Cost-cutting danger

THE collapse of HIH Insurance should sound a serious warning to small businesses considering price cuts to boost sales.

HIH grew to become a major player in the insurance industry through undercutting its competitors. This discount policy, while not the sole driver, helped sow the seeds for its collapse.

As economic times tighten, many small business operators are considering discounting as a way to boost flagging sales.

But while it might work for a while, this approach could prove fatal.

Discounting usually only works for those businesses that have pitched themselves to the budget end of the market.

Small business operators can fall into the trap of chasing sales for sales’ sake, rather than for profit.

While the business’ cashflow may look good, there is a risk that continued discounting will erode its working capital.

A chart produced jointly by BankWest and the Curtin Business School highlights the dangers of cutting costs to boost sales.

According to the chart, a business relying on a 10 per cent gross margin that opts to cut its prices by 5 per cent would need to increase sales 100 per cent to keep that margin.

Some small business operators may argue that their discounting is only a means to attract new customers, but unless the business has a way of keeping these customers after the discounting period ends, the price slashing is pointless.

Another risk with cutting prices is competitors following suit. Any discount advantage is not likely to last long.

Price cutting normally only works for price-elastic products.

Marketing Centre managing director Mike Smith said companies, especially those chasing the premium dollar, could harm their market by dropping their prices.

German sportscar maker Porsche’s attempt to launch a “budget” model received a huge backlash from its customers, who complained the company was going down market.

Mr Smith said another classic case happened in land develop-ment.

“For example, a 200-block land release is selling about 40 blocks a year. A large part of its attraction is in the perception of its appreciating value,” he said.

“If the developer then goes and discounts 10 blocks, it spoils the perceived value of the develop-ment.”

Deloitte Growth Solutions partner Rod Willis said businesses trying to stay afloat through discounting were doomed to failure.

“It’s like a bucket with a hole in the bottom. If the water going in the top is not going in faster than the water going out the bottom, then the bucket will eventually become empty,” he said.

“That’s why bigger businesses can carry on discounting pushes longer. They have a bigger working capital base.”

Mr Willis said cutting prices below a company’s break-even point to attract customers would only work as long as the business had enough working capital.

“Unfortunately, most small businesses are run on a shoe string,” he said.

Mr Willis said clients struggling for sales should cut back on their turnover, but make more doing it.

“Sometimes businesses are committed to turnover targets for monthly repayments,” he said.

“It may be necessary for some companies to bite the bullet and lay off staff – something they should look at sooner rather than later.”

Mr Smith said businesses should consider offering customers something extra rather than dropping prices.

“If the company makes bread, it may pay to give the classic baker’s dozen – something extra,” he said.

“It may be something that’s worth $1 in the market, but cost you about 50 cents to make.”