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The Dangers of Discounting

Anonymous • Feb 28, 2013 at 3:00 PM

This week we are going to roll up our sleeves and do some basic number crunching in order to illustrate just how dangerous it is for small businesses, especially niche shops, to discount on a continual basis both financially and in an intangible "perception of your store" way. The temptation to discount is great, but the danger in doing so is much greater. To set the mood, this week’s quote is from the 1986 crime comedy “Ruthless People”. In this scene the wife of a kidnapped businessman (Barbara) speaks with one of her kidnappers (Sandy):

Barbara: So, when do I get out of here?
Sandy: As soon as Mr. Stone pays the ransom.
Barbara: What's the problem? What is the ransom?
Sandy: Well, we asked for $500,000.
Barbara: That should be no problem.
Sandy: He wouldn't pay.
Barbara: He wouldn't pay?
Sandy: Then we asked him for $50,000.
Barbara: Yeah?
Sandy: He still wouldn't pay. So now we're lowering our price to $10,000.
Barbara: Do I understand this correctly? I'm being marked down?

[Starts crying]
Barbara: I've been kidnapped by K-Mart!

In many ways you can consider your business to be a kidnapper. It takes your time and energy, and demands money for you to get your lifestyle back every month. We’ll presume like in the quote it takes a gross sales (before expenses) amount of $500,000 to pay the “ransom” every year. Additionally, if your inventory discount rate is similar to mine, you get to purchase your items for 40% off retail price. Meaning I buy an item for $6 from a distributor and sell it for $10 to a consumer. Presuming I purchase another item to replace the one I sold I get to keep $4 (net sales) to pay my other bills: rent, utilities, payroll, and/or hold onto to expand my inventory or purchase assets /services like new tables or painting (profit).

So in this example we get to work with net $200,000 a year to pay our bills. For ease of math in base model we will say our fixed expenses are $160,000 (80%). We as an owner will count our own pay as separate from our employees and pay ourselves a modest $20,000 (10%). That leaves us with a $20,000 (10%) profit for rainy days or expansion. For the record, we are presuming you are both collecting and paying your sales tax and won’t incorporate it into the math. You are paying your sales tax, right? Please, for the love of anything you hold dear PAY YOUR SALES TAXES! Oh, right, where was I? Ah, yes, discounting.

This is getting complicated with words and numbers, let’s make a spreadsheet!

"BASE MODEL" (with equations)

A. Gross Sales: 500,000

B. In-Store Discount Rate: 0

C. Adjusted Gross Sales: 500,000 [=A-(A*B)]

D. Inventory Discount Rate: .4

E. Net Sales: 200,000 [=C*D]

F. Fixed Expenses: 160,000

G. Your Pay: 20,000

H. Profit: 20,000 [=E-F-G]

Now we have a stable business model above. But, we want to see if we can do better to maybe bump up our own pay, hire another employee, or get a little more set aside to purchase equipment, etc. Let’s aim for another $20,000, making our profit $40,000. Holding to the seemingly-conventional business wisdom of “discounts attract more customers, let’s discount!” 10% is a pretty standard amount so let’s go with that. Presuming nothing else changes such as your expenses we’ll run some models:

EXAMPLE 1. Let’s say that nothing happens. You discount 10% but have no increase in sales volume. This means your adjusted gross sales go down reflecting the same amount of "sales/work" you did for less money. You have just given up your profit. Or, if not profit, your own pay could be used to offset the loss. If neither of those, then perhaps you say, “Well I can downgrade this expense, fire an employee, or just not reorder X.” Well that was a bust and you are worse off than you were before having lost $20,000.

EXAMPLE 2. Presume with me, though, that your discount does in fact increase your sales by a “matching” 10%. Hurray, more business - it worked, our discount worked! Again, presuming your expenses don’t increase, you can pat yourself on the back because you've only lost $2,000 in profit from the year before. But how? We actually sold 10% more stuff! We worked 10% harder than we did before for less return. Yes, but the volume of product you sold didn't make up for that discount.

EXAMPLE 3. You’ll actually have to work about 12% harder with a 10% discount to “break even” with normal profit from the base model. We are still not even reaching our goal of $40,000 profit! Does that make sense? Why would you work 12% harder for the same return you were getting not discounting?!

EXAMPLE 4. Ok, so how much more must you sell with a discount to make your goal? Only 22%. Yeesh...

EXAMPLE 5. If we didn't discount at all and worked just as hard as the last example, we would make more than twice the extra profit we wanted! It is so much better to make an EXTRA $20,000 on top of the extra profit goal we set for the same amount of work we put in.

EXAMPLE 6. What if we ditch the discount and just work 10% harder and not 10% cheaper instead? This one is easy and a great way to bring things back around. If we do that then we'll reach our goal $40,000 without a problem. Not too shabby, eh?

“BUT WAIT,” you might shout, “If I don’t discount I will lose customers.” Will you? If you are a small business, especially a niche/retail operation, most of your customers presumably are coming to your store because of who you are and what you do. If your store is presented well, you listen to your customers and community, and especially if they know you are putting your all into your shop, we can imagine they would be willing to pay $10 instead of $9 for your widget.

Look at it this way, you may save 20 customers $1 each, but you singly just lost $20 for the day. You are losing $600/month on something that most of your customers would have no problem paying because it is supporting you and your store/community!

Will you get someone who will bemoan your necessary pricing? Maybe threaten to buy elsewhere or online because they have to pay $1 more? Someone who refuses to understand that prices go up along with expenses? Yes. Let them go elsewhere. It’s ok. Most of those customers tend to be rather verbal about other things, too, and will drive off business because of their personality. The loss of the one may actually gain you three in return because they don't have to listen to, put up with, or be around "that guy!" Admit it, you can probably think of a "that guy."

Using myself as an example, the items I sell can certainly be found cheaper online, but my customers come to me because of the atmosphere and feeling of contribution they get knowing their investment in the community is meaningful. Now we have happy customers who go out of their way to pay slightly higher, but necessary prices, for quality goods. Combine that with honest business owners who go out of their way to run a good shop and listen to their paying customers. You don't need a spreadsheet formula to see that everyone wins and you don’t have to feel “ashamed to be K-Mart” with your discount pricing.

Oh, and did I mention you should always pay your sales taxes?


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