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The Cost of a Discount


Discounting


A common mistake made by new business owners is to offer large discounts in order to attract customers. This is a problem for several reasons:
  • Customers may expect the low, discounted prices in future. It is then tempting to continue offering low prices in order to keep customers.

  • It may negatively affect the image of your products and services. Some customers associate discounted prices with lower quality products.

  • It reduces your profitability and can significantly increase the quantity of products you need to sell to break even.

  • It can lead to price wars with competitors – you may feel pressured to increase your discount to match one offered by a competitor.
Key Point

Discounts mean lower profitability. When you discount your prices, you are discounting your profit margin.

Discounts are generally offered in order to increase sales, and increase profits – but increased sales from discounts do not always result in increased profit. You need to be aware of the increase in sales you need to make up for the discount. This will depend on your gross profit margin.
 
Example: The Cost of a 10% Discount

Let’s say you’re selling a product for $100. The product cost you $60 to produce, leaving you with a gross profit per sale of $40. Also assume that, when the price is $100, you sell 1,000 units per year, giving you sales revenue of $100,000 and cost of goods sold of $60,000. If your expenses are $25,000, you are left with a net profit of $15,000.



This is a gross profit margin of 40% (since $40 ÷ $100 = 0.4).

Now let’s say you offer a 10% discount. This means you sell your products for $90 instead of $100. Your gross profit would then be $30 instead of $40. This means a 10% discount reduced your gross profit per sale by a quarter (25%).

You can then use the following formula to work out what quantity of goods you will need to sell in order to maintain a net profit of $15,000.



Offering a 10% discount means you would need to increase sales from 1,000 to 1,333.33. This is an increase of one third (33%). The key question to ask is “Will a 10% discount actually triple sales?”

Now let’s say your cost of goods sold was only $30 (not $60). When products are sold at $100, this results in a gross profit of $70 (a gross profit margin of 70%). If you follow the same steps as shown above, you would find that the 10% discount would require you to increase sales from 1,000 to 1,167. This is only an increase of 16.7% instead of 33%. The higher gross profit margin of 70% compared to 40% reduced the required increase in the quantity of sales by a half.

Key Point

The lower your gross profit margin, the larger the required increase in sale in order to maintain your profit levels. Try to look for other ways to increase sales – consider adding value instead of reducing prices.


When Should You Use Discounting?


Offering a discount is not always a bad thing. As long as it increases your profit levels, it can be a good short-term strategy to help move stock or improve cashflow. In some businesses, especially fashion-related businesses, you may need to discount old season stock in order to sell it at all. Holding on to it will only tie up your cashflow and restrict you from being able to buy more stock on which you could make a profit.

If it is normal practice to sell on credit in your industry, and also reasonably common for customers to be slow payers, it may be a good idea to offer a small discount a prompt payment. However, try to build this into your pricing in the first instance. That is, work out your profits and pricing based on the discounted price, then set your regular price a bit higher to allow for the discount.

Offering discounts for buying in large quantities can also be beneficial. In the example shown, a 10% discount for a business which had a gross profit margin of 40% resulted in the business needing to triple sales in order to maintain profit levels. In this case, the business could offer a 10% discount for customers who purchase three or more products (if it is normal for a customer to only purchase one). In other words, instead of offering the 10% discount and hoping for sales to triple, you would be only offering the 10% discount if sales actually did triple. Common mistakes are to:
  • Offer people you know a discount.

  • Offer discounts to customers who would have been happy to buy from you at the full price.

  • Use discounting frequently – customers will come to expect a discount and will not buy until you offer another one.

  • Discount products without monitoring the impact on profits.