THE BLOG
01/12/2011 03:15 pm ET | Updated May 25, 2011

# Groupon, Gap Deal: What Was the True Cost?

What is the "cost" of a group buying deal like Groupon? How does it compare to other marketing costs such as TV, radio, print ads, promotions or giveaways that your businesses incurs to get new customers, particularly ones that become loyal long-term relationships?

Before going into this cost analysis, I'll start with a confession. Way before I started OfficeArrow and before the term "social media" was even thought of, I was an accountant at Price Waterhouse who spent countless hours developing cost models for businesses ranging from frozen foods to software companies to paper manufacturers.

To develop a proper cost model for group buying, we must first and foremost remember that group buying is a form of lead generation and customer acquisition, and therefore should be captured, recorded and, above all, measured as a marketing expense. Any conversations, therefore, must begin with a discussion of what your business typically spends to acquire a customer.

Second, as I said in my last post, you need to capture the actual cost of acquiring the next sale or a new customer, not a mythical if-I-had sold-that-much-at-retail cost. The way you do that is to base it on marginal cost and contribution margin: net sales revenue minus variable costs.

Let's use the example of Groupon's infamous Gap deal from last August. As you may recall, Groupon ran a deal with the Gap: \$25 for \$50 off at Gap. According to published reports, 441,000 coupons sold for a total retail value of \$22,050,000. Assuming Groupon kept 50 percent of the coupon value, or \$12.50 per coupon, then Gap received \$5,512,500 in cash (441,000 X \$12.50 - 50% of the coupon value). Based on the retail value of the deal, it "cost" Gap \$16,537,500 (\$22,050,000 - \$5,512,500), assuming all coupons were used before expiring.

Now calculate the real cost: the marginal cost of those additional sales taking into account only
the direct variable costs, not other costs that Gap incurred anyway. That is, identify the costs that were incurred solely to satisfy the Groupon deal.

According to Gap's latest published annual financial statements, their 2009 costs of goods sold equals 59.7 percent. Their cost of goods sold includes such items as cost of merchandise, freight, production costs, insurance costs and store rental. Gap's operating expenses average 27.5 percent of net sales, and that figure includes store payroll and benefits, marketing, design costs, merchandising costs and general and administrative costs.

Thus, of the 87.2 percent of the cost incurred per sale (cost of goods sold plus operating expenses), what portion is truly direct and variable? Assuming Gap did not add employees for the Groupon deal, then payroll and benefits should be taken out of the equation, as should freight (they only sold what was already in inventory), insurance, production and design. In fact, the only cost that should be included is the merchandise cost.

Estimating their merchandising costs are no more than a quarter of the costs -- which is high -- Gap's cost is not 87.2 percent of revenue, but 21.8 percent. Using that number, the marginal cost of the deal for Gap equals \$4,806,900 (\$22,050,000 X 21.8%) -- not \$16.5 million. This is quite a difference, but still a "loss"... or is it?

A couple additional things to consider: I did not take into account or assume any sort of "breakage"; that is, a percentage of Groupon buyers who failed to redeem the coupon before expiration, which typically ranges from 10-20 percent. I also did not factor in the fact that a portion of those redeeming the coupon would buy more (or less) than the \$50 coupon value, either of which would reduce the cost. I did not assume any repeat business that the Gap would get later from the coupon buyers -- I presumed all were "one and done." And finally, I did not try and figure out new customers versus existing ones, or how many bought multiple coupons. The combined effect of these factors would likely bring the cost closer to \$4 million. And if Groupon took less than 50 percent, the cost drops even further.

Thus, at my calculated cost of \$4.8 million or so, the Groupon deal "cost" Gap around \$10.90 per customer sale. Is that high or low? (Someone in the retail business please weigh in.)

I do know that, according to Advertising Age, Gap ranked #80 in the Top 100 Leading National Advertisers for 2009 with a total U.S. Advertising spend of \$419.5 million. That's \$1.149 million per day. On that basis, and not taking into account all of the other variables, the Groupon deal "cost" Gap what it would otherwise spend on advertising over the course of just 4.18 days.

Looking at it another way, let's compare the costs to a typical ad budget of 10-12 percent of sales after, taking into account cost mark-up. Assuming about a 90 percent mark-up for Gap, a 12 percent marketing spend to drive \$22 million in sales would cost around \$2.4 million. A lot less than \$4 million, you might say. However, remember that with traditional advertising, you pay up front and accept a huge risk that you'll lose a ton of money if the campaign doesn't work. In other words, would you rather pay \$4 million after the fact for a guaranteed \$22 million in sales, or \$2.4 million up front hoping to generate \$22 million in revenue?

In the end, I come back to my admonition that you must structure the deal properly. If you do so and you use these calculations, you can come up with a group buying deal that eliminates upfront payments, assures the desired amount of revenue, and comes at an affordable cost. Now that's a breakthrough!

For some tips on proper structuring, I suggest you check out the recent study from Professor
Utpal Dholakia of Rice University. If offers some ways to structure the deal that helps lower the
costs while ensuring a higher customer lifetime value. They include:

• Placing an upper limit on the number of coupons
• Rewarding "relational behaviors", such as a coupon good for multiple visits
• Limiting the coupon to items that are high margin or not as popular
• Limiting or restricting the usage of the coupon during popular or high traffic times

As many have said, the success of group buying lies in customer retention and repeat sales beyond the coupon. That's always the case with most any promotion. And after running the numbers, I remain firmly convinced that group buying deals, properly structured, are an excellent customer acquisition play.

As for Gap and Groupon, in the end, the best measure of whether or not the Gap deal was good for Gap may be whether or not they do another one. They haven't yet, and perhaps that says it all. However, group buying is only going to grow, and the smarter we all get the better.