Even though a price cut or putting on a sale sounds like the answer to your short-term problems, it may be hazardous to your business. If you cut prices, it is true an immediate gain in sales volume usually will follow. Then what's the problem? The problem is the effect a price cut can have on profitability, even as sales are on the increase.
Take a look at the simple example described in Exhibit 1 and you'll see the profitability danger in price cutting. In this example, during the sale period (or price cut), you and your staff would have worked 30 percent harder-going out on more sales calls, doing more measuring and installing, completing more orders and follow ups-and yet at the end of the month, you would have come home with less money in your pocket despite all this hard work.
The point is, it may be advisable to sell a smaller volume but earn a higher profit margin on the products and services you sell, rather than increase your sales volume but decrease overall profitability. It's always useful to do the kind of profit analysis described in Exhibit 1 before you enter into a sale to determine the potential effects of the sale.
Exhibit 1: Profitability Worksheet
Calculating Regular Profitability and Price Cut Profitability
Scenario: Let's say you normally purchase Product X from your supplier for less 50 percent and 35 percent and regularly sell it for 35 percent off retail. You normally sell $10,000 per month of Product X. Now, let's say you decide to cut your price or go on sale. You plan to offer Product X for 50 percent off, and you anticipate your sales will increase to $13,000 per month because of the price cut.
Monthly profitability under normal conditions (without the price cut)
• Your regular purchase price is 32.5 percent of retail-this is less 50 percent less 35 percent.
• Your regular selling price is 65 percent of retail-this is 35 percent off retail.
• Therefore, your regular profit margin is 50 percent-this is (65 percent minus 32.5 percent) divided by 65 percent.
• Your regular monthly profit on Product X is $5,000-this is 50 percent multiplied by $10,000.
Monthly profitability with the price cut
• Your regular purchase price is 32.5 percent of retail-this is less 50 percent less 35 percent. (This stays the same as under normal conditions, unless you can negotiate a price break with your vendor!)
• Your new selling price is 50 percent of retail- this is also 50 percent off retail.
• Therefore, your new profit margin now is only 35 percent-this is (50 percent minus 32.5 percent) divided by 50 percent.
• Your new monthly profit on Product X is $4,550- this is 35 percent multiplied by $13,000
The bottom line: With the price cut, your monthly sales volume increased by 30 percent to $13,000, but your take-home profit declined by nine percent to $4,550. In other words, you worked 30 percent harder during the month and took home less money in the end!
Use this type of analysis when you are contemplating a price cut. Just change the numbers to fit your own scenario.
On the other hand . . . it's important to realize that a sale like the one in Exhibit 1 may be a good idea if it brings other benefits to your business such as:
• increasing sales of other high-profit products
• increasing visibility of your business so you'll sell more at a later time
• gaining new customers who will come back and buy from you again, presumably when there's not a price cut in effect
• keeping employees busy during a slow period, so you won't have to lay them off and possibly lose their expertise
• supporting a worthwhile charitable activity to which you feel a personal commitment
Try some of the following ideas to improve the profit impact of a sale:
• Ask your vendors for a bigger discount during the sale because you are promoting their products and presumably increasing sales for their company.
• Try varying your discount offer during different sales to learn how big a discount you must offer to gain a specific sales increase; in future sales, use this knowledge to offer the least possible discount that still creates a sizable sales increase. For example, you may learn that 45 percent off generates the same sales increase as 50 percent off.
• Encourage customers to spend more during a sale:
a. by purchasing more product: "Mrs. Jones, since Product X is on sale, maybe you should do the bedroom as well as the living room at this time."
b. by purchasing a higher priced item: "Mrs. Smith, since Product X is on sale, maybe you'd like to make a selection from Price Group 6 instead of Price Group 3."
c. by adding options to the sale: "Mrs. Brown, since Product X is on sale, maybe you have enough money to add a special lining or top treatment."
• Instead of focusing on price and discount for your promotions, instead offer a free upgrade or free add-ons. This will attract higher-end customers who are less price sensitive.
• Identify the value of what you offer your customers for free, such as measuring, installation, in-home appointments, design expertise or free delivery. List these items on the work order or invoice you provide your customers, and indicate "No Charge" for each free service.
One potential danger of price cutting is that what you may perceive as a temporary price cut for a sale period can rapidly become the new price standard in your community. Customers and prospective buyers may expect your special prices and hold out for the best deals. Your competitors may scurry to match your price, too. In effect, you may establish a new price point, so customers won't be willing to pay the old, higher price in the future.
Cutting prices also might cause some buyers to perceive your product or service as "just another commodity" and change their opinion of your business, now believing that you offer lower quality.
Value, not price, sells products and services. If you've advertised high-quality service and then cut your prices, some customers will suspect you've been gouging them. Most customers want quality, at a fair and competitive price, and understand there is a risk to buying at a price that seems too cheap.
Going on sale may attract bargain hunters. When you raise your prices back to normal levels, you may find these bargain hunters moving on to another low-price shop. Think about whether you really want to target customers who seek price first and aren't willing to pay for solutions and quality work. Instead, focus your promotional efforts on customers who appreciate value and are willing to pay for expertise, quality and service. These customers are often harder to find, and when you do find them, it's important to work hard to keep them.
It is always tempting to cut prices to realize short-term sales gains and, unfortunately, sometimes it is necessary to do so. Making a permanent price cut is an even more serious move. Do it only when some of the following conditions exist.
• Your reputation for quality, service and expertise won't suffer.
• Your competition probably won't retaliate. Maybe they are dealing with other issues or won't notice your price cut and so won't respond.
• Your current market share is small. If you already have the lion's share of your market, there's not much advantage in cutting prices in terms of attracting new business. If your share of the market is small, however, the potential for additional sales from a price cut is significantly improved.
• Your resources are under-used-specifically you, your employees, your installers and your showroom. You can achieve economies of scale when you work to bring in more money. Idle employees are costly. Idle installers become dissatisfied and want additional work from other businesses. And your idle time is not generating profits to take home.
• The total market for the product is growing. In this case, you don't have to steal customers from your competitors to increase sales. You can concentrate instead on first-time buyers who are attracted by this particular product at a lower price.
• Your profit margin will remain acceptable. Do an analysis like the one described. Always know your revised cost profit break-even point when considering a lower price.
Price wars can result in hefty losses and bankruptcies. When business logic is tossed to the wind as companies try to beat each other on price, a short-term gain occurs in sales volume. However, bottom line profitability can deteriorate rapidly. The basics of business finance don't change; you must sell your product or service for more than your costs to realize profit.
Pricing is one of the most important issues facing small businesses today and has an enormous impact on how your business succeeds. Think about the concepts in this article to make sure you're pricing for profit!
Kay Pegram of Kaymar Communications, a Playa del Ray, CA-based independent marketing services firm for companies in
window fashions and other industries. Pegram's previous window coverings industry experience includes serving eight years at LouverDrape and as director of marketing for the Tempo