Discounting based on Quantity?

"Locking in" business without knowing
more about your customer looks more like this.

Let’s think about quantity discounts.  For many folks the idea of “locking in” business by offering up a special discount seems to make sense when future potential is involved.  Here’s how it works.  Acme Manufacturing has yet to purchase your new product but based on your knowledge of the Acme’s size and an intuition that Acme could buy lots of your product, you provide a discount. 

Our analysis of many first time sales situations, indicates a couple of key points:  

First, the discounts are provided unilaterally, with no probing of the customer’s current purchase price.  What’s worse, we see this tactic used with new, emerging technologies and products never before introduced to the customer.  Sometimes, the seller offhandedly informs the customer, “The normal price for this product is $1,000, but I am going to knock off a hundred dollars so your ‘special price’ will be $900.”  Other times, the seller just provides a discount without even mentioning the deal.

Second, sellers provide these special deals without taking time to gather significant information from the customer on the value created by the product.  Many times sellers base their need to discount on information provided about a solution that didn’t really work; assuming something that didn’t work can even be called a solution.  Here’s an example of how that scenario might play out:

The salesperson is called to look at a waterproof motor in use at the customer facility.  The only issue is, the customer’s wash down procedure causes the motor to leak.  The motor fails regularly causing massive headaches, downtime and other electrical issues.  Somewhere along the way, the seller learns the old motor sells for $500 dollars.  The new technology will replace the motor.  Water issues will go away.  The new technology costs about 30 percent more than the failing technology of the past.  And, the customer uses quite a few of this type of motor.  So, the seller assumes they can’t sell their new product for much more than the $500 dollars already being spent.   I believe this is a major mistake.

There are three points sellers must understand…

1. Customers don’t have a true appreciation for discounts they see as “unearned.” 
According to research cited by negotiation expert Tony Perzow of SPASigma, potential customers see no real value in discounts which do not require something in return on their part.  What might be a better approach?  A discount which is tied to a long term commitment, a discount contingent upon placing a multi-piece order or a discount involving purchasing associated products.

2. Once the price level has been set, it is very difficult to raise the price.
Once a price is set, there is little opportunity to raise the price if the customer doesn’t meet your large order criteria; and this happens quite frequently.  Further, a discount provided up-front minimizes the opportunity to profitably provide added features, services or even a deeper discount if the customer does hold the key to big order potential.

3. Most sellers fail to understand the true cost of quantity discounting. 
For example, in the world of distribution, a gross margin of 25 percent is common.  Assuming there are no offsetting cost reductions such as order processing, shipping charges or discounts from your supplier, the math is relatively straight forward.  Using a 25 percent gross margin and a discount of 10 percent for the sake of easy math, we must sell something like 66 percent more product just to break even on gross margin.  Here is the formula:

Current Gross Margin / New Gross Margin = Unit increase required

We have attached a handy table developed by the State Government of Victoria to provide you with a handy reference guide. 

Checking the effect of discounts on the gross margin
If you cut your prices by...	And your present gross margin (%) is...
	0%	15%	20%	25%	30%	35%	40%
5%		50.0%	33.3%	25.0%	20.0%	16.7%	14.3%
6%		66.7%	42.9%	31.6%	25.0%	20.7%	17.6%
8%		114.3%	66.7%	47.1%	36.4%	29.6%	25.0%
10%		200.0%	100.0%	66.7%	50.0%	40.0%	33.3%
12%		400.0%	150.0%	92.3%	66.7%	52.2%	42.9%
15%			300.0%	150.0%	100.0%	75.0%

Of further concern in the distribution industry is that typical net profits run between 2-4 percent.  Shaving margin without some other offsetting factor can create profitability concerns.

There has to be a better way….

Wouldn't it be more appropriate to understand the customer’s situation before providing a discount?  Let’s start with a few questions:

• What is the customer’s problem with the current product used?  Breakdowns, scrap produced, bad data gathered, downtime, rejects or something else?
• What is the value of your solution to the customer?  To answer this, you must think about the cost of downtime, rejects produced, energy wasted, outsourced labor, repair parts consumed, etc.
• Does your solution help the customer avoid other costs?  Travel expenses might come into play here.
• Are the customer’s human resources better used because of your solution?  Referring back to travel expenses listed above, how much greater might the productivity of existing employees be if they weren’t sitting in a drafty airport waiting for the 5:50 AM flight out of town?

Finally and only after calculating the important stuff already listed, should these questions be pondered?

• What is a reasonable estimate of the cost of the previous solution, assuming one existed?
• What are the other costs associated with the old way of doing things?

I know what you’re thinking.  Sometimes, you don’t have time to explore the whole situation.  The customer calls and asks for a price.  What to do?  My suggestion is to stick with the standard cost.  Then begin to explore the situation.  You can always negotiate your price downward later.