Most of business feel that 'discounting' is the best way to increase the revenue. whereas, the reality is completely different, why? because discounting eats out most of margins and thus if not implemented carefully, it can be counter-productive.... not for Revenue but for Profits or Margins which is essence of any business.
One of the easier way to ascertain the impact of 'Discounting' is to use the 'Break-even' technique. I have explained 'Beak-Even' in my earlier Article.
or a simpler financial model can be used to understand the impact of 'Discounting' whether it is a direct discount on sales price or it is through sale package, also called sales through value-added package.
We can find numerous instances where the Managers get impatient with loss in revenue and start launching 'value-added package' to reach earlier revenue levels, without calculating the financial impact. Important point to be noted that 'value-added package' is a boon for quick sale for shorter periods or for launch of product, however if same technique is used to boost regular sales then impact on the profit margins may be adverse.
Discounting increases number of minimum sales quantity target
The common question arise, how it is possible? When we discount a product, the sales volume increase which should churn-out better profitability. Actually, Discounting a product may increase the top-line or Revenue but impact bottom-line or Profits.
Impact on Profits or Margins can be explained with following example, same example I used in my earlier Article published on 22nd May. The extract of example taken was:
We can take example of latest COVID-19 situation where even a smooth running business faced the roughness. Let's say a coffee shop was selling butter muffins and making a decent profits but after COVID-19 lockdown opens up, Coffee shop sale of muffins reduced because people do not want to spend extra. Although the sale of coffee intact. With this change in business model, monthly profitability impacted and thus changed the 'Break-Even-point' of outlet.
We will use above example to explain discounting wrapped under the name of 'value-added package'.
Let's assume that each Muffin selling price is 70 baht and having 50% Profit Margin(after taking out 30% COS and 20% for Other Expense), that is 35 baht profit with each muffin sold. Manager of outlet wants to increase the sale of Muffins and thus he introduced a value-added scheme - one muffin free with purchase of two muffins 'BUY TWO GET ONE FREE'.
With this the sale increased as anticipated by Manager however growth in top-line did not push the 'bottom-line' or margins.
This can be explained in mathematical term, the outlet was makes 35 baht profit with sale of each muffin and with sale of two muffins, outlet generates 70 baht profit. Now once the 'Value-added' scheme is introduced, customers start getting third muffin free of cost with each two muffin purchase. With this, the profit of 2 muffins sale that is, 70 baht getting set-off with the cost third free muffin. As we are aware that cost of each muffin is 35 baht, thus the outlet profit for sale of two muffin is down to 35 baht from 70 baht.
Interesting situation, now outlet need to sell 4 muffins to make same profit what they were making by selling 2 muffins. and the load on production or bakery increased three times (4 muffins + 2 free muffins).
Production staff need to produce three time and Service staff need to sell two times of earlier sale.... What do you think about 'Discounting by value-added'?
Managers of outlets didn't calculated the overall impact, not only on profitability but also on production unit and now outlet is selling more and getting less.
What can be done to avoid such situations of reduced Margins
Any owner or Investor want to have better margin producing outlets and if any business activity, reduces the 'Margins' then certainly not a good decision unless i) it is a short term Marketing Strategy to penetrate in new market
ii) Launch of a new product
iii) Countering competition to stop them to penetrate in own stronghold market
However, if any strategy reduces margin of one product then it is imperative to look for opportunity to improve margin in another product or services so that the negative impact on margin by 'discounting strategy' can be mitigated by another product or services.
Also, it is important to know, Is Fixed cost for outlet increased with change in strategy or increase in production units.
In this fast changing world, the best business model is one which operates with least 'fixed cost' component. Almost, every businesses are striving to reach the 'optimal fixed cost ratio' but it has been notices that almost all 'bankrupt' business or lets say 'business under cash crunch' are those where the fixed cost component was not kept under strict control and same is issue with 'discounting strategy'.
Two takeaway points a.) Impact of discounting' to be calculated carefully before agreeing for any discount or Value-added scheme and b) Review 'fixed cost' components regularly.
Lets run through the numbers of outlets and/or business and feel free discuss further, can contact me hoteliersfinance@gmail.com
Good Luck to all of you... Our drive to make businesses more profitable & sustainable....
Comments