BY MARK SMICIKLAS

Recent valuation reports continue to highlight the success Groupon’s business model. It’s hard to argue the benefit for the 70 million consumers that have signed up to date – the opportunity to experience a wide variety of products and services at deep discounts.

But what about the organizations providing the deals? Research about the negative impact of services like Groupon is starting to surface.

Erosion of Price and Profitability

The problem with Groupon from a strategic perspective is the ripple effect that results from a promotion model purely focused on price.

As the frequency of Groupons increase price integrity will tend to diminish, resulting in a decline in profitability. There is also the chance that the number of new customers getting exposed to your business declines. With each Groupon you are essentially conditioning your existing customers to only frequent your business when there is a deal.

Esther Dyson wrote a great article about the Groupon Paradox. In it she describes how price erosion can take place:

“The logic is simple: Merchants are encouraged to use the deals to attract new customers, who in theory will return at full price. But, in what seems to be an increasing number of cases, customers come for the deals and then leave for deals offered by other merchants through Groupon. So the number of “new” customers attracted by cheap prices increases, and the number of loyal customers decrease as shoppers prefer to become “new” again for whoever offers the best deal.”

What are the long term profitability implications of using Groupon? How many new customers does your business need to get to justify every Groupon promotion? Let’s take a look at a fictional business example.

Let’s analyze a restaurant that offers a $40 deal for $20 and gets 300 redemptions:

In this scenario, the restaurant is setting the ROI goal to equal the gross profit level of day to day business at full price. In order to do this 50% of the 300 Groupon redemptions would have to become repeat customers that dine at least once. However, the more people that became regulars, the lower the ROI goal. For example, if a regular customer dines 2 times per year, the ROI goal for the Groupon promotion would be 75 new customers or 25% ($6,000/$40 avg/2 visits per year). Is it reasonable to expect 25% of Groupons will turn into regular customers? If not, every subsequent Groupon promotion will further erode this businesses profitability.

Erosion of the Brand Experience

The nature of Groupon redemptions also poses some operational challenges. If your business is not prepared for traffic spikes from an inventory or service point of view there is the possibility of damage to the brand experience. That’s the irony, by focusing on price you run the risk of eroding the very thing that helps build equity and value beyond price – customer experience.

Effective Tactics

Maybe Groupon doesn’t make strategic sense for your business. But it can still be effective when used tactically and in relevant situations. Here are a few examples:

Advertising – Diverting some existing advertising budget to a Groupon promotion can be an effective (and measurable) way to build awareness, especially in new markets. For example, if you’re opening a store in a different region, your business can use Groupon as a market launch tactic. You benefit from the traffic lift at store level and are less susceptible to price erosion due to introductory nature of the promotion and the fact that it’s a new market.

Inventory – Groupon is a great way to help move excess inventory. You will likely be ready to offer discounts so a Groupon deal could be a good fit – but be sure to compare the commission costs vs. inventory carrying costs. If Groupon can help your business speed up turns on expensive inventory it’s likely a worthwhile tactic.

Seasonality – Groupon can be a good tactic to use if your business experiences severe seasonal fluctuations in sales. In this case an “off-season” promotion will either attract new customers or act as a reward to existing customers that support your business during peak times.

In what other situations can Groupon be used as an effective tactic? I’d love to get your thoughts. Also, if your business has used a daily deal service like Groupon please feel free to share your experience in the comments.