The Profit Pool: Where the Money in an Industry Actually Sits

A profit pool is the total operating profit earned at every stage of a chain, added up stage by stage. Draw one and profit turns out not to be spread the way revenue is. A stage can carry a huge share of what flows through and keep almost none of the money. Mapping that is a measurement. Explaining why it looks that way is a different question.

Three pieces of machinery build a profit pool, and there is no fourth. The first is a chain: the line of businesses a rupee passes through on its way from raw material to the person who finally uses the thing. The second is the split between a cost that moves with each sale and a cost that sits there whatever happens. Each stage arrives at a profit figure through that split. The third is an ordinary operating margin read off a set of statements. All three are covered separately. A profit pool totals the second across every stage of the first, and the shape of what comes out repays a hard look.

What is a profit pool?

A profit pool is a sum, and the sum is boring. Take a chain. Name every stage on it. Find the operating profit each stage earned over one period. Add those profits together. The result is the pool. There is no clever step hidden in there, no weighting, no adjustment, nothing that needs a specialist. Anybody who can read three sets of statements can build one.

The difficulty sits one step earlier, in the naming. A pool is defined by the chain that was drawn, so two people who draw the chain differently will find two different pools without either of them making an arithmetic mistake. Does the mill that supplied the board count, or does the chain start at the factory? Does the transport contractor get a stage of its own, or disappear into somebody else's cost? Is the intermediaryAny business that sits between a maker and a final buyer and handles the goods, the order or the payment on the way through. Wholesalers, agents and marketplaces are all intermediaries. a stage, or a line item? Answered differently, the pool changes size, and both answers can be defended. Refusing to say which chain was picked cannot be defended.

Take Setu Bazaar, an invented marketplace where small sellers list goods and fifty thousand buyers order them. Buyers pay Rs 500 crore over a year. Setu charges the sellers 4.00 per cent of that, so Setu bills Rs 20 crore and the sellers keep Rs 480 crore. The split just made is one way to draw the chain: two stages, and what each stage keeps out of the buyer's money. Drawn the other way, counting each seller's full sale as its own revenue, the sellers' stage becomes Rs 500 crore instead of Rs 480 crore, the chain totals Rs 520 crore, and every share below moves. Neither drawing is wrong. Every figure below uses the first drawing, stated before anything is computed.

Notice what the dashed line at the foot of that picture is doing. The dashed line states the convention rather than decorating the frame. Once the convention is written down, anybody can rebuild the pool from the same components and get the same answer, and anybody who disagrees can say precisely which stage they would have drawn differently. A pool with no stated convention is not a measurement but an assertion with numbers stapled to it.

Why do revenue share and profit share tell different things?

Start somewhere concrete. A household spends Rs 8,00,000/- on a wedding. Four suppliers share that money: the caterer bills Rs 4,00,000/-, the venue Rs 2,40,000/-, the photographer Rs 80,000/- and the decorator Rs 80,000/-. Asked which of them the wedding was best for, almost everyone points at the caterer holding half the total. But the caterer bought food, hired staff and paid for gas, and kept Rs 40,000/- of it. The venue billed a good deal less and kept Rs 72,000/-.

The last two columns read against each other are the entire subject here. The caterer tops the billing column at 50.00 per cent and comes second in the keeping column at 25.00 per cent. The venue is the reverse. Revenue share and profit share are two different distributions laid over the same chain, and they are routinely confused with each other. Anyone who has only ever seen the billing column has been looking at a picture of where the activity is, and calling it a picture of where the money is.

Now the business version, with an entity whose statements were built elsewhere and are quoted here rather than rewritten. Anjani Stationers Private Limited is an invented manufacturer that turns board and paper into files, registers and folders. Anjani is a converterA business that buys a bulk material and changes its form before selling it on, rather than reselling it as received. A mill makes the board; a converter cuts, prints and binds it., sitting between a mill upstream and the offices that finally use the goods. Its revenue for the year is Rs 2,70,00,000/- and its operating profit is Rs 41,50,000/-, an operating marginOperating profit divided by revenue, expressed as a percentage. It says how much of each rupee billed is left after the costs of running the business, before interest and tax. of 15.37 per cent.

Put two more stages beside it, both invented for this illustration. Upstream, a paper mill bills Rs 6,00,00,000/- and earns Rs 33,00,000/-, a margin of 5.50 per cent. Downstream, a set of distributorsBusinesses that buy finished goods in quantity and resell them onward in smaller lots, usually holding stock and carrying the delivery. They add no manufacturing of their own. who carry the goods to offices bill Rs 3,60,00,000/- between them and earn Rs 18,00,000/-, a margin of 5.00 per cent. The chain bills Rs 12,30,00,000/- in total and the pool is Rs 92,50,000/-.

Both panels are drawn to the same scale and both add to 100.00 per cent, so nothing in the picture is doing any persuading. The lime bar simply marks whichever stage is longest in its own panel, and it moves. The movement of the lime bar is the finding. Anjani bills roughly a fifth of the chain and keeps close to half of what the chain earns, and the mill does the opposite. Why the two panels disagree is a separate question, covered under Industry Structure and Sector Behaviour.

Can a stage carry every rupee and still earn nothing?

Yes. In Setu Bazaar the three quantities separate as far as they can go, and that makes it the sharpest version available. Every rupee any buyer spends crosses Setu's books. The gross merchandise valueThe total value of goods transacted across a marketplace over a period, at the prices buyers paid. It measures the traffic, not what the marketplace charges for carrying it. Charging is covered separately under take rate. is Rs 500 crore, and Setu's share of that flow is 100.00 per cent. Its share of what the chain bills is Rs 20 crore out of Rs 500 crore, or 4.00 per cent, the smallest of the two stages. And its operating profit for the year is minus Rs 2.5 crore.

The arithmetic behind that loss is short. Setu's contributionWhat is left of a sale after only the costs that move with that sale. It is the amount available to go towards costs that do not move, and it is not profit until those are paid. is Rs 10 crore, being Rs 20 crore of billing less Rs 10 crore of costs that rise with each order. Its fixed costA cost that does not change with the next sale: the engineering team, the rent, the software licences. It is there at one order a day and at a thousand. is Rs 12.5 crore. Rs 10 crore less Rs 12.5 crore is minus Rs 2.5 crore, and that is the whole story. Flow is a gross quantity and profit is what survives a stage's own costs, so passing through is not keeping.

Here is where drawing has to be done carefully. The merchants earned Rs 24 crore, keeping Rs 480 crore and spending Rs 456 crore on goods and running costs. The pool is Rs 24 crore less Rs 2.5 crore, or Rs 21.5 crore. So the merchants' share of the pool is 111.63 per cent and Setu's is minus 11.63 per cent. The two shares still add to 100.00 per cent, exactly as shares must, but one is above the whole and the other is below zero. A negative share cannot be drawn as a slice of a whole, so every profit share here is drawn on a signed scale with the zero marked, and never as a pie.

What do the two chains look like once they are totalled?

Two tables set out both chains with every component shown, so any total can be rebuilt from the parts rather than taken on trust. Start with Setu Bazaar. The convention is the one stated earlier: each stage's revenue is what it keeps out of the buyer's money, and each stage's profit is its operating profit for the year.

Every figure in that table can be checked against another. Setu's Rs 20 crore is 4.00 per cent of Rs 500 crore. Its Rs 10 crore of costs that move is Rs 2,000/- for each of fifty thousand buyers, leaving Rs 2,000/- of contribution each, or Rs 10 crore in total, against Rs 12.5 crore that does not move. The merchants' Rs 384 crore and Rs 72 crore add to Rs 456 crore. Taken from Rs 480 crore, that leaves Rs 24 crore. And Rs 24 crore less Rs 2.5 crore leaves the pool at Rs 21.5 crore.

Anjani Stationers' chain totals the same way and finishes in a different place. Its stages are shown in the second table, and here every profit figure is positive, so the shares behave the way most readers expect a share to behave.

One difference between the two tables is worth pointing at before anyone trips over it. In Anjani's chain the mill's Rs 6,00,00,000/- of billing sits inside Anjani's own costs, so a single rupee of an office buyer's money gets counted more than once as it travels up the line, and the chain total of Rs 12,30,00,000/- is larger than what the offices actually spent. In Setu's chain each stage was drawn as what it keeps, so no rupee gets counted twice. Both are legitimate drawings. The point is that a share only means something against the total it was taken from, and that total came from a choice.

Neither table ranks the two businesses. Anjani's stage of its chain earned a positive number and Setu's stage of its chain earned a negative one, over one year, on the conventions written above. The contrast is a description and it stops there. Neither of those facts says which business is the better one.

How is a profit pool identified along a chain?

How to Identify a Company's Profit Pool

The procedure is five steps and four of them are clerical. Work through them in order, on paper, before touching any software.

One. Draw the chain end to end, recording where it starts and where it stops. Every stage a rupee crosses on its way from raw material to final buyer gets a box, and any stage left out gets written down as left out. Two. Get each stage's revenue for the same period, on a stated convention, gross or net, and apply the same convention to every stage. Three. Get each stage's operating profit for that same period. Where a stage is many small businesses rather than one, estimate it from a margin and record it as an estimate. Four. Turn both columns into shares of their own totals, so the two are on comparable scales. Five. Read the two shares against each other, stage by stage, and write down every place they disagree.

The first four steps are bookkeeping and the fifth is the only one that finds anything. A reader who stops after step four has a tidy pair of tables and no finding. The finding is always a comparison: this stage holds a lot of the activity and little of the money, that stage the reverse. Tables that look finished are easy to mistake for conclusions, so work stops at step four more often than anyone admits.

What is the difference between mapping a pool and explaining it?

Everything so far has been counting. The map says that in Anjani's chain the mill bills 48.78 per cent and keeps 35.68 per cent, and that Anjani bills 21.95 per cent and keeps 44.86 per cent. Every one of those numbers came out of an addition and a division, and any two people with the same statements and the same drawn chain will get the same four numbers. Reproducibility is what makes the map a measurement.

The next question anybody asks is why, and that is where this guide stops. Why one stage keeps more of a chain's money than another is a question about how many alternatives each side has, how easily a new entrant could set up, what buyers can switch to and who can hold out longest in a negotiation. Michael Porter set those questions out as five forces in Competitive Strategy in 1980, and traced the activities inside a single firm as a value chain in Competitive Advantage in 1985. The five forces and the value chain are set out under Industry Structure and Sector Behaviour.

A map is not an explanation, and an account that starts explaining why a stage keeps what it keeps has quietly changed subject. The discipline is worth holding because the two get run together so easily. A profit pool map is evidence that a phenomenon exists. The cause of that phenomenon is a separate enquiry with a separate method, and the enquiry gets done badly most easily right after a map has produced a striking picture.

What does a profit pool map not establish?

Four things, and each of them gets claimed for a pool map regularly. A map covers one period and holds nothing about any other, so it cannot establish that the stage keeping the most will still be keeping the most next year. A table of margins says nothing about what it would take to move a business from one stage into another, so the map cannot establish that the move is open. A large pool at a stage is not thereby available to anyone new. And whether a stage is worth putting money into is a question about price. A pool map carries no price at all.

A pool is a photograph of one period, not a forecast and not an opportunity. The most common misuse of the tool is exactly that slide: the map shows a fat pool at one stage, somebody writes the word opportunity beside it, and a conclusion about the future has been smuggled in behind a measurement about the past. The measurement is still good. The word is doing work the measurement never did.

Where does a rupee stop being a cost and start being a profit?

Where a rupee stops being a cost is the question practitioners actually ask when they build these maps, and it is more answerable than asking which stage is the good one to be in. Follow a single rupee from the buyer's hand. At each stage, ask how much of it stays and how much moves on as somebody else's revenue. A rupee that arrives at a stage and immediately leaves as a payment to the next stage is a wholesaleSelling in bulk to a business that will sell on, rather than to the person who will use the goods. A wholesale price is what one business charges another along the way. transaction and nothing more. A rupee that arrives and stays is profit at that stage.

A lender does this to work out where a borrower sits and what its stage typically retains. An analyst does it to see whether a company's margin is unusual for its stage or ordinary for it. A buyer at a large office does it to work out how much of what they pay is going to the maker and how much to the people who moved it. In each case the useful output is not a ranking but a sentence of the form: this stage carries this much of the activity and retains this much of the money, over this period, on this drawing of the chain.

Read that picture as a position and nothing more. A stage above the dashed line keeps a larger share of its chain's money than of its chain's activity, and a stage below the line keeps a smaller one. Where any of the five points sits is a measurement. Why it sits there is a separate enquiry, covered under Industry Structure and Sector Behaviour.

Anjani Stationers Private Limited and Setu Bazaar are invented.
Educational material. Not advice on any investment, tax, budget or market position.