How Discounting Affects Profitability

When we’re thinking about cash, we have to think about the discounts that we might be offering, and how discounting affects profitability. Clearly, we want to try to take discounts if we get them. But what about discounts that we’re offering, sales or incentive discounts for people to either buy more, do different things with our products, or buy them at certain times? What about sales discounts? What is that doing to the cash and profitability of our business?

DISCOUNTS FOR SALES

Discounts are one of the easiest way to sell. If I’m a salesperson, the easiest thing that I can do is lower the price of services. Remember the 4 P’s of marketing: price, product, place, and promotion. If we just sit there and take the decreased price, that’s a marketing effort, but sometimes it’s going to ruin your profitability. Let me show you how destructive it can actually be.

CALCULATING REVENUE

If we take a simple business and we’ve got revenue, COGS (cost of goods sold), gross profit, SG&A, and NOI (net operating income) and say revenue is 100. A typical manufacturing business that we’re talking about here – let’s say they’ve got 70 in their cost of goods sold, which means their gross profit is now 30. And in their SG&A, they’ve got roughly 20, which means their net operating income is now 10. Very simple manufacturing business.

But what if we offer a 5% discount to our customers because they’re buying in bulk? 5% sounds like it’s not a big deal. But let’s take a look. What’s our new cost of goods sold? It hasn’t changed. We’re still at the same cost of goods. So what’s our new gross profit, however? Now it’s only 25. What’s our SG&A? That hasn’t changed, that’s still at 20. We’re now at 5 in terms of profitability. That is a 50% decrease%. A 50% decrease simply because you offered a 5% discount. It’s incredibly important to understand, when you’re doing pricing, how to alleviate this issue.

THE BOTTOM LINE

A lot of industries out there have to take discounts. We have to take things like credit cards, because credit cards are going to do the same thing. Maybe it’s not 5%, maybe it’s 2.5%, but it still has a destructive impact on the bottom line. How do we adjust for that? Well, we have to understand that this is part of our business model, and instead maybe we take our price from 100 to 106. Now, we give our sales people the opportunity to offer up to a 5% discount. They’re not always going to do it, but when they do, we’re still at the same levels. The difference is, now we’re plus 10% in our profitability.

Now it’s not simply that easy, but you’re always going to be thinking about playing this game and as long as you know the numbers, you’re going to be able to price and discount effectively without running yourself out of business.

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