The Downside of Discounting and the Alternatives
by Mark Henricks
Every customer of every business wants to pay less. But if you're a small business owner, cutting prices can have a seriously negative effect on business cash flow. Business owners who lower prices in response to pressure from customers or with the expectation of tapping new markets often find that the hoped-for sales growth doesn't compensate for the loss of margin.
Should My Business Discount?
Each business is different, and the effect of a price discount varies by industry, profit margin, and other factors. However, as a rule, a discount of a given percentage requires a considerably larger percentage increase in volume in order to make up for lost profits.
For instance, if a ten percent discount is given off the $100 price for a product that costs $30 to produce, the business must sell 17 percent more units to show any increase in profit. The slimmer the margin, the greater the impact. When a business with 20 percent margins offers the same ten percent discount, it gives up 50 percent of its gross profit.
Because of the powerful leverage discounts have on profits and cash flow, business owners clearly need to take great care when offering discounts. This may be challenging because the pressure to discount can be intense. For businesses that sell to other businesses, pressure to offer discounts usually originates in customers. Typically, a customer reports that a competitor is offering a lower price. Anxious not to lose the sale, the seller matches the reported price.
When Is Giving Discounts Justified?
Businesses that sell to consumers often offer discounts on their own initiative, in hopes of expanding their markets. The idea is that the lower price will appeal to more potential buyers, increasing volume enough to compensate for the lower selling price. Another reason businesses often offer discounts is to reduce inventory quickly, such as an end-of-year sale or to make room for the newer lines of products distributors are shipping.
While either motivation can sometimes justify a discount, especially if it's paired with cost-cutting, they can also lead businesses to make pricing errors that reduce profits and drain cash. To avoid mistakes, a business needs a discounting strategy. Discounts should not be offered ad hoc or without understanding the effects and reasons for the discount. At minimum, no discount should be offered before calculating its impact on margins, profit, and cash flow.
If the discount is motivated by fear of losing a customer or hope of gaining new ones, objectively evaluate the likelihood of either occurrence. For instance, a discount-demanding business buyer might be asked for evidence such as an ad or price quote showing a competitor's lower price. In consumer markets, a small-scale pricing test can be used to determine the amount of additional sales a discount might produce.
Alternatives to Discounting
Before offering a discount, explore other ways you can offer value to the customer. A business can modify non-price aspects of the offer, such as delivery, customization, or after-sales support. A seller can also ask for something in return, such as a larger order or a long-term supply contract. Consumer businesses may be able to change packaging in order to reduce selling price without affecting margin.
Decisions about discounts can have far-reaching ramifications. For instance, salespeople might rely on discounts to reach sales goals. If so, sales compensation may need adjusting if discounts are reduced or eliminated. On the other hand, when discounts are given—especially when offered frequently—buyers can become accustomed to the lower price, leading to the need to reduce prices permanently.
Discounting can seem like a quick and easy way to help meet a quarterly sales goal or soothe a price-conscious customer. But the decision to reduce prices should not be taken lightly. Unless there is a clear benefit or no other way to address a problem, it may be better to hold the line on your prices.
About This Author
Mark Henricks is a freelance journalist covering business, entrepreneurship, technology, personal finance, health and fitness for leading publications.
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