performed By:

• Provide parts for truck chassis and body

• Perform preventative and emergency service on truck chassis and body

• Build truck body to customer specs

• Prepare body for and manage assembly process

• Sell body to customer• Deliver integrated unit to customer

• Offer funds as loans for truck purchase

• Arrange loan and lease transactions

• Sell chassis to/take order from customer

• Manage connection of chassis and TEM*

• Build truck chassis according to customer specs

• Collect components from manufacturers

• Chassis manufacturer• Chassis dealer• Independent garage or parts store

• TEM • Chassis dealer

• Chassis manufacturer

• TEM

• Chassis dealer• Chassis

manufacturer • TEM

• Chassis manufacturer

Chassis Manufacturing

Chassis Sales

Body Manufacturing,

Sales and Assembly

Parts & Service

Retail Finance

Notes: *Truck Equipment Manufacturers

The first step was to define the pool by identifying the value chain activities relevant to the business.

Severe Service Value Chain (Defining the Pool)

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Profit Pools

Other

Freightliner

Navistar

Peterbilt

Sterling

Mack

~$500-700MM

0%

20%

40%

60%

80%

100%

Est

imat

ed P

erce

nt o

f T

otal

Pro

fit P

ools

Severe Service Vehicle Profit Pool (Determining the Size of the Pool)

Source: Bain analysis

• Estimated profits from top 5 companies based on 10Ks and annual reports

• Performed 80/20 analysis to determine total profit pool

- assumed 20% of the companies constituted 80% of the profits

- estimated profits of remaining 20 smaller companies

• Reality checked estimates with rough industry calculations

- Estimated total profit pool around $500-$700MM based on:

$3.9B industry revenues

assumed average gross margins of 13%- 18%

Methodology

Truck Manufacturing Business Example

A rough estimate of the total profit pool was built using overall profit estimates from the top 5 competitors.

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Profit Pools

Note: Operating Margin used as the measure of profitabilitySource: Company Financials; Analysts Reports; Company Interviews

TotalIndustry

McNeilus Heil LeachKnapheideOmaha Vactor Ottawa Advance Rest ofIndustry

7.1%

12.0%

9.0% 9.0% 8.6% 8.2%

6.6%5.8%

3.0%3.9%

0%

3%

5%

8%

10%

13%

Ope

ratin

g M

argi

ns f

or B

ody

Com

pani

es

Profit estimates were generated for each activity based on the operating margins of the top industry players.

Truck Manufacturing Business Example

Example Activity: Body Manufacturing

Body Company Margins (Determining the Distribution of Profits for an Activity within a Value Chain)

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Profit Pools

Other

Freightliner

Navistar

Peterbilt

Sterling

Mack

Truck FinanceBody Manufacturingand Truck Assembly

Parts andService

ChassisManufacturing

and Sales

Top Down Bottoms Up

~$500-$700MM $600MM

0%

20%

40%

60%

80%

100%

Est

imat

ed P

erce

nt o

f T

otal

Pro

fit P

ools

Severe Service Vehicle Profit Pool (Reconciling the Estimates)

Source: Bain analysis

• Chassis + Parts & Services + Body Manufacturing + Finance the range approximated in the top down approach

Final estimates for each value chain activity is within the range of our original total profit pool estimate

Truck Manufacturing Business Example

Total profit estimates from the top down approach were compared to those from the bottoms up approach.

Page 26: Profit Pools

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Profit Pools

OtherGeneral Motors

VolvoKenworth

Freightliner

Navistar

Peterbilt

Sterling

Mack

Cha

ssis

De a

ler s

Other

OttawaAdvance Mixer

VactorOmaha

StahlLeach

Knapheide

McNeilus

Heil

Cha

ssis

Dea

lers

Cha

ssis

Man

ufac

ture

rs

ChassisDealers

Chassis Manufacturing ChassisSales

BodyManufacturing,

Sales andAssembly

TruckFinance

Parts Service

$305MM $35MM $60MM $55MM $85MM $60MM

Total EBIT=$600MM

0%

20%

40%

60%

80%

100%

Per

cent

of T

otal

Con

trib

utio

n in

Eac

h A

ctiv

ity

Once the estimates were reconciled, the final profit map enabled the client to see which segments were the most profitable and which controlled the majority of profit pool.

Estimated Margin: 12.3% 1.4% 7.1% 24.6% 11.2%

Truck Manufacturing Business Example

35.0%

Source: PBIR Profile of the U.S. Truck Body Industry; R.L. Polk Registration Database; Literature Search; TEM Financials; Prior Bain PLP analysis (7/96); Bain estimates

Severe Service Vehicle Profit Map (1997)

Page 27: Profit Pools

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Profit Pools

Dealer ownership would create access

to high margin activities

Chassis manufacturing and after market parts

are most profitable activities

High fragmentationand low profitability

make body manufacturing

unattractive

Body joint venturesattractive if lead togreater chassis or after market share

Dealers control access to high margin

finance and parts and service

Forward integration into bodies has

not occurred

Client should focus on gaining share in

chassis manufacturing and/or capturing a

greater percentage of truck finance and parts

and service

The profit map helped the client evaluate potential markets and their forward integration strategy.

Truck Manufacturing Business Example

Profit Pool Summary

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Profit Pools

Agenda

• Profit Pools Concept

• Applications

• Profit Pool Steps

• Client Example

• Key Takeaways

Page 29: Profit Pools

29CHI

Profit Pools

•Profit pools are the total profits earned in an industry at all points along the industry’s value chain

•Companies that recognize the variability of profitability and can exploit the deepest pools will earn superior returns

•Building an understanding of profit pools puts strategic thinking on firm footing• illustrates the current state of the industry•provides a competitive advantage to the client•helps develop innovative strategies

•There are many different sources of profit in any business

•Control of a choke points can influence the distribution of profits among competitors and more distant value chain participants

Profit Pools ConceptKey Takeaways (1 of 2)

Page 30: Profit Pools

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Profit Pools

Profit Pool Steps

Key Success Factors

•Key success factors include: taking a broad view of the value chain, examining the industry from different perspectives, building estimates from multiple perspectives, prioritizing focus to look at the largest and easiest components first, looking at relevant internal and external comparables, gathering and analyzing data, and creative thinking

•There are four steps in developing a profit map:

•Define the pool

•Determine the size of the pool

•Estimate the distribution of profits

•Reconcile the estimates

Key Takeaways (2 of 2)

Page 31: Profit Pools

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Profit Pools

Takeaway Slides

Profit Pool Concept Profit Pool Uses

Profit Pool Steps Profit Pool Map

3Prof it Pools

b cCHI

• Profit pools are the total profits earned in an industry at all points along the industry’s valuechain

• Pattern of profit concentration in an industry is very different from the pattern of revenueconcentration (see example)

• For example, profits and revenues in the automotive industry can be divided among manyvalue chain activities - vehicle manufacturing, new and used car sales, gasoline retailing,insurance, after-sales service and parts, and lease financing

- although car manufacturing and dealers account for almost 60% of industry revenue

- auto leasing and financing are by far the most profitable businesses

What are Profit Pools?

Profit Pools

Profit pools answer the question:“Where and how is money being

made?”

Source: Profit Pools: A Fresh Look at Strategy (May-June 1998): Or it Gadiesh and James L. Gilbert 6Prof it Pools

b cCHI

Why Use Profit Pools?

Profit Pools

• Offer a view of theunderlying industrystructure

• Help illustrate the economicand competitive forcesdriving the industry’s profitdistribution

• Offer a different perspectiveon an industry

• Illustrate relationshipbetween profit andrevenues

• Highlights potentialwatchouts (choke points inthe value chain) which caninfluence the profit flow inan industry

Illustrate the Current State of the Industry

Provide a Competitive Advantage to Your Client

Help to Develop Innovative Strategies

• Help companies see whattheir rivals don’t see

• Foster the potential to dictatethe terms of competitionwithin the industry

• Keep companies abreast ofchanges in rapidly changing(turbulent) industries- alert potential shifts in profit

distribution along the valuechain

- illustrate potential changein profit sources from newentrants

• Help guide importantdecisions about a company’soperation and strategy

• Encourage rethinking olddecisions and pursuingcounterintuitive initiatives tocreate and control profit pools

• Reduce the possibility of blindspots in a company’s strategicvision

- reduce potential tooverlook attractive profitbuilding opportunities

- lesson potential to becometrapped in areas of weak/fading profitability

• Example applications

Companies that recognize the variability ofprofitability and can exploit the deepest pools willearn superior returns.

Source: Profit Pools: A Fresh Look at Strategy (May-June 1998): Orit Gadiesh and James L. Gilbert

14Prof it Pools

b cCHI

Mapping a Profit PoolMapping a profit pool involves four steps.

Define the PoolDetermine the

Size of the Pool

Estimate theDistribution of

Profits

Reconcile theEstimates

Tasks: • Identify whichvalue chainactivities influencethe industry’sability to generatecurrent and futureprofits

• Develop a baselineestimate of theprofits generatedby all profit poolactivities within thevalue chain

• Determine theprofits generatedby each activitywithin the valuechain

• Compare theresults of step 2and 3, andreconcile thenumbers

• List of value chainactivities in profitpool (in sequentialorder)

• Estimate of totalprofit pools (maybea range)

• Point estimates ofprofit for eachvalue chain activity

• Final estimates ofactivity and totalpool profits

Output:

Step 1: Step 2: Step 3: Step 4:

Profit Pools

Source: How to Map Your Industry’s Profit Pool (May-June 1998); Or it Gadiesh and James L. Gilbert 24Prof it Pools

b cCHI

Severe Service Vehicle Profit Map (1997)

OtherGeneral M otors

Volvo

Kenworth

Freightliner

Navistar

Peterbilt

Sterling

Mack

Chas sisDealers

Other

OttawaAdvance Mixer

Vactor

Omaha

Stahl

Leach

Knapheide

McNeilus

Heil

ChassisDealers

ChassisManufacturers

ChassisDealers

Chassis Manufacturing ChassisSal es

BodyManuf ac tur ing ,

Sa les andAssemb ly

TruckFinance

Parts Service

$305MM $35M M $60MM $55MM $85MM $60MM

Total EBIT=$600MM

0%

20%

40%

60%

80%

100%

Per

cent

of

Tot

al C

ontr

ibut

ion

in E

ach

Act

ivity

Once the estimates were reconciled, the final profit mapenabled the client to see which segments were the mostprofitable and which controlled the majority of profit pool.

Est imated Margin: 12.3% 1.4% 7.1% 24.6% 11.2%

Profit Pools Truck Manufacturing Business Example

35.0%

Source: PBIR Profile of the U.S. Truck Body Industry; R.L. Polk Registration Database; Literature Search; TEMFinancials; Prior Bain PLP analysis (7/96); Bain estimates