To Groupon or Not to Groupon: The Cost of Offering Deep Discounts

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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Wouldn't it be nice if you could run a free online coupon deal and wake up the next morning to learn you'd sold two thousand pre-paid dinners, event tickets, massages, or hot fudge sundaes? Maybe, maybe not. The answer isn't as obvious as an extra $30,000 in the till may look.

Launched in 2008, Groupon has quickly become the behemoth of the social networking coupon business. They're now in over 90 cities and 20 countries. They've saved their 14 million subscribers over half a billion dollars. Just 17 months from startup, they were valued at over $1 billion and had attracted $135 million in venture capital. Forbes named Groupon the fastest growing Internet company ever. The runner-up, YouTube, has yet to make a profit while Groupon earned its way into the black in just 7 months.

No doubt about it, Groupon has been great for their investors, great for consumers, and great for Groupon — but what about the companies that offer half off their regular prices and pay up to 50 percent of what's left to Groupon? Has it been good for them?

A study by Rice University says that for a third of participants, it hasn't — at least not in terms of profitability. While Groupon's marketing pitch reports that 97 percent of merchants say they'd do another offer, only 40 percent of those surveyed by Rice who said it was not profitable say they would.

Of course, that begs the question: Why would the other 60 percent of business want to repeat an unprofitable endeavor? Well, for some, cash is king. “It's just a way to get cash in the door,” said one Groupon-er.

For some that may be true, but many business owners don't do the math. Unless there's either a long-term benefit or enough other profitable business to make up the difference, sacrificing the bottom line for the top line is the start of a downward spiral.

Discounts, coupons, and other price concessions only make sense if:

• There are economies of scale that make it cheaper to operate at higher volumes.
   
• The marginal cost of delivery is low.
   
• The business can reasonably expect to upsell the discount buyer.
   
• The discount customer is likely to return as a full-fare buyer.

Here's how the companies surveyed by Rice fared on those last two points:

• Those who called it profitable: 50 percent of their discount buyers were upsold, 31 percent were return business.
   
• Those who called it unprofitable: 25 percent of their discount buyers were upsold, 13 percent were return business.

In some cases, coupons and other deep discounts can even eat into the profitable portion of a company's business. 

A business can get so busy redeeming Groupon purchases that they have to turn away full-fare business. A number of the restaurant businesses in the Rice study found this out the hard way. An otherwise profitable Friday night is suddenly dominated by blue-plate specials while full-fare regulars go elsewhere.

• Full-paying customers who learn they've paid double what the people next to them paid — and they will find out — will be resentful. Some may either demand a discount, or leave with ill feelings and never come back.
   
• A former customer who intended to come back again (and pay full fare) may wait for a discounted deal.
   
• The sheer volume of coupon redemptions can increase administrative and other costs.
   
• Premium services, once discounted, may lose their premium luster.
   
• Past and future customers feel gouged when they see how inexpensively you can really do what you do.
   
• It may send a message to your competitors that you're desperate.

At last count — with 11 hours, 20 minutes, and 21 seconds left on a 24-hour offer — 1,011 people bought dance classes valued at $130 for just $60. A day earlier, 200 Groupon subscribers bought a Swedish Miracle body wrap for half off its $110 value.

However, the bottom line on those two offers will be very, very different. For the dance studio, the marginal cost of an extra student is very low. Whether you hold a class for 20 people or 30 people, the cost of renting the space, paying the instructor, etc. is essentially the same. For the body spa, the marginal cost is very high. In fact, it's nearly one to one. Every discounted body you wrap for $55 ties up a treatment room and a technician that could otherwise be earning $110.

Here are ten tips for a successful coupon deal:

1. Do the math. Make sure you can really afford the discount.
    
2. Limit the quantity based on what the offer will do to your overall profitability, what you can physically handle, and any pivotal points that will add administrative overhead.
    
3. Limit redemptions to your slack time (e.g., weekday only).
    
4. Aim the offer at repeat business. For example, instead of offering five golf lessons at half-off, do a buy-three-get-two-free deal.
    
5. Aim the offer at an audience that's outside your geographic or demographic reach so as not to cannibalize existing business.
    
6. Limit the redemption period.
    
7. Use it to maximize existing resources, as in filling a class.
    
8. Limit the offer to new customers.
    
9. Limit the number of coupons per person and keep track of redemptions to avoid people trying to use the same offer more than once.
    
10. Make the small print large so there's no confusion over expiration dates, limitations, whether coupons can be combined with other discounts, what's included and what's not (alcohol, gratuity, etc.), cash redemption values, return policies, partial redemptions, applicable law, etc.

Sad to say, but anecdotal evidence from businesses that have used Groupon show that the people who use them often think someone is out to screw them. Other words and phrases common in the Rice study and among companies interviewed include:

• lousy tippers
• bargain hunters
• abusive
• wheelers and dealers
• looking for discounts on their discounts
• deal chasers
• cheapskates
• worst batch of customers
• much more demanding than regulars
• harder to work with

With venture capital pouring into Groupon and their imitators, you'll no doubt be faced with the discounting decision in the coming year, but like Dad said: Just because other people are doing it doesn't mean you should.