Monday, November 29, 2010

The Holiday Tradition of Price Discounting

It’s a wonderful time of year and the holiday shopping frenzy has begun. I saw some unbelievable deals while shopping in the stores this weekend.. The deals have gotten so hot that the local news reported that something like 15% of Black Friday shoppers were “self gifting” – a funny term for shopping for yourself rather than others. And why not – the deals justified ‘self gifting.’

Retailers, of course, build discounts and deals into their business plan. They know how to do this to their advantage. They drive manufacturers to subsidize a lot of the discounts, build others into their original markups, and reap the benefits with immediate consumer traction. Not bad. But for a manufacturer, a B2B or a vendor to a retailer, discounting is a bit rougher on the P&L statement. Here is a quick illustration. Let’s take a simple 5% everyday discount on a small $5 item. How much could a measly 5% affect the bottom line?

Full Price With 5% Sales Price Discount Discount Impact on P&L
Sales Dollars per Item $5.00 $4.75 -5.0%
Cost of the item $2.60 $2.60 Fixed
Gross profit $2.40 $2.15 -10.4%
SG&A $1.50 $1.50 Fixed
Net Profit $0.90 $0.65 -31.6%

Say you sell 500,000 units per year (yes, I know you will sell lots more with that 5% discount, but hang in there for a moment). Your net profits could be $450k, but now they are $325k. Sound scary? You bet. And that is only a 5% discount. See where this is going? What did the discount percentages look like in your local department store on Friday?

Let’s say you had to close an important distribution deal – but at the last minute you had to throw in an extra 5% - no big deal, you got the business, and it was worth it. It got you the handshake. But now, two seasons later, that discount is basically your new price.
Rules to live by regarding price discounts for manufacturers:
  1. They have to get you substantially more business than the cost (or keep business you might lose)
  2. They have to have a limited duration and be reversible
  3. They are “bottom heavy” on your P&L – meaning they impact the % of profit WAY more than the % of sales dollars.
I know you know this. I know you are smart and would never give away a permanent 5% discount to close a deal. But discounting is an easily overused tool of doing business because it is built into our psyche. The smart manufacturer knows to be wary about the profit implications of discounts that don’t drive business. Don’t get caught up in the discount frenzy watching big retailer price rollbacks. When you are a manufacturer, top-line discounts come right out of profits.

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