In today’s competitive business landscape, discounts often seem like the go-to strategy to attract customers and boost sales. But, are they always the right choice for small businesses? Join us as we explore the world of discounts, uncovering the good, the bad, and the ugly truths about this often misunderstood strategy.
The Illusion of Success: The Double Edged Sword of Discounts
Discounts may seem like a surefire way to increase sales, but they can be a deceptive trap for small business owners. Let’s explore why 90% of small businesses provide discounts for all the wrong reasons.
How Does A Discount Impact Your Bottom Line?
Discounts are offered on products or services a business sells. Discounts directly impact the price per unit or service sold and, therefore, have an impact on the gross revenue in your income statement. But gross revenue is influenced by a second factor, volume. Let’s see how this works. The example I am going to use is for retail products but could just as well be for a service provider.
To keep the example as uncomplicated as possible, let’s assume we have 2 business owners, both of them selling the same product. Each business owner buys the product for $50.00. They then mark it up 100% and sell it for $100.00.
Each business sells 100 products a month and therefore makes a gross profit of $5,000.00 per month. That’s 100 products x $100.00 less 100 products x $50.00 to replenish the stock they sold.
Business owner A decides that they want to take more of the market share and offers to sell their product at a 25% discount. At the end of month 1, business owner A has sold 125 products and business B only sold 75. Was business owner A more successful than business owner B?
Let’s have a look:
Business owner A:
(125 products x $75.00 per product) less (125 products x $50.00 per product) to replenish stock = $3,125.00 in gross profits.
Business owner B
(75 products x $100.00 per product) less (75 products x $50.00 per product) to replenish stock = $ 3,750 in gross profits.
The impact of a discount, even with the increase in volume, speaks for itself, and though business owner B had reduced sales for the same month, owner B still showed $625.00 more in gross profit than business owner A.
If This is the Effect on Gross Profit, Why do Bigger Businesses Offer Discounts?
One word: Economy of scale. According to Wikipedia economies of scale are the cost advantages that enterprises obtain due to their scale of operation.
A company like Walmart has achieved economies of scales on different levels that enables them to offer these discounts without affecting their bottom line. Here are a couple of examples:
- Volume discounts: The sheer volume of the products a company like Walmart purchases from a vendor arms a company like Walmart with a lot of negotiating power when it comes to buying from vendors. In other words, they can demand better prices and then the vendor will go out of their way to try and meet those demands so as not to lose a client. A small business owner doesn’t have that negotiating power and, if the vendor loses the small business client, will not lose sleep over it either. I know this is harsh, but this is the truth.
- Shipping Costs: As a small business owner I don’t have to tell you about the cost of Freight. It is an expense that should be constantly under review as this can quickly eat into profits. For a big company like Walmart, they have solved this problem by shipping the products to their stores with their own trucks, thus bringing down the cost of freight substantially.
All is Lost for the Small Business Owner, or is it?
As a small business owner, whether you are selling a product or a service, discounting your product or service just to be able to compete with bigger companies is, to say the least, an unwise decision, and you will pay for this in the long run. As a small business owner you should focus on the benefits you can offer to your customers that bigger corporations can’t provide and then build that into your product or service as an added value, rather than focussing on price matching with the” big dogs” alone.
There is Still a Time & Place for Discounts in Smaller Businesses
Now that we looked at when not to use discounts, let’s look at situations where using discounts are a great option for smaller businesses. As you read through these examples, you will see one underlying theme emerges as a reason to utilize a discount as a small business owner. Let’s see if you know what it is when I reveal this at the end.
Accounts Receivable
As a small business owner it is of vital importance to make sure your clients pay you on time. In the old days, the standard was to charge your late paying customers with a monthly interest, and although you can still do it, there is another option. Instead of punishing your late paying customers, try to motivate them to pay faster by giving them a discount for paying on time.
Memberhips
Some businesses have the ability to offer memberships, and what you can do in this instance is to offer a discount on annual memberships. At this point you might think about the calculation above and say well that is going to have the same impact on my bottom line, and you are absolutely right, so lets see how to mitigate that with an example:
At the beginning of the year, you calculate that for your business to meet its goal at the end of the year, each member needs to pay $250.00. When you re-sign your members for the next year, you offer the monthly package at $22.91 per month = $274.92 for a year and now run your discount and offer an annual membership that if paid immediately for $250.00.
Services
As a service provider you can offer packages which will include bundling a highly profitable service with a less profitable one. As the high end more profitable service doesn’t sell as often, by providing the package at a higher price, you can provide a discount on that price as you will make up the difference with the more profitable service rather than just discounting the less profitable service.
At this point you should start to realize what the underlying reason is when providing a discount as a small business owner makes sense. Yes, you guessed it. It is to improve cash flow. Cash flow is the single most important problem small business owners run into, and if you haven’t guessed it by now, just providing discounts because you want to compete with the bigger store, only elevates the problem to a whole new level. But offering discounts to improve cash flow while keeping your gross profit intact, changes the playing field.
The above examples are just a few, and they mostly focus on Accounts Receivables. As a small retail business owner who doesn’t have charge accounts, you might think that this doesn’t apply to your business. You are wrong, retail business owners have another line item in the balance sheet that ties up cash, can you guess what that is?
Inventory
As a retail business owner, inventory is the heart of your business, it is therefore of the utmost importance to monitor your inventory with a hawk’s eye. A good bookkeeper with a keen understanding of the impact of inventory levels and how to monitor it, is crucial.
Inventory levels need to be monitored for a myriad of reasons, but two of the most common reasons are to see if inventory is going missing, and to identify inventory that is not moving, or moving too slowly. We are going to focus on that later.
Before we go any further, I want to quickly talk about inventory itself, so that you as the reader can better understand where I am coming from. Inventory lives on your balance sheet under current assets. Why? According to accounting definitions, a current asset is an asset that you as the business owner will try and convert into cash within a year. Can you see where I am going with this?
Your inventory levels should be optimized so that it can be cycled, at the least, in a 12 month period or, preferably, a lot shorter but, that is the idea.
If you have inventory that is not being depleted in a 12 month period, then you need to adjust your levels downwards. And if you have inventory that hasn’t moved in more than 24 months, get rid of it all together.
So how do you achieve that, by offering discounts. Now we just established that the inventory is moving slowly, or not at all. So just offering a discount on those products might work, but there is another way as well. Selling them as bundles will move the underperforming stock faster. Just remember these items aren’t selling, so even if you discount these items, just to cover your cost, then at least you would be putting money back into your bank account that will allow you to buy other inventory items that are moving faster.
Conclusion
Discounts are a powerful tool, but they should be wielded with caution and strategy. Small business owners must understand that the true value of discounts lies in their ability to improve cash flow while maintaining profitability. Instead of simply chasing bigger competitors, focus on offering unique benefits to your customers.
If you are a small business owner looking for expert advice on how to navigate the complexities of discounts and optimize your financial strategies, connect with Darwin Business Solutions. We’d love to help you make informed decisions that drive your business forward. Contact us today to learn more about how we can assist you in achieving your business goals.
