The True Cost of Discounting
I’m guilty of it. You’re guilty of it. We’re all guilty of it.
It’s the default response when we’re trying to win new business. To make a proposal more attractive.
A tactic to close the deal.
It’s easy to knock-off 10%, 15% or even 20% off the sales price. We can get so obsessed with discounting that it becomes standard practice in our business.
However, rarely do we step back and truly understand the costs of this run-of-the-mill approach to winning new business.
The financial and non-financial costs.
In this blog, I’ll unpack how much discounting is really costing your business. And what you must do about it.
Pricing is the most powerful financial lever in your business
There are 4 ways you can improve the profitability of your business.
They are as followed:
- Increase prices
- Sell more units
- Decrease Direct Variable Costs
- Decrease Fixed Operating Costs
Now, the fun thing about these tools to improve your profit is that they are not created equal.
Increasing prices is the most effective way to maximise the profitability of your business.
This is because raising prices doesn’t impact the unit costs of every sale you make. All the additional dollars you make in sales goes straight to the bottom line.
The same thing happens in the reverse when you offer discounts – you are haemorrhaging your profitability, even to the extent that you may lose money!
Let’s use this fictitious service based business as an example.
This business does $1M in annual sales. It generates a 10% profit margin on the back of these sales, which is a pretty standard target profit margin. You wouldn’t want to be doing any less than that.
As you can see, willingly offering a 10% discount essentially erodes the company’s profitability. At a 15% discount, it loses money.
The problem here is that the costs of production will stay the same. Irrespective of the price and discount offered to the customer, the work still needs to get done on spec and on budget.
The sales-person has unknowingly sold the service just to break-even and even lose money. A rational business owner has to now suck it up and still deliver the service at the same quality and spec that was promised. Only this time, they’ll be incentivised to take short-cuts. To do things faster, cheaper, scrappier – in an effort to make some money.
You could get away with this in the short-term, but over time, customers catch on. Lower quality devalues the service being offered…which devalues the price that anyone is willing to pay. The simple act of offering a ‘discount’ can spiral into lowering the value of the entire business.
This is the very definition of ‘race to the bottom’.
It’s a vicious cycle.
In summary, that math is simple. For every % discount that you offer to prospective customers is a % that is coming off your bottom line.
The Psychology of Discounts
Whilst we have touched on the financial costs of offering discounts to prospective customers, it’s the non-financial costs of discounting can be the most damaging to your business.
I’m referring to the psychological impact of discounting and the impact to your brand.
First, a quick lesson in behavioural psychology
Humans have a lot of flaws when it comes to decision making. We’re actually quite irrational when making everyday decisions.
And when it comes down to making a choice that considers price, we’re subject to a cognitive bias known as ‘Anchoring’.
It’s all relative
Anchoring bias occurs when people rely too much on pre-existing information or the first information they find when making decisions. It occurs because humans need a reference point to contextualise the price they would pay to buy a good or service.
Let’s use a real example to explain my point.
When I was starting my business I was very generous with our discounting policy. Hungry to win new business I would openly give discounts because I wanted to make the deal enticing.
The discounts ranged from 1 month of ‘free trial services’, to 10% off the entire package! We even had a policy to offer discounted rates to Not-For-Profits and ‘Cash burning startups’.
In the beginning, this was ok. We were happy to provide discounts to win a deal. The problem is that over time it was really difficult to increase prices back to market rates, as customers were anchored to the discounted rate.
In addition, it set an expectation with customers that the prices we set were negotiable – and hence we were always being challenged on price.
From a production perspective, it was always challenging to give these customers an equal level of service and customer experience compared to the customers that paid full price.
Eventually, I asked myself – why is this particular customer so special that they get cheaper rates for the same outcomes?
I realised I was unintentionally price discriminating – which was not fair on anyone. Including myself.
Discounting sets a price anchor
The problem with discounting is that it sets a ‘low’ price anchor at the beginning of a new transaction and relationship. Once the bar is set, it’s often challenging reset the customer’s expectations to what the price should be. Your customers have anchored themselves to the discounted price – and anything above that is perceived as expensive in their eyes.
In addition to this, offering discounts sets a precedent where every product you offer can be negotiated for a lower price.
You are lowering your price, standards and expectations for short-term pleasure but long-term pain.
Avoid it at all costs.
How to say no to discounts
I’ve tested a bunch of methods and tactics to object to the question of ‘can I get a discount?’.
The responses have ranged from nice and friendly, to blunt but respectful.
Here’s the response that has worked for me.
Client Prospect: Hi Jason, overall the proposal looks good but it’s a bit over my budget. What discount can you provide?
Me: Absolutely none, but I don’t blame you for asking.
Then shut up…just pause for at least 5 seconds… Don’t talk.
Don’t mutter, don’t cover your words.
Embrace the uncomfortable silence.
Let them talk first.
8/10 they’ll fold and accept the price.
And what if they suggest your product/service is too expensive?
The truth is that your product is both cheap and expensive to different people. Simply put, it’s all relative.
You get what you pay for
I find it fascinating that brands like Supreme can charge upwards of $120 for a tshirt, compared to Kmart who sells them for $1. Without digging too deeply into their supply chain, it wouldn’t be unreasonable to assume both garments were produced in the same factory in Bangladesh.
So how do some brands sell identical products for 120x the price compared to others?
It’s because they can.
Setting the price for your product and service is not about margins, or costs or profits.
It’s about status. It’s about value. It’s about the customer.
Ultimately, the price you charge is a form of signalling. A tactic to help customers understand where your product and service fits in a heirachy of status and brand value.
Equally, pricing has a placebo effect. We value things that cost more. If it’s cheap, it probably is. If it’s expensive, it’s probably better.
Whether it’s the actual case or not, it doesn’t matter.
The costs of production have nothing to do with the outcome. If the customer sees it as valuable, then it is.
The problem for most businesses however, is that we fall into a trap of pricing based on inputs. Time, materials, headcount, overheads.
The reality is, your customers don’t care about your costs of doing business. They only care about themselves…and what utility they will derive your product. You need to price accordingly.
I’m busy working on my next project which is around Pricing strategies for Service-based business. It is for consulting, creative agencies and professional services businesses on how they should be thinking about pricing their services.
If this is of interest to you, subscribe in the form below and I’ll let you know when it’s ready.
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