Profit Pools

Author: Dana Peck

Reviewer: Michael Collins

December 1998
Copyright 1998 Bain & Company, Inc.

Profit Pools Agenda

Profit Pools Concept Applications

Profit Pool Steps

Client Example Key Takeaways

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Profit Pools What are Profit Pools?

Profit pools are the total profits earned in an industry at all points along the industrys 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

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
Profit can be defined in one of three ways:

What is Profit?

Accounting profit - represents companys 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 companys 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 - companys 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 Be aware of differences in accounting standards when evaluating companies with profits spanning different industries
Source: How to Map Your Industrys Profit Pool (May-June 1998); Orit Gadiesh and James L. Gilbert
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Profit Pools

Truck Manufacturing Business Example Revenue vs. Profit Split

The pattern of profit concentration in the truck manufacturing industry is very different from the pattern of revenue concentration.
100%

$3,865MM
Truck Finance Parts and Service
Body Manufacturing and Truck Assembly

$600MM
Truck Finance Parts and Service
Body Manufacturing and Truck Assembly

80%

Percent of Total

60%

40%
Chassis Manufacturing and Sales Chassis Manufacturing and Sales

20%

0%

Revenue Split by Activity

Profit Split by Activity

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

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Profit Pools
Companies that recognize the variability of profitability and can exploit the deepest pools will earn superior returns.
Illustrate the Current State of the Industry Offer a view of the underlying industry structure Help illustrate the economic and competitive forces driving the industrys 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 Provide a Competitive Advantage to Your Client Help companies see what their rivals dont 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

Why Use Profit Pools?

Help to Develop Innovative Strategies

Help guide important decisions about a companys 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 companys strategic vision - reduce potential to overlook attractive profit building opportunities - lesson potential to become trapped in areas of weak/ fading profitability Example applications
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Source: Profit Pools: A Fresh Look at Strategy (May-June 1998): Orit Gadiesh and James L. Gilbert

Profit Pools How Profit Pools Illustrate the State of the Industry
Profit pools provide a means to evaluate the competitive dynamics of an 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

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)

Be aware of choke points - particular business activities that control the flow of profits throughout an industry.
Microprocessors Other Components Personal Computers

Software*

Peripherals

Services

Examples: Intels dominance of microprocessors

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

Microsofts dominance of Windows

Consolidation of control over the customer interface

Control of a choke point can influence the distribution of profits among competitors and more distant value-chain participants
*includes operating system and application software 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 Con.)

Although choke points exist in the computer industry, it is still possible for companies to create and leverage new profit pools within this industry. 40% PC Industry Profit Pool

Operating Margin

30%

20%

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

10%

Microprocessors

0%

Other Components

Personal Computers

Share of Industry Revenue

Soft- PeripheralsServices ware 100%

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

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Profit Pools
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. 25% 20% Operating Margin 15% 10% 5% 0% 100%

U.S. Auto Industry Example

Aftermarket parts

New car dealers

Auto loans Leasing Gasoline

Auto manufacturing

Used car dealers

Auto insurance

Share of Industry Revenue

Service repair

Auto rental

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Profit Pools Key Questions to Help Develop Innovative Strategies

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

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)

Companies can use their understanding of profit pools in different ways: Examples
Identify New Sources of Profit 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

Chart Acquisition and Expansion Strategies

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)

Develop Distribution Strategy 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 dealers 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 industrys 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

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 pool involves four steps. Step 1:
Define the Pool

Mapping a Profit Pool

Step 2:
Determine the Size of the Pool
Develop a baseline estimate of the profits generated by all profit pool activities within the value chain

Step 3:
Estimate the Distribution of Profits Determine the profits generated by each activity within the value chain

Step 4:
Reconcile the Estimates
Compare the results of step 2 and 3, and reconcile the numbers

Tasks:

Identify which value chain activities influence the industrys ability to generate current and future profits

Output: 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

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

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Profit Pools
Defining the pool involves identifying value chain activities relevant to the business.

Guidelines (Defining the Pool)

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 Dont 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 Industrys 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 industrys profits gauge the profits of the smaller players by adjusting the leaders margins to account for the smaller players 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 Industrys 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 companys financial data if the industrys players are vertically integrated mixed players

Source: How to Map Your Industrys 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 dont add up

Collect additional data if necessary

Resolve inconsistencies
Source: How to Map Your Industrys 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

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Profit Pools

Truck Manufacturing Business Example Severe Service Value Chain (Defining the Pool)

The first step was to define the pool by identifying the Body value chain activities relevant to the business.
Manufa Chassis Chas cturing, Manufa sis Sales cturing Sales and Assemb Sell chassis Build truckly body Activities: Build truck chassis to/take order to customer specs according to from customer Prepare body for customer Manage and manage specs connection of assembly process Collect chassis and Sell body to components TEM* customer from Deliver integrated manufacturers unit to customer Performed Chassis Chassis dealer TEM By: manufacturer Chassis manufacturer TEM

Retail Finan ce

Parts & Servic e

Offer funds as Provide parts for loans for truck truck chassis and purchase body Arrange loan Perform and lease preventative and transactions emergency service on truck chassis and body Chassis dealer Chassis manufacturer TEM Chassis manufacturer Chassis dealer Independent garage or parts store
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Notes: *Truck Equipment Manufacturers

Truck Manufacturing Business Example Profit Pools Severe Service Vehicle Profit Pool (Determining the Size of the Pool)
A rough estimate of the total profit pool was built using overall profit estimates from the top 5 competitors. Methodology Estimated Percent of Total Profit Pools 100%
~$500-700MM Other

80%
Freightliner Navistar Peterbilt

60%

40%
Sterling

20%
Mack

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%
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0%
Source: Bain analysis

Truck Manufacturing Business Example Profit Pools Body Company Margins (Determining the Distribution of Profits for an Activity within a Value Chain)
Profit estimates were generated for each activity based on the operating margins of the top industry players. Operating Margins for Body Companies 13% 10% 8% 5% 3.0% 3% 0% 7.1% 12.0% Example Activity: Body Manufacturing

9.0%

9.0%

8.6%

8.2%

6.6%
5.8% 3.9%

Total McNeilus Heil Industry

Leach KnapheideOmaha Vactor Ottawa Advance Rest of Industry

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

Truck Manufacturing Business Example Profit Pools Severe Service Vehicle Profit Pool (Reconciling the Estimates)
Total profit estimates from the top down approach were compared to those from the bottoms up approach. 100% ~$500-$700MM Other $600MM Truck Finance
Body Manufacturing and Truck Assembly

Estimated Percent of Total Profit Pools

80%

Freightliner
Navistar Peterbilt

60%

Parts and Service

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

40% Sterling 20% Mack 0% Top Down

Chassis Manufacturing and Sales

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

Bottoms Up
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Source: Bain analysis

Profit Pools

Truck Manufacturing Business Example Severe Service Vehicle Profit Map (1997)

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.
Percent of Total Contribution in Each Activity 100% $305MM General Motors Other Volvo Kenworth Freightliner Navistar Peterbilt 40% Sterling 20% Mack 0% Chassis Manufacturing 12.3%
Chassis Sales

$35MM $60MM $55MM $85MM $60MM Other

80%

Ottawa
Advance Mixer

Omaha
Stahl

Vactor

60%

Leach Knapheide
McNeilus

Chassis Dealers Total EBIT= $600MM

Heil
Body Manufacturing, Sales and Assembly

Estimated Margin:

1.4%

Truck Parts Service Finance 7.1% 24.6% 11.2% 35.0%

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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

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

Truck Manufacturing Business Example Profit Pool Summary

Chassis manufacturing and after market parts are most profitable activities

Body joint ventures attractive if lead to greater chassis or after market share

Dealer ownership would create access to high margin activities

Client should focus on gaining share in chassis manufacturing and/or capturing a greater percentage of truck finance and parts and service

High fragmentation and low profitability make body manufacturing unattractive

Forward integration into bodies has not occurred

Dealers control access to high margin finance and parts and service

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Profit Pools Agenda

Profit Pools Concept Applications

Profit Pool Steps

Client Example Key Takeaways

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Profit Pools Key Takeaways (1 of 2)

Profit Pools Concept

Profit pools are the total profits earned in an industry at all points along the
industrys 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

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Profit Pools Key Takeaways (2 of 2)

Profit Pool Steps

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 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

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Profit Pools Takeaway Slides

Profit Pool Concept
Profit Pools What are Profit Pools?
Profit pools are the total profits earned in an industry at all points along the industrys 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

Profit Pool Uses

Profit Pools
Companies that recognize the variability of profitability and can exploit the deepest pools will earn superior returns.
Illustrate the Current State of the Industry Offer a view of the underlying industry structure Help illustrate the economic and competitive forces driving the industrys 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 Provide a Competitive Advantage to Your Client Help companies see what their rivals dont 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

Why Use Profit Pools?

Help to Develop Innovative Strategies Help guide important decisions about a companys 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 companys strategic vision - reduce potential to overlook attractive profit building opportunities - lesson potential to become trapped in areas of weak/ fading profitability Example applications
b
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Profit pools answer the question: Where and how is money being made?
b
Source: Profit Pools: A Fresh Look at Strategy (May-June 1998): Orit Gadiesh and James L. Gilbert
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c
P rof it P ools 3

c
P rof it P ools 6

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

Profit Pool Steps

Profit Pools
Mapping a profit pool involves four steps.
Step 1: Define the Pool Tasks: Identify which value chain activities influence the industrys ability to generate current and future profits Step 2: Determine the Size of the Pool Develop a baseline estimate of the profits generated by all profit pool activities within the value chain

Profit Pool Map

Profit Pools Truck Manufacturing Business Example Severe Service Vehicle Profit Map (1997)
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.
100%
Percent of Tota l Contribution in Each Activity

Mapping a Profit Pool

Step 3: Estimate the Distribution of Profits Determine the profits generated by each activity within the value chain

Step 4: Reconcile the Estimates Compare the results of step 2 and 3, and reconcile the numbers

$305MM
G e n e r al M o to r s

$35M M

$60MM $55MM Other

$85MM

$60MM

Oth er

Volvo 80% Kenworth Freightliner 60% Navistar Peterbilt 40% Sterling 20% Mack 0% Heil Total EBIT= $600MM Truck Finance Parts Service McNeilus
Cha ss is Manufac turer s
Ch as sis De ale rs

O tt a wa
Ad va nce M ixe r

Chassis Dealers

Va c to r

Om a h a

Stahl Leach
Kn a ph e id e

Chassis Dealers

Output:

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

b c
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Chassis Manufacturing

Bo dy C h a s s is Sa l e s M an uf ac tur ing , Sa les an d Asse mb ly

Estimated Margin:
Source: How to Map Your Industrys Profit Pool (May-June 1998); Orit Gadiesh and James L. Gilbert

12.3%

1.4% 7.1%

24.6%

11.2%

35.0%

b
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
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c
P rof it P ools 24

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