The Dangers of Discounting

Anonymous
Feb 28, 2013

 

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?
 

Comments

Trustafarian

Da problem wit dis counting is I's gots to get nekkid to counts to 21. That's how comes I lost my last job.

Contango

I discounted the sale of my last house.

I lowered the asking price by several thousand dollars every couple wks. until I got "someone's" attention.

The last I looked, according to Zillow, the market price of that house is 35% lower than what I sold it for three yrs. ago.

IMO, cash is your pocket is better than hangin' onto an illiquid asset.

Sometimes ya just gotta make your best deal, cut your losses and move on.

LadyC

What is sad is perishable food items in the grocery store, so high priced that they sit and rot because no one can afford them. Then they are thrown away. Who gains anything in that situation?

The Hero Zone's picture
The Hero Zone

I am not sure if any of them operate in Sandusky, but there are many charity kitchens and food pantries that send volunteers to grocery stores to pick up the nearly-expired food and cooks it up to distribute the next day. The grocery store gets a charity write-off, the non-profit serves its function, and the food isn't gone to waste.

pntbutterandjelly

Mr. Morgan, I understand your simplfied hypothetical "formulas" however...the ones you postulated are deeply flawed on numerous accounts and are therfore less than valid. 1) you took the liberty to "discount" your entire inventory rather than a few, select items (your sceanario is not "real world" business practices), 2) you failed to take into account the very real possiblity of attracting new customers with discounts, 3)you failed to take into account that discounting of some items will lead to the generation of other items being sold that the customer may not have purchased otherwise, 4) discounting is another way of thanking loyal and new customers alike for their patronage, 5)discounts are one more element in the entire "branding" process, 6)98% of business use discounts which in and of itself displays the valid economic use and gain from discounts, ie. sales-profits,7) the use of discounts to clear out discontinued items and 8)the model you use {$200,000 gross vs. $20,000 pre-tax net} equates into a rough post-tax net of $15,000 which is a net R.O.I. of 7.5% That can not be construed as a stellar or even sustainable business environment. It leaves little, if any, possibility for capitol improvements, expansion or for savings. That is unless purchase your own goods and services "at discount". Speaking of that...do you or do you not "shop around" to find a good deal in order to boost your bottom line or do you pay the "full price all the time without question"?
After having reviewed your website, I can see some of the possible reasons you have chosen to pummel the use of discounts. The primary reason would appear is, "You feel you have no other local competition to speak and therefore don't feel compelled or see the need to dicount". Lucky you but that makes your stance an easy one to take in an off-hand way.
Furthermore...I think a lot of the businesses who advertise on the Sandsuky Register and some with coupons (another form of discounts) are shaking their heads too at you article. I'm even amazed that the Register hasn't called you out on it. Discounts, coupons, sales and other incentive-based strategies are good for the business owner, the customer and the local economy growth as a whole.
As the owner of three small local businesses (AND a blog as well!)...I will attest to the positive enconomic gain garnered from "discounts".
If you should decide to know more about the correct use of discounts and the full range of impact they will have on your business...reply back to me here and I'll call you to set up an appointment.
Sincerely,
Pntbutterandjelly

The Hero Zone's picture
The Hero Zone

Many of the things you said get into the minutiae of specific business operations that cannot possibly be addressed in a single, simple blog entry. As you pointed out this is considering everything was discounted, that you receive the same same discount from all distributors, etc. The entire point of what I wrote was, in simple terms, to show how quickly being a discounter can cause a loss of money you may otherwise have made. It was a cautionary tale that used basic examples to convey the point. The numbers were convenient for both the quote and the ease of math so readers could quickly follow along the premise and perhaps think of examples themselves.

I appreciate your feedback and letting people know that you shouldn't discount discounts. They shouldn't. Done intelligently they can do what you say. Even I run sales and discounts. But, that wasn't the point of warning about the dangers they can present if you make that your ONLY method of being able to run a business and attract/retain customers. Especially as stated in the opening by running a small, niche retail shop.

On that note I would love it if your presumption about my competition was true. It isn't, both in brick-and-mortar and especially online (refer to the wizards.com Store Finder if you wish to see for yourself). The crowd I cater to are all EXTREMELY web-savvy, mobile, and many, as I stated blatantly in my blog, can buy for a less expensive price elsewhere. Yet, they choose (in most cases) not to for the intangible reasons I conclude with in the writing. I am not a special case as a niche retailer.

I'm curious why would I be called out by The Register or even by other businesses? Did I say you shouldn't advertise or that this paper isn't worth your time/dime? Or perhaps you think I implied that any store that discounts is unworthy of mere existence? I am hardly going to chase the Town Money Saver (as another example) out with a torch-and-pitchfork mob for crimes against prosperity, nor mount a protest against a local restaurant for having dollar-off subs on "X"-days.

You are welcome in my store any time and we can certainly talk more and in specificity about my business as compared to other card shops, other small businesses, or general principles. Thanks again for the reply and having the passion to say "but wait, there's more!"

pntbutterandjelly

Thank you, sincerely, for your reply.
My overall "complaint" with your original post was that it could easily be construed as a " dire warning" to businesses to not use discounts. Had you also balanced its critique with the positive aspects and personal use of discounts...the entire article would have given readers a different and better understanding of the "pros and cons".
I applaud your gallant efforts with your store in these tough economic times and for the time it requires to formulate copy for a blog. I assume the latter is for "public announcement" informational purposes AND...as another way to gain market expsure for your store. That's a smart move!
I hope we can digress from this becoming a personal "thing" and move forward in a altrustic direction for everyones' benefit. With that being said...we just may take you up on your invitation to stop in and chat about New-age (Internet)marketing practices. There may well be mutual benefits in our intial happen-chance meeting! "Things happen for a reason."
Have a great day and hope to see you in the future.

Licorice Schtick

A picture is worth 1282 words...
Simple break-even analysis:
http://images.vertex42.com/Excel...
The link below is an image that shows how price influences earnings. It can be tricky to know whether to raise or lower your price, because you could be on either side of the peak, or already on it. One approach is sensitivity testing - try something and see what happens. Note- it is possible that the peak of the curve my still be below break-even, I which case, you need to adjust your business model.
http://t3.gstatic.com/images?q=t...

The Hero Zone's picture
The Hero Zone

It's true and hopefully your picture helps to accent things. I appreciate the additional concepts and commentary. Once delved into, it can be a boggling experience doing calculations and numbers to see if you are always literally hitting your peak. For general advice to small shops, though, I hoped it served its purpose. Thanks for contributing!