By the numbers; “Where do Discounts come from, revenues or profit?”

Many of my clients have sales staff and pay sales commission on “top line” revenues. I often get the question regarding my opinion on offering a “discount” to close the deal. I usually give The Boss a typical consultant’s answer like, “It depends.” I begin the discussion by asking The Boss where the discount is coming from. They look at me with a somewhat puzzled look and ask, “What are you talking about?”

Most of the business owners I work with see discounts coming solely off of “top line” revenues. For example, they may have a $10,000 proposal that is in a competitive situation and their sales person believes they need to discount the job in order to get the work. Together they may believe a $1,000 discount is necessary to “close the deal”. A 10% reduction in price to get the job and reach their revenue goals, keep their people working, and possibly steal a competitor’s customer is acceptable in their minds. It very well may be but we need to understand the full impact of the discount as it pertains to net profit not just “top line” revenues.

We continue the discussion and I ask; “What is the profit margin on the original proposal?” For this example let’s say this proposal will generate a 40% gross profit or $4,000 ($10,000 × 40%) so that $1,000 discount which was 10% of revenue is also 25% of gross profit ($1,000 ÷ $4,000). This 25% discount on gross profit may not be what The Boss intended but he may still think it’s OK in order to get the job. Taking this job a step further, let’s say the proposal has a net profit of 15% after overhead is factored in. I factor overhead into every job. Why, because every dollar of revenue has to pay for its part of the company’s total overhead. By definition I am using overhead to include all expenses not captured in total cost of goods sold. In this example the company has a year-to-date overhead of 25% of revenues; this means that every $1 of revenue has to contribute 25¢ towards overhead. Think about this, where else does the company get the funds to pay for the overhead? Answer, from every dollar of revenue it generates.

So in our example the “net profit” from this proposal is estimated to be 15% (40% gross profit minus 25% overhead) of the $10,000 total proposal or a net profit on this job of $1,500 ($10,000 × 15%). Now take the discount as a percentage of the net profit and you are planning to reduce the net profit on this job by two-thirds ($1,500 net profit minus $1,000 discount leaving $500 of net profit). If you think about discounts as coming from the net profit of a job rather than off of the “top line” revenue of a job it puts it in a different light and may cause an owner to think twice before offering a discount, remembering that net profit is a major contributor to the owner’s equity of the business. One point I want to stress is that we are estimating (and eventually will be job costing after the job is completed) to a “net profit” number and not a “gross profit” number when we include overhead as part of the calculation.

What is the best case scenario? In my opinion, selling on price alone is not a sustainable business model. Identifying your company’s differentiators such as quality products, custom products, timeliness of delivery, industry relationships, etc. and training sales staff how to close deals using these competitive advantages will generate more profits in the long run and may keep your company out of a pricing war in your market. The book, Blue Ocean Strategies, ISBN 978-1-62527-449-6, is a good read which explains this concept in more detail. Your numbers may be larger or smaller and your percentages will vary but the principle will remain constant. Discounts may be a necessary evil and understanding discounts as a percentage of net profit rather than solely coming off of “top line” revenues is necessary as we strive to grow owner’s equity.