Do This Simple Math Before Discounting a Price
I’m often shocked by the discounts and price cuts some catalog and internet retailers hand out like candy. If you’re like most auto parts retailers, you sometimes feel the need to stimulate business, or to match competitor’s price. And at times this is necessary … but make certain you understand the consequences before you act.
While there are lots of valid theories on price-setting, I’m simply going to address this: the effect of giving away a discount.
Quick – you’re thinking of offering a 15% discount. What percent increase in business (in units or orders) must this generate in order to break even?
If your margins are typical, you’ll need to sell at least 50% - 60% more just to bring in the same profit contribution! If this surprises you even a little bit, I’ll show you a simple formula that will apply to your business.
First, let’s look at your cost structure. Say, for example, you typically mark an item up 100%, so your cost of goods sold is 50%. And let’s assume that it costs another 10% of sales to fulfill an order. This means your contribution margin (sometimes called “flowthrough”) is 40%. For every $100 you sell, $40 is available to pay for overhead and (with luck) profits.
The mistake I’ve often seen happens when marketers act as though these costs are a constant percentage of sales revenue. For a given item or bundle of items, your cost of goods (COGS) in dollars is virtually the same regardless of the price you charge — and the same is true for the majority of your “other variable expenses.” When you lower prices (alas), you don’t get to lower COGS.
Taking the above example, let’s further assume that, in the status quo for a given period, you would expect 100 orders at the current prices, at an average order of $100. That means your sales would be $10,000, with a resulting profit contribution of $4,000.
Now suppose you wake up one morning and consider goosing up sales by offering a 25% discount. That’ll move some parts! But whoa, running the numbers, you find you’ll need 267 orders to maintain the same contribution of $4,000! That’s an increase of 167%!
There’s a simple formula for this, assuming you have a pretty good understanding of your variable costs, and therefore your contribution margin (and you should). For a given % discount, here’s how to find the increase in orders (or units) you’ll need in order to break even:
INCREASE REQ. = DISCOUNT / (CONTRIB MARGIN - DISCOUNT)
If you figure your company’s contribution margin at 38% and you’re considering a discount of 15%:
15% / (38% - 15%) = .65
This says you’ll need a 65% increase in orders to maintain the same contribution dollars.
Ever consider offering free shipping? This one is even more insidious. If you’ve been using a shipping and handling table that’s based on the size of the order, keep in mind that it may have been serving to discourage small, nuisance orders (this depends on the “curve” imbedded in the table). Offering free shipping without a minimum purchase strips away customers’ incentives to consolidate their parts orders.
To analyze free shipping, think of it as a dollar discount — one that gets taken away from profit contribution (and, like percentage discounts, it won’t lower your cost per order!). Whatever you do, don’t get confused by thinking it has anything to do with your actual shipping cost.
Incidentally, I’ve recently spoken with the CEOs of several large catalog & internet retailers who have been moving away from free shipping offers. They tell me their lifetime value (LTV) studies confirm that customers acquired using discounts purchase at a lower rate in any subsequent period. They exhibit less loyalty, and may not buy again unless they’re getting another “deal.”
I don’t mean to imply there’s never a reason to discount. If you’re overstocked or sitting on obsolete parts, by all means do what you have to do. What I’m saying is: If you’re planning to use a discounts to increase sales, make sure you know how much more business you’ll have to do.
One last note: if you want to figure out how much business volume you could afford to lose when raising a price, you can use the same formula (above). Just plug in the price increase as a negative discount. To use the above example, but with a 15% price increase:
15% / (38% - - 15%) = 15% / (38% + 15%) = .283
In other words, if your contribution margin is 38% (as above), you could afford to lose 28.3% of your orders and maintain the same contribution to fixed costs and profits. If one out of four customers defects, you’ll still be ahead!