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.