Profit Pools Concept

Profit Pools
- A Fresh Look at Strategy

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Profit Pools
4
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
This document is a partial preview. Full document download can be found on Flevy:
http://flevy.com/browse/document/profit-pools-concept-744

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Profit Pools
7
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

CHI
Profit Pools
10
0%
5%
10%
15%
20%
25%
OperatingMargin
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
Newcar
dealers
Used car
dealers
Autoloans
Leasing
Gasoline Auto
insurance
Servicerepair
Aftermarket
parts
Autorental
Share of Industry Revenue
100%
U.S. Auto Industry Example

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Profit Pools
13
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
16
Mapping a Profit Pool
Mapping a profit pool involves four steps.
Define the Pool
Determine 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:

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Profit Pools
19
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”

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Profit Pools
22
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
25
Other
Freightliner
Navistar
Peterbilt
Sterling
Mack
Truck Finance
Body Manufacturing
and Truck Assembly
Parts and
Service
Chassis
Manufacturing
and Sales
Top Down Bottoms Up
~$500-$700MM $600MM
0%
20%
40%
60%
80%
100%
EstimatedPercentofTotalProfitPools
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.

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Profit Pools
28
Agenda
• Profit Pools Concept
• Applications
• Profit Pool Steps
• Client Example
• Key Takeaways

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Profit Pools
31
Takeaway Slides
Profit Pool Concept Profit Pool Uses
Profit Pool Steps Profit Pool Map
3P rofit P ools
b c
CH I
• 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
Profit pools answer the question:
“Where and how is money being
made?”
Source: Profit Pools:A FreshLook at Strategy (May-June 1998):Orit GadieshandJames L. Gilbert 6P rofit P ools
b c
CH I
Why Use Profit Pools?
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 FreshLook at Strategy (May-June 1998):Orit GadieshandJames L. Gilbert
14P rofit P ools
b c
CH I
Mapping a Profit Pool
Mapping a profit pool involves four steps.
Define the Pool
Determine 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:
Profit Pools
Source: How to Map Your Industry’s ProfitPool (May-June 1998);Orit GadieshandJames L. Gilbert 24P rofit P ools
b c
CH I
Severe Service Vehicle Profit Map (1997)
Oth erGeneral Motors
Volvo
Kenworth
Freightliner
Navistar
Peterbilt
Sterling
Mack
Ch as sis
De ale rs
Other
Ottawa
Ad va nce M ixe r
Vactor
Omaha
Stahl
Leach
Knapheide
McNeilus
Heil
Chassis
Dealers
Cha ssis
Manufacturers
Chassis
Dealers
Chassis Manufacturing Chassis
Sal es
Bo dy
M an uf ac turing ,
Sa les an d
Asse mb ly
Truck
Finance
Parts Service
$305MM $35MM $60MM $55MM $85MM $60MM
Total EBIT=
$600MM
0%
20%
40%
60%
80%
100%
PercentofTotalContributioninEachActivity
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%
Profit Pools Truck Manufacturing Business Example
35.0%
Source: PBIR Profile of the U.S.Truck Body Industry; R.L. Polk RegistrationDatabase; Literature Search; TEM
Financials; Prior Bain PLP analysis (7/96); Bain estimates

1
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