Profit Pool Analysis

The profit pool framework was developed by Bain & Co. You will find the key references in a 1998 HBR article by Orit Gadiesh (Chairman of Bain & Co.) and James Gilbert: “Profit Pools: A Fresh Look at Strategy.” The strategy of a firm should be informed by an understanding of the sources and distribution of profits generated in an industry. Gadiesh and Gilbert took a value chain perspective to this when developing the profit pool framework. This is really more of a broad strategic framework, and there are multiple ways to depict profit pools visually. But one common graphic looks as follows:
Even though the concept is quite simple, implementing it in reality is generally quite complex. Profitability in different segments and stages of the value chain may vary a lot by product and customer group, by geography, or by channel. Also, make sure to clarify how you define profits (Accounting profits? Return on investment? Cash Flow?). Finally, the definition of activities in the value chain is not trivial either. The following process will help you map the profit pools.

Step 1: Define the industry and value chain steps.

Key is to look at the industry broadly, beyond it’s traditional boundaries. Include all the activities that are meaningful to influence your organization’s ability to earn profits (today and in the future). Examine the industry from four perspectives (your own, your competitors’, your customers’, and your suppliers’) to make sure that you include all relevant elements. Talk to key analysts and industry players to understand if there are any emerging business models. Some other key questions to consider: Are there activities performed in other industry that could replace parts of what you’re doing? How would your customers define the life cycle of your product? The objective is to come up with a complete list of activities in the value chain, be broad, but not unnecessarily detailed.

Step 2: Determine the size of the pool.

At this point, the goal is to estimate overall industry profits, which will serve as a base line. This may require some estimates for individual companies, and already an initial breakdown of aggregated numbers by product, channel, region, etc. Try to cross-check the numbers by combining different perspectives (e.g. by company, by product). Focus on the larger companies and key products – you can always extrapolate these numbers to smaller players.

Step 3: Break down the profits by activity.

If you are in an industry where all companies focus on an individual step in the value chain, you can just aggregate their respective numbers. If – and this is generally the case – there are a number of vertically integrated or mixed players, you will need to disaggregate each company’s financial data, and make estimates for specific activities. Again, looking at pure players, and looking at large companies who break out their results in 10Ks by segment, will help you solve 80% of the puzzle, so that you can then extrapolate the other 20%. Don’t forget to look at your own company’s economics as a proxy. And finally, here is where creativity comes in!

Overall, the “profit pools” framework can serve a number of purposes:
– help identify new sources of profits for a company;
– rethink the role a company plays in the value chain, potentially helping to refocus;
– assist in product and segment decisions.

Conclusion

Profit Pool Analysis is a strategic tool for understanding where profits are generated across an industry's entire value chain, not just focusing on sales volume or revenue. By mapping these profit pools, managers can identify high-profit activities, understand the economic forces driving profitability, and make strategic decisions to capture a larger share of the overall profit in their market. This analysis requires in-depth knowledge of the industry's structure, competitive dynamics, and customer behaviors, and it is crucial for companies seeking to maximize their own profitable growth rather than simply increasing revenue.

How it Works

1. Value Chain Analysis:

The process involves dissecting an industry's value chain into its various activities, such as raw material sourcing, manufacturing, distribution, sales, and service.

 

2. Mapping Profit and Revenue:

For each segment of the value chain, the analysis estimates the total profits and revenues generated.

 

3. Identifying Profit Hotspots:

The goal is to visualize the "shape" of the industry's profit pool, revealing which parts of the value chain are most profitable and which are less so.

 

4. Strategic Application:

Once the profit pools are mapped, businesses can develop strategies to:

Focus on High-Profit Areas: Direct resources and efforts towards the most profitable segments. 

Find Untapped Pools: Discover new areas of potential profit that competitors might be overlooking. 

Challenge the Status Quo: For startups or disruptors, it can reveal where to target their efforts for early profitability and competitive advantage. 

Why it's Important

Moves Beyond Revenue Growth:

Unlike traditional market share analysis, profit pool analysis emphasizes where the money is made, leading to more sustainable and profitable growth. 

Provides Strategic Insight:

It provides a solid foundation for strategic decision-making, helping companies understand the industry's economic and competitive landscape more deeply. 

Informs Resource Allocation:

By understanding where profits lie, businesses can better allocate resources, knowledge, and talent to high-return activities.

 Many leading companies have successfully applied the Profit Pools framework to refine their strategic focus and enhance profitability. For instance, in the automotive industry, companies realized that after-sales services such as maintenance and financing offered larger profit pools than the sale of new vehicles themselves. By shifting focus to these areas, companies were able to significantly boost their bottom lines.

Similarly, in the retail sector, businesses discovered that private-label products often offer higher profit margins than branded goods. This insight has led many retailers to expand their private-label offerings, capitalizing on this lucrative profit pool.

Key Considerations

Data Requirements:

The analysis requires access to accurate and detailed financial data, which can be challenging to obtain.

 

Complexity:

Mapping profit pools can be a complex and intensive process, especially for industries with intricate value chains. 

Requires a Broader View:

It necessitates a deep understanding of the entire industry, including customer behaviors and competitive dynamics, not just a company's internal financials.