The high cost of price discounts
I was talking recently with a client who was 30 days from the end of her fiscal year. She was determined to post a year-over-year increase in sales.
“We’re pulling out all the stops! I have every salesperson looking at every deal they have for the next 90 days. I’m planning to offer some great price discounts to close those deals before year end.”
I asked her, “Is any of this business you’d expect to close without the discount after year end?”
“Yes, some of them, certainly,” she answered.
“So why, ” I asked, “would you discount your prices – and lose the revenue you’d get from selling at full price?”
“I see big companies do this at the end of the year all the time,” she said. “Isn’t it a common tactic?”
“You’re right,” I said. “Big companies do indeed run discounted sales at year end to drive the annual sales number in order to please Wall Street and their stockholders. But you’re a privately held company. The only person you have to please is you. And when you explore the real cost of discounting your prices, you may not be so pleased!”
The impact of discounts
A price discount’s impact on profit is directly dependent on your Cost of Goods and resultant Gross Margin percentage (GM%). As you’d expect, the lower your GM%, the higher the impact of a discount on your profits.
So how much of an increase in sales do you need in order to realize the same Gross Margin you’d have achieved without the discount? Let’s look at some examples.
| Company/Product | |||
| A | B | C | |
| Current selling price | $275.00 | $275.00 | $275.00 |
| Percentage discount | 10.0% | 10.0% | 10.0% |
| New selling price | $247.50 | $247.50 | $247.50 |
| Current Gross Margin % | 25% | 50% | 65% |
| Percentage increase in sales needed to create same Gross Margin dollars | 67% | 25% | 18% |
Company A has a 25% Gross Margin, which is typical of a distribution company. They’d need to increase discounted sales by 67% to achieve the same Gross Margin dollars as without the discount.
For Company B, with a 50% Gross Margin, the increase in sales required to achieve the same Gross Margin dollars is more than twice the discount rate.
Even if your Gross Margin is above 50%, you’d still have to increase sales by 18% more than the discount rate to realize the same Gross Margin dollars you’d achieve if you held your current price.
(This leads to a discussion of selling Price versus Value – but that’s another blog post.)
Also keep in mind that when you discount, you run a serious risk of establishing a new market price for your product – if not for all your customers, at least for those who buy at the discounted price.
These examples clearly demonstrate that discounting price makes sense only if you’re liquidated inventory or you’d never have gotten the sale without the discount.
One other exception: this discussion assumes that you’re operating at approximately 75% of capacity, however you define capacity in your business. If you’re not, issues of capacity utilization and the impact of a direct cost model on capacity utilization come into the discussion.
And that leads to yet another blog post – but let me just point out that if you’re below 60% of capacity utilization, you need to improve your utilization. In this case, discounting may be a way to do so. As long as you cover the direct cost margin, the Gross Margin on your profitable business goes up because you’re utilizing capacity instead of writing depreciation off on lower volume.
So how do you calculate the sales increase required to achieve equivalent Gross Margin dollars at the reduced price? The formula is below – or you can download a spreadsheet with this article and a space for you to conduct “what if” calculations on your own business numbers.
% Sales Increase = Current Gross Margin % / (Current Gross Margin % – % Discount Offered)
