UPDATE 7/16/10: I’ve added an Excel calculator to make it easier to determine how GroupOn might work for you. It’s very simple, but uses all the logic described in this post.

UPDATE 7/16/2010 – I’ve also added a new post with real world numbers with a Groupon Case Study.

How do you know if GroupOn is right for you? I like numbers quite a bit and became obsessed with this, so I’ve put together an ROI calculation to try to answer this question. This post includes the calculation I came up with towards the beginning and the detailed breakdown of what everything means for any masochists that like that sort of thing.

At a very high level, the GroupOn pitch seems questionable. They want you to sell a certificate through GroupOn (say $30) for a deep discount (say $15) and they are going to take a percent of the income (say 50% or $7.50). In this example, you are getting 25% of what you would normally. Why would anyone do this?

• New Patrons – This is the biggest reason. If you can get new patrons into your organization with a deep discount and they keep coming back and spending big bucks, there is a lifelong value.
• Cash flow - You get paid the day after the promotion which can help out if you need to buy that new oven or make payroll. Since the certificate is valid until the expiration date, you can expect the loss to be spread out over a period of time – although most of it will probably be pretty soon.
• Unredeemed certificates - there will be some people that pay for the deal, but never actually use the certificate. That’s just free money.
• Average ticket value exceeds offer -If you limit the offer to one certificate per table (for example),  what if they bring friends and buy a boat load of food – only getting a deal on the first $30? Nice.

There is one additional cost to also consider, though.

• Brand value. How do you think offering this type of outrageous deal will affect your image? You might decide this is positive, negative or not a concern.

Define your numbers

So should you do it? Let’s ignore the immediate Cash Flow benefit and make some assumptions.

• Offer Amount (O) – you are going to offer a $30 certificate and only allow one  to be redeemed per table
• Sell Amount (S) – the purchase price for these certificates will be $15
• GroupOn’s Cut (G) – GroupOn’s cut will be 50% of the sell price… for every $15 certificate, they get $7.50 and you get $7.50
• Margin (M) – your margin is 50%, i.e., if it costs you $20 to make something, you are going to sell it for $30.
• Average Ticket (A) – the average ticket of people using the offer will be $50
• Redeemed Certificates (R) – only 80% of certificates will be redeemed
• Total sold (T) - you expect to sell 500 of these
• New patron percentage (N) – you expect 40% of the people taking advantage of the offer to be new patrons (the remainder are people that are already patrons). This is a number that you pretty much have to make up, but 40% seems pretty good.
• New Patron Lifetime Value (L) – We’ll say the average patron will spend $150 with you (beyond the offer) over a period of 1 year (if you choose 2 years, 3 years, etc, your ROI will be spread over that period). Determining this value is a science on its own so good luck coming up with the right number.  Taken in conjunction with your Margin, this can be used to determine profit from your average patron.
• Brand Value (V) – Some organizations worry that offering such deep discounts will damage their brand and make them look “desperate.” Others might think there is an overall brand benefit that is not captured in the lifetime patron value. This variable is intended to capture this “fuzzy” influence and represents how the promotion will affect revenue over a period of 1 year (if you choose 2 years, 3 years, etc, your ROI will be spread over that period) SEPARATE FROM INCOME RELATED TO NEW PATRONS. If you think it will increase revenue over time, choose a positive number, but since I have heard concerns about the negative effects, I will choose a negative number and that I am making up – -$4,500.

GroupOn ROI Calculation

Here it is… the total long term profit you can expect from this promotion is:

Total initial income … + … Loss from certificate redemption … + … New patron Benefit … + … Brand Damage

T*(S-G*S) …. + …. R*T*[(A-O)-(A-O)/(1+M) - O/(1+M)] … + … T*N*(L-L/(1+M) … + … (V-V/(1+M)) = PROFIT

or ….

500 * ($15 – .5*$15) … + … .8*500*[($50-$30)-($50-$30)/(1+.5)] … + … 500*.4*($150-$150/(1+.5) … + … (-$4,500-(-$4,500)/(1+.5)) = $3,750 … – … $5,332 … + … $10,000 … – … $1,500  = $6,918

For the purists out there, this is not technically ROI, which is defined as (gain from investment – cost of investment) / (cost of investment). Fine.

Cost of Investment

The cost of investment is:

What it costs you to redeem certificates … + … what it costs you to fulfill purchases beyond the limits of the offering … + … your cost of fulfilling lifelong purchases … + … brand value

R*T*(O/1+M) … + … R*T*(A-O)/(1+M) … + … T*N*(L/(1+M) … + … V

or …

.8*500*($30/(1+.5) … + … .8*500*($50-$30)/(1+.5) … + … 500*.4*($150/(1+.5)) … + … $4,500 = $37,833

NOTE: You should move the brand value to Gain calculation if you think it will be positive.

Gain from Investment

The gain can be determined as:

Initial revenue from offer … + …. income from sells beyond the limits of the offering … + … income from life long purchases

T*(S-G*S) … + … R*T*(A-O) … + … T*N*L

or …

500*($15-.5*$15) … + … + .8*500*($50-$30) … + … 500*.4*$150 = $41,750

Official ROI

ROI = ($41,750 – $37,833)/($37,833) = 10.35%

KEEP IN MIND THAT THIS ROI IS FOR THE PERIOD YOUR CONSIDERING FOR BRAND VALUE AND PATRON LIFETIME (if you’ve entered a value assuming 1 year, 2 years, 3 years, etc, this is the ROI for that period).

Also keep in mind that these are hypothetical numbers. Your numbers will most likely be different.

Calculation details for Masochists

TOTAL INITIAL INCOME

How much money do you receive from GroupOn the day after the sell? This is the total number of certificates sold minus GroupOn’s cut, or:

T*(S-G*S) = 500 * ($15 – $15*.5) = $3,750

AMOUNT OF LOSS BASED ON REDEMPTION OF CERTIFICATES

For every certificate redeemed, you are going to have to give away a certain amount of inventory, service, etc (O=$30), but the cost to you will be less than the certificate amount because of your margin:

O/(1+M) => $30/(1.5)=> $20 (what it costs you to redeem a certificate)

You also will be able to make a profit on the average ticket amount above the offer amount, or the total income above this amount minus the cost:

(A-O) – (A-O)/(1+M) => ($50-$30) – ($50-$30)/(1.5) => $20-$13.33 = $6.67 (additional profit per redeemed certificate based on assumed Average Ticket)

So for each certificate redeemed, your profit is most likely negative:

(A-O)-(A-O)/(1+M) – O/(1+M) = $6.67 – $20 =  – $13.33

But some people will not redeem their certificates, which means free money for you! Taking into account the total number of certificates sold (T=500) and the redemption rate (R=.8) leads to an updated equation of:

R*T*[(A-O)-(A-O)/(1+M) - O/(1+M)] => .8*500*[($50-$30) - ($50-$30)/(1+.5) - $30/(1+.5)] = -$5,332.

So at this point, you have gained initial income of $3,750 and, over the course of several months, it is forecasted to cost you $5,332 leading to a net loss of $1,582… but there are some additional potential benefits.

NEW PATRON BENEFIT

We’ve talked about the obvious income and costs, but there are other benefits. The idea of paying for a print ad seems pretty reasonable because it might attract new patrons and you’re willing to pay money for it, so why not GroupOn? It is advertising and seems pretty effective at getting people to show up.

You’ve made an assumption about how much the average new patron will spend at your organization over their lifetime (L=$100). So the amount of profit you expect to make from the average new patron, after you take into account the costs associated with the transactions is:

L-L/(1+M) => $150 – $150/(1+.5) = $50

When taking into account the promotion by GroupOn, people sharing the information with friends, buyers bringing friends with them to redeem certificates, etc., you expect a certain number of new patrons tied to the number of certificates sold (T=500) and a New Patron Percentage (N=.4). This results in an expected increase of profit of:

T*N*(L-L/(1+M) => 500*.4*($150-$150/(1+.5)) = $10,000

There are 3 major things that should be noted:

1. The lifelong value of a customer is hard to determine and we kind of made up the actual number. We also made up how we calculated the number of new patrons your promotions will generate.
2. It might or might not take into account the viral nature of new patrons bringing along friends and introducing them to your organization. This is potentially a chain reaction that can greatly amplify this number.
3. Lifelong value is something that can build up over a very long time. This is not a quick income event and will likely be spread over a period of years.

With that being said, the running tally of the GroupOn benefit is now at a Net Profit (over time) of $10,000 – $1,582 = $8,418 in profits.

BRAND DAMAGE

Do these deep discounts damage a brand’s image and lead to reduced sales? I don’t know, but we’ve assumed it does and have pulled out of thin air a number to represent the decreased regular income from running this promotion (V=$4,500). Since this is “top line revenue,” to understand the impact on the bottom line, we need to consider your Margin.

(V-V/(1+M))=> (-$4,500 – (-$4,500)/(1.5))=-$1,500

Additional Comments

This was a lot of work so please let me know if I made any mistakes. Also, if anyone wants to build a calculator to run these numbers, let me know!