• Mike Atkinson

Discounting - the race to the bottom?

This is a topic that is often discussed and debated time and time again. It all stems from your pricing strategy. In my last article I outlined a number of pricing models and options to consider. The importance of a robust pricing strategy cannot be underestimated!

However, what we often see is a haphazard approach to pricing. This is typically due to the approach used to react to slow sales, which in most cases is to instantly blame the pricing of your product or service, and as a result offer a discount. The price is too high, and no one is buying it, so let’s discount the price, and everyone will come racing in. If this is your strategy, then applied inappropriately this may devastate profits. As business owners, we all need to be aware that a pricing problem might be symptom of other weaknesses within your business, and a simple discounting approach may only serve as a band aid on a larger issue. 

In our current business environment, we are seeing businesses face growing costs for compliance with legislation, staffing pressure and subsequent wage increases, freight costs increasing on the back of fuel costs and congestion issues, and material cost increasing. Have costs changed, but not been passed on? Have sales decreased, but staffing levels are constant? Is the stock being accurately accounted for? Are jobs being priced correctly? All these elements create an environment that is putting pressure on our margins. So, to discount our prices and reduce our margins ever further seems like a race to the bottom, yet that is what we are doing in droves. 

Much has been made of the construction industry, and the pricing and margin woes that those businesses have faced recently. And while it is easy to accept in theory that we should be increasing prices, not discounting them, we also all know that kiwis love a bargain and we are surrounded by calls to action with sale after sale. Consequently we seem to think that in our business we too have to offer a bargain. Rest assured, I agree with you that you must offer value, but that doesn’t need to imply offering a discount. Discounting is a short-term solution with a long-term impact, which once started can take you down a deep and lonely unprofitable rabbit hole.

When considering pricing and discounting strategies, you need to know what your business is competing on, that is, what do you want to be famous for? We often refer to a tool called the market positioning star to assist business owners and management to consider what strategy best suits their business. Essentially you have three choices from which you must beat the market in one and meet the market in at least one other. The options are to compete on: 1) Product offering, 2) Price or 3) Customer Intimacy / Experience. 

So if your business is competing on price, then you are probably a low price, low margin, high volume business. If price isn’t a competitive strategy, and instead you are competing on differentiation, then you are probably a high price, high margin, low volume business. It’s vital that pricing strategies match your target market. It’s okay to be priced higher than your competitors, as long as you meet your customers’ expectations of quality and value, and you can clearly articulate that message to your customers.

So let’s look at an example of the impact of a price discount versus a price increase. Let’s assume for a moment that we have a business with sales of $11,970,000 for the last 2018 financial year, delivering a contribution margin of 19% or $2,034,900. Note; your contribution margin is the margin or percentage of sales left to cover all the fixed costs after paying the variable costs. In simplified terms, let’s assume that this is your gross profit margin. Lastly, let’s say that our business has fixed costs of $1,400,000. 

To set the scene, let’s also say that our average transaction value is $5,000. After applying break-even analysis, we have calculated our break-even sales to be $7,368,421, or 1,474 transactions ($7,368,421 / $5,000).

What would happen to our business in this example if we offered a discount of 10%? And similarly, what would happen if we could put our prices up by 10%?

 

 

 

 

 

 

 

 

From the example it is clear that if we had offered a discount of just 10%, we would have had to increase the number of transactions by more than double. That is sales transactions must increase 111% from 1,474 to 3,111. Do you feel that your business could double its sales due to a discount that you might have offered? Does your sales team have the ability or appetite to double sales? Is there enough room in your market for you to double your sales? If you answered No to any of these questions, then you have an issue that needs serious attention. 

To counter that, if in our example we were able to put our prices up by 10%, then we could have afforded to reduce 1/3 of the number of transactions sold, or potentially 1/3 of our customers. Often a price rise will cause customers who are not really target customers to move on, thereby freeing you up to spend time with the customer who value your business offering.

Sadly, it’s not this simple in the real world, and any price increases still need to be relevant to the market you operate in. Discounting, bargains, pricing pressure is all part of being in business, especially in a business to consumer market, but how you react to that pressure and what strategies you set will either make you money or lose you money, so choose wisely.

There are some key lessons to be learnt here, and they are:

Always consider the magnified effect of a small discount or a small price increase on gross margin

Avoid discounting – who wants to be a busy fool

Consider adding more value and / or increasing price

Seek good advice to understand the impact of your pricing decisions to avoid the race to the bottom.


Issue 91 September 2018