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Technical September 1, 2014

The Dangers of Discounting

If you’re a compulsive discounter……I hope you’ve done your numbers!!!Consumers are often drawn to businesses offering discounts, and rightly so.  But more often than not, those businesses offering discounts do not fully understand the impact this has on overall profitability.

Here’s a simplified example to illustrate the staggering impact discounting can have to a business……

Sam’s Software Company

  • Sam sells Software Programs at $100 each
  • Sam has 875 Customers which are retail computer shop outlets
  • Each outlet buys 4 Packages a Year on Average
  • Sam’s Direct Costs to buy each program is $70 per Program
  • Annual Revenue is therefore 875 outlets x 4 packs p.a. x $100 per pack = $350,000 turnover to Sam
  • Gross Profit Margin ($100 sale price – $70 cost) = $30 or 30%

Now…..Sam discounts the sale price FROM $100 per package to $90

Price$100$90
Revenue =875 customersx 4  packages per customer= 3500 packages @ Price$350,000$315,000
Direct Product Costs3,500 packages at $70 each$245,000$245,000
Gross Profit$105,000$ 70,000

 

  • What Increase in Sales is required to maintain the current gross profit level ($105,000) if you discount prices by 10% from $100 to $90?
PRICE$100$ 90
SALES$350,000?
COST OF SALES @ $70 PER UNIT$245,000?
GROSS PROFIT$105,000$105,000

This may come as a surprise…..and it doesn’t look pretty!!!

PRICE$100$ 90
SALES UNITS3,5005,250
SALES REVENUE$350,000$472,500
COST OF SALES @ $70 PER UNIT$245,000$367,500
GROSS PROFIT$105,000$105,000

A 10% Price Reduction where the Margin is 30% requires a 50% Increase in Sales UNITS to maintain Profitability

Use this matrix to help you assess the effect on your gross profit given a particular level of discounting

Gross Profit Margins

Gross Profit Margin10%15%20%25%30%35%40%45%
Price Discount ↓Sale
 1% Discount11%7%5%4%3%3%3%2%
 2% Discount25%15%11%9%7%6%5%5%
 4% Discount67%36%25%19%15%13%11%10%
 6% Discount150%67%43%32%25%21%18%15%
 8% Discount400%114%67%47%36%30%25%22%
10% Discount200%100%67%50%40%33%29%
15% Discount—-—-—-150%100%75%60%50%
20% Discount—-—-—-400%200%133%100%80%
25% Discount—-—-—-—-500%250%167%125%
30% Discount—-—-—-—-—-600%300%200%
35% Discount—-—-—-—-—-—-—-350%
40% Discount—-—-—-—-—-—-—-800%

The reality of this does not take in to account:

  • Any requirements to increase sales staff which would be required to meet the demand of selling 50% more units per year.
  • The overhead costs of additional storage space to stock 50% more than what was required before the discounting. ie Stock on hand to sell 3,500 units may only be 700 units at a time (20% of monthly sales), compared with 1,050 units.
  • The additional administration costs, delivery costs, and general expenses such as phone costs, electricity, etc. to handle 50% more stock without any benefit to the gross profit line.

Now, that’s not to say businesses shouldn’t discount.

Discounting is often looked upon as a ‘Cost of Marketing’.  It can be extremely effective given the right intentions.  In addition to that, discounting may be a necessary evil in converting old stock in to cash, which can be better spent on more popular stock items which sell quickly at larger profit margins.

The point is…..understand the impact of discounting before ‘pulling the trigger’.

 

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