Value chains and profit pools
Who does what from raw material to customer, and which steps keep the profit, with a worked profit pool.
Key takeaways
- An industry's value chain lists every step from raw material to the final customer.
- Common mistakes: Confusing revenue with profit.
- Scarcity. A step that controls something rare earns more.
- Few players. When only two or three companies do a step, they have more power over price.
- Brand and the customer relationship. The step closest to the customer can often charge more, because customers trust the brand and do not compare every price.
Key idea
An industry's value chain lists every step from raw material to the final customer. Its profit pool shows how much profit each step keeps, and the steps with the most revenue are often not the steps with the most profit.
Every industry is a chain of companies. Each one adds something and passes the product on. A value chain is the list of those steps, in order. A profit pool is the total profit that the whole industry earns, split by step. Orit Gadiesh and James Gilbert of Bain & Company set out the profit pool idea in the Harvard Business Review in 1998, using the US car industry as their main example. Their point was simple: to decide where to compete, look at where the profit is, not only at where the revenue is.
Michael Porter used "value chain" for the activities inside one company: buying inputs, operations, logistics, marketing and sales, and service. In industry cases, people usually mean the steps across the whole industry, from raw material to customer. Both are useful. Say which one you mean.
- Coffee: from farm to cup
- FarmingMillions of farms grow green coffee beans. Brazil, Vietnam, Colombia and Ethiopia are among the large producers.
- Trading and exportTraders buy, grade, store and ship the green beans.
- Roasting and brandingRoasters turn green beans into branded coffee in packs, capsules or beans for cafés.
- Retail and cafésSupermarkets sell packs. Cafés sell cups, where the coffee itself is a small part of the price.
- CustomerPays for the coffee, and in a café also for the place, the service and the convenience.
Five steps. Many farms, fewer traders and roasters, and many cafés and shops near the customer.
Where profit concentrates
- Scarcity. A step that controls something rare earns more. Examples: a patent on a medicine, a licence to use radio spectrum, a landing slot at a busy airport.
- Few players. When only two or three companies do a step, they have more power over price. When thousands do it, as with coffee farms, buyers push prices down.
- Brand and the customer relationship. The step closest to the customer can often charge more, because customers trust the brand and do not compare every price.
- Switching costs. If customers find it costly or slow to change supplier, the supplier can hold its price. Business software is a common example.
- Commodity steps earn little. When products are identical and easy to compare, price falls toward cost. Basic steel and many raw materials work like this.
Worked case
A car ownership profit pool
The prompt
In a fictional country, the car ownership industry has five activities. Using the table below (USD billions per year, illustrative figures, not real data), work out the profit of each activity and compare each activity's share of profit with its share of revenue.
The structure
- Profit pool = revenue x margin, for each activity
- Profit of each activity
- Share of total revenue
- Share of total profit
- Key: Compare the two shares, activity by activity
The exhibit
| Activity | Revenue (USD billions) | Operating margin (percent) | Operating profit (USD billions) |
|---|---|---|---|
| Making and selling new cars | 400 | 4 | 16 |
| Selling used cars | 160 | 5 | 8 |
| Car loans and leasing | 60 | 20 | 12 |
| Car insurance | 100 | 8 | 8 |
| Parts, service and repair | 120 | 10 | 12 |
Working it through
1. Profit of new cars
Revenue 400 times a 4 percent margin.
New car profit (USD billions):400 × 0.04 = 162. Total profit
Add the profit of all five activities.
Total profit pool (USD billions):16 + 8 + 12 + 8 + 12 = 563. Total revenue
Add the revenue of all five activities.
Total revenue (USD billions):400 + 160 + 60 + 100 + 120 = 8404. New cars: share of revenue
400 out of 840.
New cars, share of revenue (percent):400 ÷ 840 × 100 = 47.625. New cars: share of profit
16 out of 56.
New cars, share of profit (percent):16 ÷ 56 × 100 = 28.576. Loans: share of revenue
60 out of 840.
Loans, share of revenue (percent):60 ÷ 840 × 100 = 7.147. Loans: share of profit
12 out of 56.
Loans, share of profit (percent):12 ÷ 56 × 100 = 21.43
What the exhibit shows
New cars bring the most revenue but a much smaller share of profit. Financing and after-sales punch above their weight.
The recommendation
New cars hold about a 48 percent share of the industry's revenue but only about 29 percent of its USD 56 billion profit pool, because their margin is only 4 percent. Loans and leasing are the opposite: about 7 percent of revenue but about 21 percent of profit, since loans earn about a 20 percent margin. So a carmaker that wants more profit should ask whether it can win more of the financing and after-sales activity, not only sell more cars. The risk is that these margins are illustrative, and loans need a large balance sheet, so compare return on capital as well as margin. As a next step, check real figures for the country in the case.
Risks: These margins are illustrative. Check real figures for the country in the case.; Some activities need much more capital than others (loans need a large balance sheet), so compare return on capital as well as margin..
How to use this in a case
- Market study: "Where is the profit in this industry, and where is it moving?" Draw the chain, then estimate the profit of each step.
- Market entry: "Which step should we enter?" A step with high margins and few players is attractive, but ask why the margins are high and whether you can get in.
- Vertical integration: "Should we buy our supplier or our distributor?" Buying a high-profit step can help. Buying a low-profit step rarely does, unless it secures supply.
- Mergers and acquisitions: a target in a profitable, growing step is worth more. Check whether new players are about to squeeze that step.
- Disruption: new players often take the most profitable step. Online travel platforms, for example, took much of the customer relationship from travel agents and hotels.
Confusing revenue with profit. Adding up revenue across steps: a car's price already includes the steel and the parts, so summing the revenue of every step counts the same money several times. Assuming the profit pool stays still: technology, regulation and new players move profit between steps. Comparing margins without capital: a lender's 20 percent margin may need far more capital than a repair shop's 10 percent.
A 250 g pack of coffee sells for EUR 6.00 in a German supermarket (illustrative). The farmer received EUR 0.60 for the beans in it. What share of the shelf price reached the farmer, in percent?
In an industry, retailers earn revenue of 200 at a 3 percent margin and brand owners earn revenue of 80 at a 15 percent margin. What share of the combined profit do the brand owners earn, in percent?
A client makes batteries for electric scooters in India. Margins on battery cells are thin because many suppliers make almost identical cells. Which step is most likely to hold a larger share of the profit?
What does a profit pool show?
Why do steps with many near-identical suppliers usually earn low margins?
To size the car industry, you add the revenue of steel makers, parts makers and carmakers. What is wrong?
Sources for this lesson (2)
- Recognized public explanations of case-interview concepts and frameworks
- Gadiesh and Gilbert, "Profit Pools: A Fresh Look at Strategy", Harvard Business Review, May 1998
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