Pricing Strategy and the Dangers of Discounting
Black Friday. Thanksgiving was over and the starter pistol had gone off. It was the unofficial start of the Christmas shopping season. Joy to the world and whatnot, but why is it that every year around this time I seem to get uncomfortable?
The Christmas shopping season can be extremely competitive for local businesses, particularly retailers. This past year, it seemed that more and more businesses offered deeper and more numerous discounts. With the challenging business environment and thirst for cash flow it may seem on the surface that any tactic we can take to boost sales is a positive. But does discounting always make good sense?
WHY BUSINESSES DISCOUNT PRICES
Discounting is an instinctive response for many business owners looking to improve their results. Here are a handful of the responses given by business owners / managers as to why they discount their products and services.
• “I discount to get customers in the door and make it up on future sales”
• “I use sales to get rid of old inventory”
• “My competitors reduced price, if I don’t reduce prices in turn, I risk losing all my customers”
• “Customers expect a sale at this time of year and it’s an easy way to remind them that our business exists”
• “My bonus is based on end of year sales. I’ll do everything I can to boost that – I didn’t even think about the shareholder’s profits.”
It’s interesting to note that while there is a general assumption that price reductions would increase unit sales volume (not always sales volume in dollars), decision makers seldom had a system for measuring the impact of pricing strategy on profitability and overall business value.
A DANGEROUS MISCONCEPTION
A common misconception is that if a business reduces the price of its products by a certain percentage – let’s say they have a 25% off sale – that they ‘break even’ on the sale if they increase unit sales volume by an equal percentage – they sell 25% more units. If we look a little deeper, we can see that this math just doesn’t add up.
CASE STUDY - RUDIMENTARY PRICING STRATEGY
The following case study is an attempt to give a simple example of the effects of pricing strategy.
• Bob’s business sells one type of product. It purchases product at a landed wholesale cost of $100 per unit and applies a 100% markup, selling at a regular retail price of $200 per unit.
• Total fixed costs of the business – for rent, salaries and other operating expenses – are $10,000 per month.
• Bob wants to see if it makes sense from a to try and boost business performance by offering product at 25% off the regular retail price.
• What would happen if Bob sold product at $150 per unit, but everything else (purchase price, operating expenses etc.) remained the same?
From the analysis of Bob’s business, he learns key items that will help his pricing strategy:
• To ‘break even’ at his current retail price structure, Bob would need to sell 100 units per month and have monthly sales of $20,000.
• If Bob fell into the trap of the misconception we detailed earlier, Bob’s business would have lost money even if the overall dollar value of sales remained the same at $20,000 for the month.
• If he decides to go forward with the 25% off sale, Bob’s business will need to double units sales from 100 to 200 units to ‘break even’. He would have to increase the dollar value of sales by 50% from $20,000 to $30,000 in order to break even.
HIDDEN COSTS OF DISCOUNTING
Further to the visible financial effects explored above, business owners and managers would be well advised to consider potential hidden effects of discounting including:
• Risk of Price Wars – Your competitors may retaliate by cutting their own prices. This can downgrade into a downward spiral where the winner may be the biggest loser.
• Changing Customer Expectations – Customers who paid ‘full price’ may feel cheated because they couldn’t benefit from the price reduction. They may develop new pricing expectations, after all if you could afford to sell a product at 25% off, why should they ever think it’s fair for them to pay ‘full price’?
• Devaluing your brand – Customers may become conditioned to view your service or product as a commodity and encouraged to shop around with the lowest price having a greater influence on their buying decision.
• Reduced Profit Margins Degrade Operations – Reduced profit margins can negatively influence your ability to sustain the quality of your products and service down the line as you are forced to cut costs in support and other areas that influence customer experience.
• Effect on Staff Income - If your staff is predominately compensated via commission or gratuity, they will find themselves working harder for less reward. This can have a negative impact on the employer / employee relationship and your ability to retain good staff.
• Cannibalization of Existing Sales – Current customers who would otherwise have paid the regular price will be only too happy to take advantage of a sale but are unlikely to buy in sufficiently excessive amounts to ‘take up the slack’.
Pricing strategy is an often poorly understood element of business operations that can have a tremendous impact on a business’ return to shareholders and to its very survival. This article explores some of the potential risks of discounting, however it should be recognized that a low cost strategy, when matched with an appropriate operating model can be successful (case in point the rise of Walmart).
A benefit of value architecture is that it provides transparency to business owners before they make serious missteps and enables them to increase profits (thus their return) while reducing risk.
“The secret to success is to do the common things uncommonly well.” — John D. Rockefeller
Kumi Bradshaw is President of Firm Advisory Ltd.
T: +441 295 3301 E: email@example.com
Firm Advisory Ltd. helps “business owners measure, grow and harvest the value in their companies”
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