As Groupon’s IPO approaches, commentators continue dissecting the company’s questionable financial reporting and its implications for Groupon stock valuation.  In recent weeks, we’ve heard much about Groupon’s use of the controversial “ACSOI” accounting technique and annual revenues that evaporated into about half of their original figures (from $713.4 million to $312.9 million in 2010 and from $30.5 million to $14.5 million in 2009).  The SEC has required amendments to Groupon financial reporting, and the most recent Groupon financials demonstrate negative shareholder equity and working capital.

Here, we dig deeper as an economic consulting firm – past the basis of Groupon’s valuation and IPO price to analyze its internal business model, one based almost entirely on scale.  We ask whether getting a Groupon can be a reliable source of profits for the company and investors going forward.  The economists’ take: Groupon might pull it off… but dramatic changes must ensue.

Economies of scale are the foundation of Groupon’s business model. 

• Scale economies attract merchants to Groupon.  As the scale of production increases for a merchant, over the long-run the average cost per unit produced declines.  This cost reduction results from costs being spread over a greater number of units produced and improvements in production efficiencies.  These costs savings can be passed on to consumers in the form of lower prices (dramatically discounted deals) and also generate higher profits for businesses.
• Scale economies attract customers to Groupon.  Network economies of scale occur when the cost of adding another subscriber is negligible and the benefits large as each new subscriber interacts with others to create additional worth.  For example, think of how knowing more people on Facebook makes it more interesting (both for you and advertisers).  Network economies can create synergies so minimum deal thresholds are met.

However, these economies of scale do not appear to work effectively for all Groupon merchants and customers.  According to a study by Prof. Dholakia at Rice University, only slightly more than half of merchants actually make a profit on Groupon offerings.  Some industries more frequently turn a profit on their deals – for instance, 76.2% of health and fitness businesses report making a profit on daily deals compared to only 16.7% of cleaning businesses.  This may reflect the fact that cost structures of these industries are inherently different – some subject to scale economies and others not.  For instance, cleaning services are typically labor intensive – meaning the majority of their costs increase proportionately to services offered, making the ability to achieve scale economies more difficult.

One possible Groupon economic solution: tiered customer deals (in economics, we call this price discrimination).  Create a daily deal segment targeting higher-end deals and customers with greater disposable income.  These individuals are likely more willing to purchase more expensive “discounted” deals, more likely to purchase other products when using Groupon, and may offer a greater source of loyal, repeat customers.  These deals could solve the problems associated with the scale-business model, resulting in greater profits.  Groupon could then afford to share more of the revenue with merchants, making those merchants profitable as well.