The True Cost of Discounting

January 6, 2016

 

 

 

One of our clients pointed me to a fascinating article originally published in the TIMBERTRADE NEWS MAY 2009 illustrating the real cost relationship of providing discounts or forced price cuts on margins and sales volumes. 

 

Whether it is retail, wholesale or service based businesses, the effect of rate cutting or price discounting both small and large, is long term when you break it down to the sales volume to recoup that lost margin.  When you see all the TV adverts about beating the lowest advertised price, is this actually a long term sustainable business strategy?  Maybe, but in Dick Smith’s retail business and many other WA company receiverships since the mining boom, this certainly was not the case among other issues with the recent business collapse.

 

The below article was first published in March 1992 and then again in May 2009, and I feel the relevance of this theory remains strong in today’s environment leading into 2016 given the strain on the current economy in Australia.

 

Have a read, even print out the discounting table to laminate and stick next to your computer so employees can think twice next time a sales transaction is purely price based – is this sale actually beneficial to the business? 


The Real Price of Discounting

Look up the definition of “price cutting”  and you come up with ‘Reduction of retail prices to a level low enough to eliminate competition’ or ‘cutting the price of merchandise to one lower than usual or advertised price’.

 

It’s the oldest sale tactic in the world but before you make your next price cut in the face of sales resistance, the question you have to ask yourself is not, “ Does it work?” but rather, “Can you live with the bargains?”

 

The recession has forced many businesses to believe that cutting prices on merchandise, that they can sell more for greater profit.  But they are falling for one of the greatest fallacies of merchandising.  All too often in our over competitive economy high volume turnover allied with minimum profit margins leads to disaster.

 

Some traders will agree and satisfy themselves (and sometimes their listeners) with theoretical calculations based on assumptions that increased volume will make quicker merchandise turnovers – and this will then enable them to operate on a smaller gross margin.

 

We ran the following article back in March 1992 and while the price of goods will obviously vary to today’s market, the figures – and the moral – remain the same.

 

IN PRACTICE

While these theories appear reasonable, close observation proves conclusively that they do not work out in practice.  Those who have used this mistaken theory (to their sorrow) did not go into their calculations deep enough to fully understand how much increased business must be secured to effect the loss sustained by cutting prices.  If the practice created a new additional field for this product there might be some justification for this action, but unfortunately this is seldom, if ever true.

As a consequence it is not only an unprofitable procedure bit usually is ruinous to the whole trade industry.

 

DO THE ARITHMETIC

Many otherwise shrewd business people forget their sixth grade arithmetic.

 

Here are a few examples to prove that arithmetic is the same today as it was when we were in school.

 

A merchant or manufacturer realises that he must make, let’s say, 25% gross margin on his sales.  Therefore he adds 33.33% to his costs in establishments his selling price.

 

Selling price                                                 $100

Cost of material                                           $75

Gross margin                                               $25

 

Under the pressure of a “buyers market” he weakens, even though he knows that a 25% margin is necessary to absorb his selling and administrative expenses.  He lulls his better judgement by thinking that the added volume and quicker turnover will surely compensate for the price cut of 10% and secures the order.  The sale then appears as follows:

 

Selling price                                                 $90

Cost of material                                           $75

Gross margin                                               $15

 

The table also shows the extra sales that must be achieved to attain the same profit after discounts have been applied.  

 

THE MORAL

Price reductions can do nothing more than create a situation where you have to run twice as hard to stay in the same place!  It’s better to sell on QUALITY, BENEFITS and SERVICE than to cut your prices.

 

 

 

 

 

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