Are you considering offering discounts to customers to boost sales? Or even cutting prices permanently? If you are, you need to read this, because you may be killing your business.
The thing is, people often underestimate by how much their unit sales need to increase to compensate for the price cut or discount.
We’ll use an example to illustrate the issue:
Let's say you're selling a product for $100 per unit, and you're selling 1,000 units per year, for a total revenue of $100,000.
And, you're wondering whether lowering prices through a temporary discount (or even a permanent price cut) could help you boost sales.
Scenario 1: When selling an additional unit costs you nothing
Let’s start by imagining your product is a digital one, so producing one more unit costs you nothing.
So, how much more would you have to sell, in terms of units, to compensate for selling at a lower price due to the discount or price cut?
In this case, what we would want to make sure of, is that that before and after the lowering the price, our total sales stay at least the same (ideally higher, but at least the same).
Let’s then calculate how many units we’d need to sell to keep the total revenue constant, depending on the level of the discount (or price cut) offered.
So, let's analyse these 7 potential scenarios, with potential discounts/price cuts ranging from 5%, to 40%.
With these new prices, our unit price would decrease from $100 to $95 in the case of a 5% price reduction, going all the way down to $60 per unit, if we were lowering prices by 40%.
And, since we said we want to keep out total sales at least constant, let's add a row with the $100,000 target, that we will use to calculate the minimum number of units we'd need to sell to reach it.
So, to reach our $100,000 target revenue, if we were to lower the selling price to $95, we would now have to sell 1,053 units, instead of the 1,000 units we were selling before.
In the more extreme situation in which we would offer a 40% lower price, to get to the same $100,000 target, we would have to sell 1,667 units.
As you can see, if we were to offer a discount of let's say 20%, you might think that to compensate for that, you’d have to increase your sales by 20% also, right? But that’s not true. You’d have to increase sales by 25%.
And if you were to offer a price reduction of 40%, you’d have to sell almost 70% more units!
And with this information in mind, the question becomes: if we were to cut our prices or offer a discount of let’s say 40%, is it really reasonable to expect that our unit sales increase by over 70%?
If it’s not, then cutting prices may not be the best idea.
And if it is, then there are some additional things that we should take into consideration:
- The first one, is the impact of discounting or price-cutting on market dynamics. For example, is this likely to trigger a response from your competitors? Your business might be too small to be noticed, but what if it is noticed? Can you be starting a price war?
- And then the second aspect, is your overall marketing strategy: how does cutting the price / temporarily lowering the price of a product (or product line) fit into your marketing strategy?
- Is offering discounts or a lower price consistent with your overall positioning?
- And if you're analysing a particular product or product line, is the resulting price for this product/range consistent with your overall product portfolio’s prices?
So, once the mathematical part is taken care of, there are still some important strategic considerations that must be taken into account here.
Scenario 2: When there's a cost per unit sold
But let’s now move on to a more general situation, in which your product does have a manufacturing or purchasing cost.
In this case, in our example everything is exactly the same as in the previous situation, with one exception:
Each unit of the product you’re selling costs you $60 to produce or buy.
If you’d like to know why we’re only considering variable costs for this analysis, I suggest you take a look at the posts about the contribution margin.
Just as before, we’re going to calculate how many units we’d need to sell to be in an equally good situation after a price reduction, as we are at present.
A very important thing here: because every unit we sell has a cost, achieving the same sales volume isn’t what we’re looking for.
What we want, is to get the same profit (after all, what good is it to have an astronomical revenue if we’re losing money?)
Because we have a variable cost for each unit we sell of $60, what we want here, is to achieve the same contribution margin, or a higher one, after the discount.
In this example, we have that:
With a selling price of $100 per unit, and a variable cost per unit of $60, we get a contribution margin per unit of $100 minus $60.
Which is equal to $40 per unit sold.
Which means that our total contribution margin, if we're selling 1,000 unit of our product, and we're getting a contribution margin per unit of $40, amounts to a total of $40,000.
As said, our goal here is to keep those $40,000 constant, or preferably higher. So, let’s look at some discount scenarios to see what would have to happen to our unit sales to compensate for the price-cutting.
Here, we assume we'll be considering price reductions from 5% to 35%. And just as in the previous case, we'll start by calculating the resulting unit selling prices we would get with each price reduction.
And, since now we have a $60 cost whenever we make a sale, we will have to subtract those $60 to our unit sales price, to get to our contribution margin.
Again, remember that our goal here is to keep our contribution margin constant at a level of $40,000.
So, we can now calculate the number of units we'd need to sell, to get to the $40,000 contribution margin, depending on the price reduction offered.
And that's what we can see here. In the last two rows, first in units, and then in percentage change.
So, by now we already know that to compensate for a price reduction of 20%, increasing your sales by 20% isn’t enough. But what might come as a surprise in this situation, is that to compensate for a price cut or a discount of 20%, we would have to increase our sales by 100%.
Although our price only decreased 20% from $100 to $80, the contribution margin was cut in half. After all, it still costs $60 to produce or buy that unit.
While before we had a contribution margin of $40, now, we would have a contribution margin of $20. That's half!
So, a seemingly small price reduction of 20%, has actually cut our profit in half!
And, if you were to cut your prices by 35%, you would have to sell 700% more units!
Because although your price went from $100 to $65, your margin went from $40, to $5!
To get the same $40,000 in total contribution margin, instead of selling 1,000 units, you'd have to sell 8,000!
And again, the question becomes… are these required increases realistic?
If they’re not, the discount doesn’t make sense. And if they are, again, we have to consider the strategic aspect we mentioned before.
Whenever you are in a situation in which you have to decide whether to slash prices to boost sales, there are two previous steps you must take before making a decision:
- The first one, is to do your numbers, and see whether the required increase in unit sales is realistic.
- And then the second one, is to consider the strategic aspect that go beyond the mathematical part, like the market dynamics and your business' overall marketing strategy.
And that's it for today! Hope you found the post useful!