Q. I own a small retail operation. With the holidays upon us, many of my competitors are offering discounts. I have always resisted this because I think my prices are fair and I don’t like giving away margin. However, I’m worried I am missing an opportunity. Can you help me think about whether discounts are a good idea?
A. We’ll start by outlining the effect of reducing price on a single product and then expand the thinking to the effect on your entire store. One reason you would reduce the price on an item is that you hope to sell enough additional units to offset the margin you lose because of the lower price. It would be helpful to know the number of additional units you would have to sell to breakeven. Breakeven occurs when the additional money you make because you sell more units exactly offsets the money you lose because of the lower price.
Money Lost Because of Lower Price = Money Made Through Additional Sales
Units Sold(Old) X (Price(Old) – Price(Discount)) = B/E Additional Units X (Price(Discount) – COGS)
Units Sold(Old) = the number of units you would have sold had you not reduced the price
B/E Additional Units = the additional units above Units Sold(Old) you need to sell to breakeven
Price(Old) = the original price of the item (> Price(Discount))
Price(Discount) = the price after the discount (typically > COGS)
COGS = what you pay per unit to buy the item and get it on the shelf
B/E Additional Units = Units Sold(Old) X (Price(Old) – Price(Discount)) / (Price(Discount) – COGS)
Any units sold above the breakeven volume will generate incremental profit. The formula for calculating the benefit of discounting the product is:
Benefit = [Units Sold(Discount) X (Price(Discount) – COGS)] – [Units Sold(Old) X (Price(Old) – Price(Discount))]
Benefit = the total dollar benefit you receive from discounting
Units Sold(Discount) = the number of units sold at the discounted price
Obviously, if you run the discount, you won’t know with certainty how many units you would have sold if you had held price constant. However, based on prior experience, you can estimate what you would have sold without the discount. This will give you a sense of the benefit you will receive from the increase in sales of this item alone.
However, there is another potential benefit to discounting. Particularly if advertised, the discounting may result in more people coming to your store. If the people who come to your store, that otherwise would not have, buy products other than the discounted product, you will make incremental money on those sales as well. Estimate the benefit of incremental customers in the following way:
Benefit = # Inc Cust X (1 – % Disc Buyers) X (Avg Ticket – Disc Price) X Avg Margin %
Benefit = the benefit in dollars of the incremental people that come into your shop
# Inc Cust = the number of incremental customers due to discounted items
% Disc Buyers = the percentage of the incremental customers that buy only the discounted item
Avg Ticket = the average amount purchased by a customer coming into your shop
Disc Price = the price of the discounted item (the benefit of this purchase is included above)
Avg Margin % = the average gross margin dollars you make on a sale as a percent of the sale price
It is difficult to know with certainty that offering a discount will increase your profit. However, utilizing the equations above will help you get a better sense of whether or not discounting is a good idea.