Notes for an Entrepreneur - Discounts

Every single time I teach a Marketing course at a Business School, I find myself spending a fair bit of time discussing the impact of discounts on revenues and profits.

A number of students will propose offering a discount as a means to garnering more sales. While this approach might be acceptable in the short run, the adverse impact on the bottom line can be disproportionately large. This is especially true when you are dealing with a product where the marginal cost of producing a unit is a large proportion of the selling price.

Consider a product that you can manufacture for Rs 90 and that you can sell for Rs 100 thus yielding a gross profit margin of 10% on selling price. When you offer a 5% discount, the selling price drops to Rs 95. Presuming that your cost structure does not change in the short run, your gross profit margin drops from 10% to 5% of selling price. To make this offer worthwhile, the entrepreneur needs to be bullish about one of two things. One, the 5% discount will bring in more than double the sales volume, thus implying a rather high price elasticity of demand. Or two, the increase in sales volume will remain sticky even after the discount has been withdrawn. Discounts then, offer a relatively simple way to possibly increase top line, but at a large cost to the bottom line.

I have been misleading in my use of this example though. The situation changes when we consider a product or service where the marginal cost of producing an incremental unit is near zero. Examples would be a software company selling a software package on the internet for download or an airline selling an incremental seat on a flight. In such cases, a 5% discount might affect the contribution by an equal percentage. This is the reason why we notice so many software companies willing to give away their product for free in a bid to buy sticky behaviour. In some cases like Whatsapp, this gamble can pay off spectacularly.

There is a spate of internet companies giving away their product for free or below cost price and making losses for years. This is easier to fathom when these companies are spending Venture Capitalists' money. Once in a while, one loss making taxi company is bought by another for ridiculous amounts of money.

The entrepreneur would do well to remember however, that this strategy of hoping for such an event is roughly the equivalent of buying a lottery ticket.