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Does discounting pay?

For small business, the pressure of generating sales never stops. Big business is increasingly dominating all aspects of the market and small business operators are being compelled to compete as best they can.

A standard strategy used by small business to generate sales is to discount prices. However, this strategy can be very dangerous if the business owner does not have a good understanding of the price/cost relationship applicable to the business.

For example, if a business is operating on a 30 per cent gross profit margin and introduces a ten per cent discount sale, the business owner would need to generate an additional 50 per cent in sales to maintain the 30 per cent profitability level.

This is optimistic at the best of times. Even more startling, at a 20 per cent discount strategy, sales would have to increase by an enormous 500 per cent to maintain profitability.

The key to the successful adoption of a discount strategy is to ensure costs are also reduced, otherwise the increase in sales will be cancelled out by a decrease in profitability.

A classic case of this was the demise of Goldmark jewellers, a retailer known for its extensive use of discount pricing to generate sales, but it did not generate the sales volume needed to maintain liquidity.

A success story is that of Pizza Hut. In order to compete with smaller operators offering good quality but cheaper pizzas, Pizza Hut effectively discounted its prices by 50 per cent (based on two pizzas for the price of one compared to prices two years ago).

Sales did increase, but more importantly, profitability also increased substantially.

The increase in profits was achieved by drastic reductions in the chain's total cost structures. Everything was reviewed, from the ingredients used through the way the pizzas were prepared and cooked to the number of staff employed in restaurants.

Costs were reduced as much as they could be while still maintaining the basic standard and quality of the product. They understood their price/cost relationship.

The principles applied by Pizza Hut can be applied to any sized business. The fundamental rule is not to look just at the price side of the business equation, but also to consider the cost side.

An alternative approach for small business is not to discount but to adopt a pricing premium strategy – that is, to increase prices.

The same firm on a 30 per cent gross profit margin that increases its prices by 10 per cent could afford a reduction in sales of 25 per cent without impacting on profitability.

Of course, there must be justification for the price increase, such as added product features or services.

Sales discounting is a valid business strategy, however it can be fatal if you don't understand its relationship to costs. In today's competitive environment, the issue is to work smarter, not harder.

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