Sunday, April 4, 2010

Groupon's model (and how local businesses should think about it)

Let’s assume you sell a service worth $100 and you agree to offer that item for $50 to Groupon users. You and Groupon will split the revenue generated 50/50. So you receive $25 in return for agreeing to provide $100 in value to a buyer. That’s effectively a 75% discount.
This transaction makes sense only if you believe the average cost of acquiring a new customer is less than the average lifetime value of that customer.
The cost of acquiring a customer depends primarily on your average cost of goods sold (ie the incremental cost of delivering the $100 service to your new customer) and on the opportunity cost of serving someone with a discount (instead of a full paying customer).
The simplified average lifetime value depends on how much profit you can earn each time a customer visits multiplied by the average number of times you expect that customer to come back.
So for this equation to make sense it’s important that you:
- Maximize the average lifetime value of a customer
- Minimize the opportunity costs of displacing your fully paying customers.
As you will see, Groupon fails on both fronts. It results in a lower than normal average lifetime value and often increases the opportunity costs of serving your discount customers. And these are not minor issues: These are fundamental problems with their open, high-volume,  gimmicky model. In essence, what has made Groupon so successful with users, is exactly why it’s unsustainable and hurtful for businesses.