Understanding the Purposes – and Weaknesses – of Online-to-Offline Discounting

by Ben Edelman

October 26, 2011

I’ve watched with interest as scores of online marketers have promised to transform local commerce. It’s exciting to bring the efficiencies of online marketing to retail commerce, particularly for sectors like restaurants and leisure where static websites, search ads and banners have proven a poor fit. Initially, services struggled to get consumers interested. “Daily deals” services solved that problem by offering discounts that often exceed 50%, mobilizing millions of consumers spending billions of dollars. Yet this model faces growing resistance, particularly from merchants concerned that “deals” offers are unprofitable. The natural question: When and how are large discounts sustainable? 

Questioning the “Discovery” Promise

In its “road show” pitch to investors, Groupon promises to help consumers “discover local businesses at a price that makes it difficult to say no.” In particular, Groupon positions “repeat visits” as “the most valuable part” of its offering.

I credit Groupon’s emphasis on loyal customers who return regularly. If Groupon can find and deliver top-quality customers, it should be richly rewarded for its efforts. Indeed, Groupon seeks a high fee, typically half of a customer’s prepayment. So if a merchant runs a $20-for-$40 offer, Groupon takes $10, netting the merchant just $10 when the consumer buys items with ordinary price of $40.

To earn these fees, Groupon needs to deliver customers who in fact return, paying full price. But there’s little to no evidence that that actually happens. For example, talking to friends, colleagues and students, it’s rare to find a person who tried a new establishment with a Groupon (or similar) voucher, then came back for another visit at full price. With data from British and Irish spas, Dylan Collins found that just 1% of Groupon customers returned – a rate too low to justify Groupon’s cost. At least spas record customer names as they accept reservations, facilitating analysis of repeat visits. In contrast, few restaurants track diners in similar detail. In principle, a point-of-sale system could recognize customers using an encrypted or partial credit card number. But if a POS doesn’t have this feature, no restaurant can readily add it.

If Groupon seeks to justify its fees with the promise of return visits at full price, the burden should be on Groupon to demonstrate that return visits actually occur. On the surface, Groupon embraces that challenge, promising “efficient, measurable marketing” and offering numerous tools for merchants. But only last month did Groupon finally announce integration with merchants’ credit card processors – the beginning of a system to track return visits. Groupon’s new tracking is not yet widely available, so a full assessment is premature, but news coverage reveals a focus on following one deal with another – hardly the full-price customers merchants are looking for.

Enter Price Discrimination

An alternative vision of online-to-offline marketing emphasizes price discrimination in the form of ongoing discounts to price-sensitive customers. Here, merchants hold out no expectation of discount customers returning to pay full price. Rather, this model embraces the fact that customers enticed by discounts are likely to return only if the discounts remain available. If a merchant’s cost of goods sold is sufficiently low, large discounts can still be profitable. But a merchant would never want to discount below its marginal cost. And if large fees to voucher services push merchant revenue below marginal cost, then those fees are a non-starter.

Carefully-designed price discrimination can offer merchants important benefits. Few restaurants are full around-the-clock, and an offer limited to weeknights or lunches can fill tables that would otherwise go empty. Same for off-peak service in categories as diverse as salons, dental service, and auto repair.

Notably, the most popular voucher services have shied away from design features that facilitate price discrimination. Consider: Almost all Groupon vouchers are valid seven days a week, yielding an influx of customers at times when many restaurants would have been full anyway.

Worse, technological advances can actually undermine price discrimination. Consider offers invisibly loaded onto credit cards or smartphones, as in Savored.com and Rewards Network, which let consumers claim a discount without revealing the discount to other members of their party. With transparent redemption, consumers can enjoy discounts during even high-value meals such as dates and business lunches. That’s great for consumers. But for a merchant attempting price discrimination, it’s terrible, for those consumers would have been willing to pay full price. So too for the requirement of printing a paper voucher. Printouts may seem an awkward twentieth-century anachronism, but printing helps separate those who plan in advance from those dining on a whim. If the latter group is more prepared to pay full price, printed vouchers help limit discounts to the customers who genuinely respond to the offer.

Pick Your Strategy

There is surely room for services that help consumers find new merchants they’ll visit over and over. When such services demonstrate a track record of success, they’ll deserve the high fees they seek. Following countless businesses with high customer acquisition costs, restaurants and other local businesses may prove willing to invest funds upfront in exchange for solid prospects of future visits. But if merchants are accepting upfront losses, they should demand protections to prevent repeat use. Could a merchant cross-check voucher buyers against existing customer lists? Certainly merchants should rigorously measure how many customers actually return.

There is also room for services that facilitate price discrimination. Under price discrimination, return visits are no problem. But merchants should design their offers to avoid cannibalizing existing business. In an era of mailed coupons, merchants often removed existing customers from a list of prospects, thereby avoiding sending discounts to regular buyers. Online equivalents aren’t yet well-developed, but merchants should aspire to target their offers so their existing customers don’t find out and to restrict offers to discourage use by existing customers.

Woe onto the discounters and merchant that conflate finding new customers and price discrimination. If a merchant accepts short-run losses in anticipation of return visits, then finds that customers do not return, there’s no reclaiming the funds that were advanced. Merchants also face large losses if they attempt price discrimination but make redemption so easy that benefits accrue to customers that would have paid full price. Effective, profitable offline-to-online marketing requires a thoughtful alignment of intended use scenarios with the details and incentives of system design. Only when vendors achieve this fit will new discount services achieve their full potential.

Ben Edelman is an assistant professor at Harvard Business School. (Read More)

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