The term “Discounting” in its common usage, refers to a mechanism used typically to stimulate business. It is commonly used, but generally poorly understood.
Understanding how discounting works at a financial level is key to using this successfully as a tactic for stimulating business. Simply discounting prices without proper thought and analysis can be a recipe for disaster.
For a business to be a business it needs to make a profit. This means that your revenues must exceed your expenses by your profit margin. Discounting reduces that excess and can reduce it to the point where is is zero or less than zero. This can easily catch the unsuspecting business person out with costly consequences.
Don’t get the wrong impression. Sometimes discounting can be a good idea. Often it is used in a “Loss leader” strategy, where customers are lured into a store by a low priced item, in the hope that they will make additional purchases, where the overall transaction value is profitable. Even in this case it needs to be carefully analysed, monitored and controlled. Hence the limit-per-customer type of rule that one commonly sees in conjunction with discounted items.
If the discount is applied across the board then here is the information you should understand:
If your present margin is | |||||||||
And you discount your price by | 20% | 25% | 30% | 35% | 40% | 45% | 50% | 55% | 60% |
Your sales must INCREASE by the amount shown to keep the same Gross Profit | |||||||||
2% | 11% | 9% | 7% | 6% | 5% | 5% | 4% | 4% | 3% |
4% | 25% | 19% | 15% | 13% | 11% | 10% | 9% | 8% | 7% |
6% | 43% | 32% | 25% | 21% | 18% | 15% | 14% | 12% | 11% |
8% | 67% | 47% | 36% | 30% | 25% | 22% | 19% | 17% | 15% |
10% | 100% | 67% | 50% | 40% | 33% | 29% | 25% | 22% | 20% |
12% | 150% | 92% | 67% | 52% | 43% | 36% | 32% | 28% | 25% |
14% | 233% | 127% | 88% | 67% | 54% | 45% | 39% | 34% | 30% |
16% | 400% | 178% | 114% | 84% | 67% | 55% | 47% | 41% | 36% |
18% | 900% | 257% | 150% | 106% | 82% | 67% | 56% | 49% | 43% |
20% | 400% | 200% | 133% | 100% | 80% | 67% | 57% | 50% | |
25% | 500% | 250% | 167% | 125% | 100% | 83% | 71% | ||
30% | 600% | 300% | 200% | 150% | 120% | 100% | |||
So for example, if your margin is 35%, quite typical, and you give a 10% discount, then your sales need to increase by 40% to make the same amount of gross profit. It is quite easy to see how risky this proposition could be.
There are scenarios where this effect can be catastrophic. For example: there are many businesses who have used “coupon sites” in their marketing mix. The discounts offered are usually high, often over 30%. In some cases where insufficient analysis has been done, not only has the business that has been generated been very unprofitable , but where volumes are are high, an “overtrading” situation results from which some businesses never recover.
A timely and well written article. Those numbers really are bewildering