The financial press of late has been full of stories of how the economy is turning for the worse, how China’s downturn will be bad news for Australia and how unemployment is set to rise.
As I was reflecting on this news, I recalled a recent shopping expedition. My better half and I spent a lovely day in the city utilizing all the gift cards I had received as Christmas presents. I was simply amazed by the number of stores offering massive discounts on their products. With the increase of For Lease signs in shops, it is not hard to tell that retail has been tough. However, the amount of discounting on offer was something I don’t recall having seen quite at this level before. (I humbly admit I am not an avid shopper, so that doesn’t necessarily mean much.) Having had a retail arm at a previous business I owned, I was really feeling for them, knowing full well the level of damage discounting does to your profitability.
While there are a small number of legitimate reasons for discounting in some industries (fashion, for example, when the current stock is out of style), in general terms I abhor discounting. And in fact even in fashion, superior supply chain management and inventory control can help prevent the need for clearance sales. Discounting places substantial pressure on profitability.
The level of damage done can be clearly demonstrated by examining the widely used profitability discount matrix. In summary, this is a traditional matrix that shows the gross profit (GP) percentage on one axis and the percentage of your price cut on the other. The intersecting cells indicate the increase in sales volume that is required in order to make up for the discount you have provided. Let me repeat that: The increase in sales required to make exactly the same level of gross profit. Not more, but exactly the same amount.
For example, if you are operating with a 25% gross margin and you reduce your sales price by 10%, you will have to increase your sales by 66.7% to make the same dollar profit. This is also assuming you can accomplish the following things:
a) You are actually able to achieve a 66.7% increase in sales as a result of the discount.
b) You are able to achieve this increase without incurring any increase in other operational costs, such as additional sales people or delivery costs. A detailed “cost to serve” analysis will help you here. (If you don’t know what cost to serve is, give me a call—you’re missing out big time.)
The increase required to cover the reduction escalates rapidly the higher the discount goes. For example: Again your GP is 25%. A discount of 13% requires an increase in sales of more then double (110%). So for an additional 3% increase in the discount, an additional (approx.) 30% increase in sales is required to make up the difference.
Hopefully, you can quickly see why competing on price is the scourge of business. My philosophy is always to compete by providing extra value, not a lower price. When times are competitive, look for ways of adding value to your customers’ experience rather than reducing the price. If you don’t have a copy of this discount matrix, send me an email at firstname.lastname@example.org with “Discount Matrix” in the subject line, and I will forward you a copy.
© David Ogilvie 2015 All Rights Reserved
David is a global expert in profitability improvement and maximising investments in ERP systems.
Phone: +61 (0)438 787 759