Discounts have their place, but more often than not, they are used incorrectly. Prior to offering a discount, controllers involved with establishing pricing strategy need to take the following steps:
Understand your business economics. If you have a 15 percent profit margin and for a period of time you are willing to give up a third of the margin to offer a discount, that may be a correct business decision. However, if you have a 15 percent margin, and for a period of time you give up an amount equal to 150 percent of the margin to offer a discount, that approach will hurt your business.
Establish the discount duration. Discounts should have a finite life. If they continue into perpetuity, you are just resetting price with the word “discount.” A discount is simply a marketing tool—a program that is planned, fielded, and completed. At a certain point, once the program ends, it is important to calculate the return on marketing investment received to understand whether the expense was worthwhile.
Understand the client’s needs. Some clients are driven by the word “discount.” In this situation, you should find the price that allows you to achieve your required returns, and increase the price of the product/service by the discount you will be giving. Billing and applying the discount will result in the attainment of your profit requirements. This approach is quite common in all businesses.
Different Types of Discounts
There are three types of discounts that work, as they benefit each party in the transaction. These are:
Discount to try your product or service. For a service, this includes discount pricing while the service provider gains the required knowledge to provide the client with the maximum service possible. During the early days of a relationship, a client should not be asked to pay full price, while you learn their business. For products, a discount provides an incentive for consumers to try your product vs. staying with their usual selection.
Discounts provided to clients based on their purchase volume, i.e., relationship pricing. The philosophy behind this type of discount is as follows: “If I can count on you to purchase 10 units of my product or service, I will charge you full price. But as you purchase more, I can take advantage of economies of scales, which I can pass down to you.”
Discounts provided for early payments. To incentivize early payment, it is common to offer a benefit (discount) to consumers. Receipt of your money sooner rather than later is worth the customary 2 to 3% in discount. But if your profit margins are already razor thin simply raise the price by the discount amount. Billing and applying the discount will result in the attainment of your profit requirements.
Whichever type of discount is used, the greatest responsibility of the manufacturer/service provider is to communicate the discount terms and when they will expire. In fact, over-communicate these items. If you implement a discount to benefit the client but the discount goes away prior to when the customer was expecting it to go away, the relationship will be disrupted. The discount expense will be a waste.
Avoid Three Common Discounting Errors
Controllers also need to be aware of the following three common errors when offering discount pricing:
Offering a discount to customers to entice them to pay their late bills. The message you relay here is, “Do not pay on time and I will reduce your price.”
Offering a discount to match the competitor’s price. This approach assumes your economics are the same as those of your competitor. That assumption is often very wrong. For example the competitor may be giving up a piece of their margin, while you may be giving up your entire margin.
Offering a discount on one product or set and losing money, expecting to make it up in other products/services. In some situations, one product is heavily discounted while other products are premium priced. The goal is to lose money on a few items in order to entice the client to also buy others, while making a higher margin on those other products/services. However, this approach will always backfire when you work with clients who understand the market price. They will understand where to focus their purchasing, i.e. only on the lower priced products.
The Bottom Line
A business will not thrive when it competes on price. Ensure that your value proposition is strong. Customers should seek out your company because the value you provide exceeds the cost of doing business with you.
When considering discounts as part of pricing strategy, controllers would be wise to take the following steps:
– Always calculate the projected cost of the discount to the company, prior to implementing.
– Consider a key performance indicator that measures discount usage and report on it.
– Ensure that discounted sales are booked separately from non-discounted sales, so discount usage is clearly quantifiable.
I wrote this post for the Institute of Finance Management “Controller’s Report Member Briefing.” It was published in the May 2015 edition.© Copyright 2015 Regis Quirin, All rights Reserved. Written For: CFO Tips - What you need to know, to be a CFO TODAY!