Discounts reduce the profit earned per sale unless additional sales volume or another financial benefit offsets the lower margin. How discounts affect profit depends on your starting margin, discount size, costs, and how much additional volume the offer generates.
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 is that doing to the cash and profitability of our business?
Understanding the Relationship Between Discount and Profit
Understanding the relationship between discount and profit is essential for any business owner.
A sales discount reduces the selling price of a product or service, which lowers revenue and margin per discounted sale. The financial impact depends on whether the additional business generated by the discount is enough to offset that reduction.
DO SALES DISCOUNTS ALWAYS REDUCE REVENUE?
A discount lowers revenue per discounted sale, but total revenue can still increase if the promotion generates enough additional volume. Higher revenue does not automatically mean higher profit, however, because the business earns less margin on each discounted sale.
HOW DO DISCOUNTS AFFECT SALES AND PROFITS?
Offering discounts can have both positive and negative impacts on a company’s profits. On one hand, discounts can attract customers and increase sales volume, leading to higher revenue.
On the other hand, discounts can also reduce profit margins, as the discounted price reduces the overall revenue per sale. That makes it important to evaluate the financial impact before setting a price or promotion.
Before approving a promotion, consider the margin lost on each sale, the additional volume required, any incremental costs created by higher volume, and the potential value of repeat business.
LONG-TERM VS SHORT-TERM IMPACTS OF DISCOUNTING ON PROFITABILITY
Understanding the Balance
How does offering discounts affect profits in the short term and the long term? While discounts can boost immediate sales and cash flow, the relationship between discounting and profitability can change over time as customer expectations and purchasing behavior develop.
Short-Term Benefits
In the short term, discounts can be a powerful tool. They can significantly increase sales volume, improve cash flow, and attract new customers, especially in competitive markets. Short-term discounts are particularly effective for specific goals like clearing excess inventory, launching new products, or achieving sales targets within a tight timeframe.
Long-Term Considerations
However, the long-term impacts of discounting require careful consideration. Frequent or deep discounts can lead to a perceived devaluation of the brand. Customers might begin to associate the brand with lower quality or only wait to purchase when there’s a sale, affecting regular sales at standard prices.
HOW TO CALCULATE PROFIT MARGIN AFTER DISCOUNT
Discounts are one of the easiest ways 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.
If we take a simple business and we’ve got revenue, COGS (cost of goods sold), gross profit, SG&A, and 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.
But what if we offer a 5% discount to our customers because they’re buying in bulk?
Assuming sales volume, unit costs, and SG&A remain unchanged, the impact looks like this:
Before the discount
Revenue: 100
COGS: 70
Gross Profit: 30
SG&A: 20
Operating Income: 10
After a 5% discount
Revenue: 95
COGS: 70
Gross Profit: 25
SG&A: 20
Operating Income: 5
Operating income falls from 10 to 5, a 50% decrease, even though the selling price only dropped 5%.
It’s incredibly important to understand, when you’re doing pricing, how to alleviate this issue.
HOW MUCH MORE DO YOU NEED TO SELL AFTER A DISCOUNT?
The next question is whether additional volume can make up for the lower margin. In the example above, each original sale generated 30 in gross profit, while each discounted sale generates 25.
30 ÷ 25 = 1.20
That means the company would need to sell 20% more units to generate the same total gross profit, assuming the cost per unit and fixed SG&A remain unchanged.
A simple way to estimate the required increase is:
Required Volume Increase = Discount ÷ (Gross Margin − Discount)
The calculation matters because a promotion can increase sales and still reduce overall profit if volume does not rise enough to offset the margin given up.
BUILDING A PRICING STRATEGY THAT WORKS
A lot of industries out there have to take discounts. Businesses also have to account for transaction costs such as credit card processing fees. These are not customer discounts, but they still reduce what the business keeps from each sale. 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 about 105.26. 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. A 5% discount on 105.26 brings the selling price back to approximately 100, preserving the original selling price before considering other costs.
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.
Alternatives to Offering Discounts
While offering discounts can be an effective way to increase sales volume, understanding how discounts affect profit may encourage you to consider alternatives that can be more productive and profitable for a business in the long run.
One option is to focus on adding value to products or services, rather than simply lowering prices. This can be achieved through features such as better quality, faster delivery, or improved customer service.
Another alternative is to offer bundled packages or cross-selling options that encourage customers to purchase additional products or services. These strategies can help to maintain profit margins while still incentivizing customers to make a purchase.
Additionally, businesses can focus on increasing brand awareness and loyalty through targeted marketing and advertising campaigns, which can lead to more sustainable and long-term growth.
Other options may include minimum order thresholds, volume commitments, or limited-time incentives that give customers a reason to buy without permanently lowering the standard price.
HOW TGG CAN HELP
With all of these factors to consider, your business might benefit from the guidance of a financial expert. They can align discount strategies with your business’s overall financial health and long-term objectives.
Rather than one-size-fits-all strategies, hiring a financial expert means you get tailor-made strategies for your business’s unique needs. From testing pricing assumptions to comparing actual results with the forecast, you’ll be better positioned to thrive.
At TGG, we pride ourselves on offering expert financial guidance. Our team
can help evaluate gross margin, break-even volume, profitability by product or service, budgets and forecasts before a pricing decision is made. This gives leadership a clearer view of what additional sales a promotion needs to generate and whether the economics support the strategy. Get in touch with us today to learn more.
FAQS ABOUT HOW DISCOUNTS AFFECT PROFIT
What should you measure after a discount campaign?
Compare actual sales volume, revenue, gross profit, and operating profit with the results you expected before the promotion. Repeat purchases and customer acquisition costs can also help determine whether the discount created value beyond the initial sale.
When can discounting make sense for excess inventory?
A discount may make sense when the cost or risk of holding excess inventory outweighs the margin you give up to sell it. The decision should account for carrying costs, expected demand, and the profit remaining after the discount.
How should a business decide when to end a promotion?
Set the objective, timeframe, and financial targets before the promotion begins. If the offer is not generating enough incremental profit or is encouraging customers to delay full-price purchases, it may be time to adjust or end it.
What is the difference between markup and margin when setting discounts?
Margin measures profit as a percentage of the selling price, while markup measures profit as a percentage of cost. Because discounts reduce the selling price, margin is usually the more useful number when evaluating how much room you have to discount.
How Are Sales Discounts Recorded in Accounting?
Sales discounts are typically recorded as contra-revenue, reducing gross sales to arrive at net sales. Tracking them separately also makes it easier to see how much revenue discounts are costing over time.
Is offering an early payment discount worth it?
It can be, especially if faster collections improve cash flow or reduce late payments. But the discount has a real cost, so compare it with other financing options before making it a standard policy.
Read More >>>
Matt Garrett is the Founder and Chief Executive Officer of TGG. He is a regular speaker across the country on behalf of Vistage educating business owners on the need for sound financial practices, and is Vice President of the Board of Directors of FINACA. Under Matt’s leadership, TGG has received the following recognition: INC. 5000 top companies in the U.S. five years in a row; one of “San Diego’s Fastest Growing Companies” the past four years; and is among San Diego’s “Best Places to Work.”