I often feel alone in a world full of discount lovers. My wife takes pride in her ability to find a discount (I was once shouted at for paying full price for a couple of hoodies from Next!) after she has already decided to buy - and herein lies the problem.
In my opinion they:
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Cheapen the brand / Product / Service
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Prioritise sales over profit
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Destroy loyalty
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Create a culture of discounts that is hard to escape
Why bother spending the time to calculate a price point that delivers profitability to trash it with discounts?
Now that I have that off my chest, I can accept that they might have their place, BUT only when used as part of a clear pricing strategy and where the impact on profit is truly understood.
When could it make sense to offer discounts?
The obvious answer is when you need to drive sales quickly. Let’s come back to this as there are a few good reasons to consider first.
To Boost Cash
One of the few times I use discounts in my service businesses is in exchange for early payment. Typically this will be paying a year’s fees in advance, but I only offer this when I can use the extra cash wisely. There is little point in taking the hit on profit to have the money sitting unused in your savings account. I covered this in last week’s email.
It’s why virtually all SaaS platforms default to the lower yearly figure on their pricing page. What SaaS business isn’t crying out for more cash? Plus their COGS are minimal compared to eCommerce and Service.
To Shift Unwanted Inventory
A perfect time to use discounts is when you have outdated inventory that you need to get rid of sharpish or risk having to scrap it. Taking that reduced profit margin is much better than writing off the full cost of the stock.
You could also do this where you have too much cash tied up in stock but try to avoid making this a habit.
To Get Something Else in Exchange
This will typically apply to a service business but could be used in e-commerce too.
In a sales negotiation, NEVER give a discount for “free”. It’s the quickest way to destroy your profits.
Instead, you can offer a discount in exchange for something you want from the client. It could be early payment, as above, but it could be a testimonial, a case study, a review, or a referral - you get the idea. Anything you value.
The Impact of Discounts on Sales
Back to the main reason most businesses use discounts, to boost their sales.
The theory is that the cost of providing the discounts outweighs the additional sales it brings in. Whilst I agree that generally, discounts will boost sales, I am less sure about it outweighing the cost.
This is particularly common in the e-commerce sector. Clients come to expect discounts and will often delay purchasing decisions to await the discount voucher they know they will get.
The biggest culprit of all is Black Friday. I see some businesses making as much as 50% of their annual sales over the Black Friday week (because one day clearly isn’t enough anymore), so it does bring in extra sales. However, look at the months on either side, and you will often see they take a big hit. To an extent, you are shifting sales from October and December into November but at a lower profit margin.
One of the biggest issues with these discounts is that they become a habit. They become ingrained in your business’s and your customers’ culture. Discounts are the crack cocaine of the eCommerce world, an ever-increasing reliance on them to hit unrealistic sales targets drags your business into a death spiral of low margins and cash flow hell.
Pressure to please investors pushes you further down this path.
There are, of course, uses beyond just hitting sales targets. If you would otherwise likely lose the deal, a discount might be the right answer. For example:
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Cart abandonment
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Bundling products
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New launches
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Fierce competition (be very careful with this one!)
The True Cost of Discounts
Most people would know, at a superficial level, that offering discounts reduce profit, but very few truly grasp how much.
The best way to do this is by working through an example.
My eCom store, Desmond’s Desks, sells only one product. Our high-end standing desk. Sales have been slow this month, and my co-founder Mark wants to email discount codes to try to hit our sales target.
Our desk usually sells for £1,000, with a GP% of 60%. So for every unit sold, we make a gross profit of £600.
Mark wants to offer 25% discount. His argument is, “We make enough profit. We can afford to drop profit by just 25% for a few weeks.”
So now we are selling each desk for £750. Our COGS are still £400. It hasn’t magically gotten cheaper to buy the product. This makes our gross profit £350 per unit or a GP% of 35%.
So yes, our GP% has dropped by 25 percentage points, but this is not the same as profit decreasing by 25%. Our profit has gone from £600 to £350, a drop of £250.
This is a decrease of 41% in profit, not 25% - oops!
Our £10k profit for the month has just dropped to £5,900.
Accounting for Discounts
Far too often, I see businesses not reporting on discounts in their Management reports. They will simply book the net sales figure, after discounts to their sales account - ARGH!
This is simply lazy. It clouds the numbers and makes it much harder to see what is happening in the business.
Instead, here is what you must do. Create a new account code in Xero called “discounts” (us accountants are naturally very creative) under the sales grouping in your Chart of Accounts. When you book the sale, gross it up and book the full price to sales, and then the discount as a negative figure to the newly created discount account.
Here is what it will look like. You sell a product for £80, and it was originally £100. You book £100 to the sales account and £20 to the discount account. Overall, your sales will still show £80, which is correct.
If you don’t do this, you are effectively hiding your discounts which is not helpful to anyone using the data to make future business decisions.
I also like to show clients what their Gross Profit % would have looked like without the discounts. Keep in mind without the discounts, sales could have been lower. Still, this is a really powerful way to show the true cost of discounts on profitability.
Round Up
You can tell by now that I am a bit of a sceptic regarding discounts. I can, however, agree that they have their place; it’s just that I often see them used incorrectly, with little understanding of the impact and as a last-ditch resort to please investors.
Here are my tips about how to use them correctly (TL;DR):
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If you are a service business, only use them if it is pre-planned and in exchange for something you need.
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Only use them if your Gross Profit margins are strong enough to take the hit.
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Use them sparingly, don’t become an addict.
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Use them as part of a clear, thought-out pricing & marketing plan.
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Understand the impact on your profit and measure / report this.
Lastly, don’t let your ego prioritise sales over profit.
About the author
Luke Desmond
Fractional CFO for Tech, eCommerce & SaaS. CEO @Crisp_Acc provides virtual finance functions. Co-Founder @getvaulta SaaS Startup for accountants.