Harvard Business Review
The Idea in Brief
Many managers chart strategy without a full understanding of the sources and distribution of profits in their industry. Sometimes, they focus their sights on revenues instead of profits, assuming that revenue growth will eventually translate into profit growth. In other cases, they simply lack the data or the analytical tools required to isolate and measure variations in profitability. Whatever the cause, an incomplete understanding of profits can create blind spots in a company’s strategic vision, leading it to overlook attractive profit-building opportunities or to become trapped in areas of weak or fading profitability.
In this article, we will describe a useful framework for analyzing how profits are distributed among the various activities that form an industry’s value chain. Such an analysis can provide a company’s managers with a rich understanding of their industry’s profit structure – what we call its profit pool – enabling them to identify which activities are generating disproportionately large or small shares of profits. Even more important, a profit-pool map opens a window onto the underlying structure of the industry, helping managers see the economic and competitive forces that are determining the distribution of profits. As such, a profit-pool map provides a solid basis for strategic thinking. (See our article “Profit Pools: A Fresh Look at Strategy” in the May–June 1998 HBR.)
Mapping a profit pool is, in one sense, a straightforward exercise: you define the value chain activities and then you determine their size and profitability. But while the goal is simple, achieving it can be complicated. Why? Because in most industries, financial data are not reported in nice, neat bundles corresponding to each value-chain activity. Detailed data may be available on individual companies, but those companies will often participate in many different activities. Similarly, there may be good information on product sales or customer purchases or channel volumes, but the products, customers, and channels will rarely line up cleanly with the boundaries of a particular activity. Translating the available data into accurate estimates of an activity’s size and profitability requires considerable creativity.
Although no two companies will perform the analysis in precisely the same way, it is possible to describe a broadly applicable process for getting the answers – a process that lays out the tasks that need to be accomplished, the questions that need to be asked, the types of data that need to be collected, and the types of analyses that need to be done.
A Four-Step Process
Mapping a profit pool involves four steps: defining the pool’s boundaries, estimating the pool’s overall size, estimating the size of each value-chain activity in the pool, and checking and reconciling the calculations. (See the chart “Mapping a Profit Pool.”) We will describe each step and then provide an example of how the entire process is applied. Finally, we will look at ways of organizing the data in chart form as a first step toward plotting a profit-pool strategy.
Define the pool. Before you can start analyzing your industry’s profit pool, you need to define its boundaries by identifying the value-chain activities that are relevant to your own business. Where, for purposes of developing strategy, should the value chain be said to begin and to end? At the conclusion of this step, you should have a clearly defined list of the individual value-chain activities that make up your profit pool.