Profit Pools: A Fresh Look

Profit Pools: A Fresh Look at Strategy

In the Harvard Business Review article, Profit Pools: A Fresh Look at Strategy (Gadiesh, Gilbert, 1998) the authors provide a series of examples of how companies faced with daunting competition, consolidating markets experiencing exceptional price competition and erosion, and a very myopic focus on profitability were able to find profit pools and grow. The companies included in the analysis completed by the authors include Budget, Gucci, Hertz-Penske, Ryder and U-Haul. The authors have anchored their analysis with examples that clearly illustrate how many of the world's leading companies are blind to greater opportunities for profitable growth by only focusing on a specific area of their value chains instead of its entire breadth of opportunities (Gadiesh, Gilbert, 1998). They have defined a profit pool as the total amount of profits that are earned in an industry across all points of its value chain.

Included is a particularly well-done analysis of the PC Industry value chain, showing the dominance of microprocessor development followed by software and services. As Dell would find out, the PC industry is more of an integrative function that inherently doesn't have the value-add potential of Intel for example (Gadiesh, Gilbert, 1998). The innate structure of an industry will often dictate the trajectory of growth or decline and composition of profit pools over time as well. The series of examples throughout this analysis make these points very clear with regard to profit pool analysis and their implications on the current and future stability and viability of industries and the companies who compete in them. The following section of this assessment of the research in Profit Pools: A Fresh Look at Strategy illustrates a series of valuable lessons learned for companies who are competing in the industries mentioned. The lessons learned are also directly applicable to firms in industries that resemble the structure of the auto, PC manufacturing and distribution, high-end luxury goods (Gucci) and the truck and moving rental businesses.

Critical Assessment and Analysis of Profit Pools: A Fresh Look at Strategy

What is immediately apparent after reading the cited article is how pervasive and all-encompassing the pricing and profitability strategies are of the companies mentioned and how these strategies re-order profit pools. Many of the companies mentioned in this analysis quite frankly have no idea how their pricing and profitability strategies are influencing the profit pool composition, direction of growth, development of substitute products driven by lack of profit pool consideration, and costs of ignoring profit pool dynamics. Upon reflection fo these dynamics, it's apparent that profit pool-based strategies immediately negate price elasticity-driven strategies that unintentionally doom many companies to fail. For those firms competing on price alone, attempting to ride what they see as a highly elastic price curve, their illusions are immediately shattered when competitors who see profit pools in the value chain of an industry act on this. This is exactly what happened with U-Haul as they excelled past competitors in profitability, attaining a 10% gross operating margin against a very flat 3% industry-wide (Gadiesh, Gilbert, 1998). What U-Haul quickly realized that no matter how far they price-discounted their core business that was relying on an older fleet that required intensive maintenance to just be usable. Price discounting in their industry was quickly proving out a fact U-Haul executives read perfectly: the demand curve for rentals was flat and getting more inelastic over time. No amount of price drops would drive up volume, even on their fleet that many customers viewed as aging and unreliable.

Instead of just relying on price as a competitive weapon in an inelastic market, U-Haul decided to use pricing as a means to penetrate more sales of their accessories as a profit generation, investing heavily in the sales of boxes, insurance, ancillary trailer rentals, and also a move into storage space rentals as well. This completely redefining their value chain and also led to their changing the industry value chain as well. The competitor's executives thought this approach was not going to deliver any significant competitive differentiation as their mindset was on just the rentals and not the value chain (Gadiesh, Gilbert, 1998). U-Haul accelerated beyond all competitors with a 3X gross margin improvement by concentrating on the value chain as a means to generate profitability and stabilize their financial viability, completely redefining the industry's profit structure as a result. The U-Haul example is excellently used in the article to show how profit pools are formed, how they can change when a competitor in an industry recognizes and quickly acts on sources of profitability, and also implies that in industries with very high levels of inelasticity, there is great urgency to use the value chain, not price, as a means to gain competitive advantage and differentiation. These themes continue to play out through the several other examples the authors have provide in this excellent article.

The example of the U.S. auto industry is also very illustrative of how potent the profit pool concept is in defining how companies need to align their strategies and initiatives for greatest financial results. As of 1996 the U.S. auto industry has a value of $1.1 trillion and is generating nearly $44B in revenue yearly. The value chain that all competitors have become very complacent using is comprised of production of new cars, sales of used cars, gas, insurance, services., leasing and financing. The industry is in a stagnation phase during the time of the research with competitors concentrating on after-sales service as the only visible profit pool given a myopic view of their value chains. With every competitor in the auto industry concentrating on the 60% of revenue generated form manufacturing and retailing, no one is seeing the value of insurance and leasing, which are the highest profit margin area. With prof pool analysis, the Big Three auto makers moved aggressively into auto financing and started selling leases much more than had ever been the case in the past.

Another critical factor this analysis provides is that when industries are undergoing turbulence either through market consolidation or through intensive levels of compliance and deregulation have their value chains re-order so significantly that entirely new profitability opportunities emerge. The profit pools in stagnating industries tend to galvanize the industry into a specific pace of innovation. Turbulence in an industry can actually redefine an entire value chain to create new potentially higher profit businesses than had ever been the case before. A prime example of this is the rise of Sarbanes-Oxley Act (SOX) spending on the part of publically-held companies that had to comply with this Act in order to keep trading their stock on American stock exchanges. This major shift in financial reporting completely changed the value chain of compliance and system integration. The authors show how Microsoft and Merck attempted a comparable strategy by creating a Strait of Gibraltar condition in their respective industries. With Microsoft's attempt to acquire Intuit (which failed) and touched off a massive effort on the part of the industry to support IBM and their Internet-based banking channel, the authors show how consumers and government regulators both are very attuned to how value chain turbulence and disruptive change will affect them. Microsoft still is struggling to gain a foothold in personal finance and Merc has acquired Medco to move into a more competitive position in their industry value chain.