James Harland recently argued in his post that Groupon is not as deserving of its latest high valuation. Although I believe Groupon is a great business with enormous potential, I agree with James that it’s not a good idea for many sellers, specifically low margin vendors like restaurants. Among all the reasons James gives to be wary of Groupon’s potential, the most compelling challenge is its business’s low barriers to entry.
To understand why, let’s first take a look at the economics that underlie the value proposition for restaurants.
Assumptions on average deal:
- Restaurant profit margins after variable costs – 20%
- Sales less COGS, labor
- Bill size (for two) – $50
- Groupon – $25 off $50 purchase
- Restaurant payment to Groupon – $10
Value to Restaurant from Groupon to New Customers
Assuming a bill size of $50 and margins of 20%, the restaurant gains $10 every visit. On the first visit, the restaurant loses the initial $10 (payment to Groupon) and $25 (discount on bill), so it nets a loss of $25. Therefore, the customer needs to go back to the restaurant at least three additional times on average before it even breaks even.
Value to Restaurant from Groupon to Existing Customers
If the customer was going to go to the restaurant anyway, then it nets a loss of $35 from the payment to groupon and the discount on bill.
The table below illustrates what these economics mean for restaurants.
| % of Groupons to New Customers | Avg. Number of Visits per New Customer Required to Breakeven |
| 10% | 35.0 |
| 25% | 14.0 |
| 50% | 7.0 |
| 75% | 4.7 |
| 100% | 3.5 |
These numbers suggest that if a restaurant is already very successful with existing customers who tend to be very loyal AND if the restaurant has unused capacity, then using Groupon can be a profitable endeavor. But even those restaurants require a very high mix of coupon purchasers to be new customers.
Customers don’t decide from whom to receive an email, Groupon or LivingSocial… they sign up for all of them! Customers decide which coupons to purchase. When customers have more choices, they are more likely to purchase a coupon from a restaurant they already go to. So whereas a Groupon deal may have once yielded 75% new customers, the emergence of so many competitors has resulted in a much lower mix. Personally speaking, around 25% of the coupons I buy are for new places, and there is no way I’m going back to those places 14 times. I’m sure most restaurants will eventually realize these economics don’t work for them.
It’s obviously a problem when potential customers choose to buy their coupons from competitors instead of with them. But it’s an even bigger problem when the emergence of competitors serves to undermine your entire business model. Groupon (or any other Groupon clone) should forget about restaurants completely and build a brand around being the premier provider of coupons for higher margin service businesses.
What do small business owners think of Groupon?…
Using Groupon is a great idea for certain businesses that have: 1. High margins 2. Available capacity (consistently not filling up) 3. Very high loyalty among existing customers The reality is most small businesses do not meet all of these criteria. A…
By: Quora on December 18, 2010
at 12:59 pm
Based on my experience with Groupon deals for restaurants, I believe they are getting more than you show in your calculations.
First of all, not all items on the menu are equally expensive. If you choose the top ones, they may be prices at $50, but naturally people will choose what they like, making the actual price, say $45 on average.
Secondly, people are likely to get some extra stuff. Some restaurants upsell you on water and bread because you think they are included in your deal, but they are not. Plus wine and other drinks are extra.
And finally, tips (which may or may not go to the staff depending on the country) may sweeten the pill.
So I am sure that most of the restaurants are able to break even on these promotions. And having a full restaurant attracts new customers because they think it must be good.
By: Polina on January 5, 2011
at 8:07 am
[...] win-win-win outcome for the Customer, the Merchant, and Groupon: See for more perspectives:http://cameronlevy.com/2010/11/2…http://knowledge.wharton.upenn.e…Is there a flaw in the Groupon business?Insert a dynamic date [...]
By: What is Groupon's biggest vulnerability? - Quora on January 8, 2011
at 2:17 pm
What % of groupon deals have you taken as an existing customer vs. new customer?…
When Groupon was the only player, almost all of the groupons I purchased were for new places. Since I joined LivingSocial and BuyWithMe, and since the novelty wore off, less than 50% of the deals I purchase are for new places. These levels are scary lo…
By: Quora on January 15, 2011
at 9:21 pm
The numbers may be off Polina, but they are off the other direction. According to the National Restaurant Association, the average profit for a full service restaurant is about 4% of gross sales. For a quick service restaurant, it’s around 10%. If anything, assuming a 20% return is too high, not too low. In addition to the costs listed, restaurants also have to consider the cost of current customers using Groupon discounts for food they would have paid full price for, and Groupon customers that may be filling tables at a discount that other customers could fill at full price.
What most restaurants find with Groupon is that they do not earn new customers from Groupon. The customers that use Groupon are loyal to Groupon, not the restaurant. After they have used your 50% offer, they move on to the next restaurant offering 50% off. As a general rule, I can usually tell a restaurant is about 2 months from closing when I see them using Groupon.
When Groupon sell a $50 gift certificate to your restaurant for $25, Groupon keeps half of that $25. Your share is $12.50. No restaurant can make money collecting $12.50 on $50 worth of food. Their margins simply aren’t that high.
By: bodellconsulting on January 16, 2011
at 12:26 am
Great to hear the voice of reason. As an MBA, academic, and former entreprenuer, I am constantly amazed at how few self-taught (and classically educated for that matter) business owners don’t do the math and get hosed as a result! Groupon is doing a disservice to all but the most high-margined businesses. Keep spreading the word. America doesn’t need its small businesses to fail!
By: Bob Shmob on April 21, 2011
at 11:03 am
Entrepreneur mag March 2011 had a story that featured Groupon “Is groupon a good idea” in the story an associate professor at Rice University Utpal Dholakia did a study that found only 66% of Groupon promotions were profitable and 32% lost money. Almost half the businesses surveyed said they would NOT participate in such a promotion again. But Groupon and many other group buying sites are geared to the consumer and leave the business owners out to dry after the rush not sharing credit card processing fees or emails for follow-ups. One site that has roots here in Orlando is doing a mashup of Groupon and Craigslist for businesses. The business owner controls the price point and the coupon offer with a small monthly fee of $5 the business owner can post coupons and drive business as they want. The site is free for the consumer to use and with targeted emails local merchants drive local traffic to their location. Bigsavinglist.com is a great tool for both business owners and consumers but best of all it local.
By: Jim R on March 3, 2011
at 11:19 am
Hey Cameron
There is a slight problem with your analysis :)
A proper evaluation would be based on Gross Margin, not Profit Margins, and restaurants typically have high Gross Margins.
Quick Example:
Coupon $20 for $60 worth of food
Typical bill for a couple – $100
Gross Margin 70%
Restaurant collects $50 on a $100 meal that cost them $30.00
So that new customer contributed $20 to the fixed overhead.
A business that sold exclusively on Gross Margin will go out of business, however it is possible to price a coupon in such a way as to not cost you anything to gain a new customer.
Offering a coupon is an advertsing strategy and should be evaluated as such.
Peter
By: Peter Fuller MBA on June 1, 2011
at 2:16 pm
Peter, thanks for your comment. Profit margins = gross margins in my calculation. These tend to be very low for restaurants (20-30%).
By: Cameron Levy on June 7, 2011
at 12:47 pm
The gross margin for most restaurants are nowhere near 70% Peter, I promise you that. For a restaurant, looking at gross margins are not a “proper” way to assess the value of an offer either way because controllable expenses do not stay static as business increases. A restaurant must consider all costs of doing business when evaluating the worth of an offer, including the normal 55-65% prime cost (food + labor) they run, which only decreases slightly as business increases, AND the additional 10-12% in occupancy costs which may or may not be fixed depending on the type of lease a restaurant has. In addition, the remaining larger controllable expenses such as utilities, chemicals, paper goods and linens all increase as traffic increases. In all, a restaurants REAL cost for any offer is at least 70%, but usually closer to 80-85%.
Also, restaurant owners do not collect $50 on a $100 tab paid for with a Groupon offer. They only get $25, usually minus any processing charges for Groupon which could be another $1.50 to $2.00. Groupon gets the rest.
Groupons also do not usually produce new customers for restaurants. They produce new customers for Groupon. THAT is the brand being advertised and the brand earning the loyalty. I wish I had a collection of all the feedback I’ve heard from restaurant owners who have done Groupon, Restaurant.com, Livingsocial and the like.
By: bodellconsulting on June 7, 2011
at 1:33 pm
Hey guys!
I cordially disagree with you :)
We are looking at how coupons would affect a business, which usually is a short time experience.
For a restaurant Gross Margin is Revenue less Cost of Goods sold, which is high, usually 60 to 70%.
Certainly a restaurant has a lot of fixed expenses and variable expenses that are technically fixed over certain levels of volume that are included to get to Net Profit.
If running a coupon campaign creates a situation where you have to increase staff and other costs then those costs do need to be included in the analysis.
However the major cost of goods sold is the cost of food. Any addition costs, such as paper and linen costs per table are negligible.
Think of it this way, if a person came into my restaurant what are my variable costs in serving that customer. Typically it is the cost of food. All other expenses stay fixed,
Of course if a business sold 1,000 coupons to be used within a few days the scenario changes and I would argue that they are using coupons in a wrong way.
The best way for a restaurant to use coupons is to design the program to deliver new customers over reasonable periods of time so as not to increase their staff.
By: Peter Fuller MBA on June 8, 2011
at 10:05 pm