"2X Tax Savings," read the headline on the
page 11
ad in last Sunday's Boston Globe Magazine.
"…Your purchase will be tax free, along with
an equal
savings from Leather Creations" during
Massachusetts'
retail tax holiday August 12th and 13th.
"Save 55–65% off their original
prices," said
the Filene's ad on page A3 of the same edition,
followed by
"Savings throughout the store from
25–75%"
by Alpha Omega on page A6.
"Spend and save — how sweet it must
be,"
says my wife Annie, looking up from the newspaper,
a note of
sarcasm barely detectable. Having become a
successful
Purchasing Manager during her many years of family-
building,
she knows better. She knows about loss leaders, and
she
knows that "original prices" may never have reached
the sales
counter. For sure she knows that there's no such
thing as
saving by spending.
But even she asks from time to time "How do
they stay in
business?" especially when she sees markdown
after
markdown on brand-name merchandise that's not a
retailer's
overstock purchase.
The simple fact is that a lot of them don't make it,
and
drastic price reductions often signal a death
spiral not only
for retailers but for all other types of business
entities, as
well. (Which is not to suggest that any of the
three retailers
mentioned above is currently in that situation.)
Here's how it happens:
Sales: If we can just cut our unit
price
to this customer from $120 to $90, I'm sure
their orders
will increase our total revenue by at least
25% in the
next year.
Owner: But then we'll make only $15
gross
profit per unit.
Sales: We'll make it up in
volume.
What does Sales know? That the easiest
product/service
feature to sell on is price, and that her/his sales
commission is based on total revenue.
What does the Owner know? That his direct
costs are $75
per unit. He also knows that his overhead
costs
— for the sales commission, for marketing
expenses, for
his salary, for rent, for utilities and for all of the
other general
expenses of the business — are about
$35/unit.
This usually leaves about $10/unit for
profit,
which is good. So Sales is suggesting that he sell
below full
cost.
When sales are down, the conversation gets
more
intense:
Production: If we start laying
people
off, we'll never get them back, and the people
we keep
will start looking around.
Sales: This piece of business will take
up the
slack for at least the next quarter. Beyond that,
we can get
lots of new business at this price.
Owner: But if we get much more
new
business, we'll have to add overtime, and maybe
some
new equipment, and we're running out of space. All
of these
involve more overhead.
And then another element gets added to the
management
discussion:
Finance: Let me make three points.
- Direct costs tell only part of the story. Our
materials,
labor, and outside contractors don't cover a number
of other
expenses that grow with volume, such as
maintaining
more inventory, running our machines longer,
processing more
incoming orders, sending more invoices, accounting
for more
transactions, and so on.
- Discounts create a very slippery slope. There
are only
a few steps between a one-time concession and an
unwelcome
"margin reduction program." The D-word
(Discount) will
inevitably get around. Customers are always pushing
back on
price, and having conceded once, Sales will have
trouble
holding to the original line.
- Keep your eye on average margin. There
will
always be variations in our margin percentage based
on
market dynamics, product mix, customer needs, and
sales
effectiveness. But if we know what we need for
an
aggregate margin — across all products,
customers, and markets — and we
regularly track
the actual average margin, we can match our
discounts in
some sectors with premiums in others to stay in
control of the
bottom line.
Sales: So we can never cut prices or
offer
discounts?
Finance: Discounting is like any
other
part of the marketing mix — advertising,
promotion, trade shows, sales incentives, etc. You
weigh all of
these factors, budget for each, and an increase
in one
factor requires a decrease in a related expense.
Is
$50,000 in additional discounting worth taking
$50,000 out of
the budget for sales incentives?
Production: Our competition is
continually
underpricing us.
Finance: Then we have to reduce
costs, or
develop new products, or both. Everyone in the
company
has to understand that they have a stake in
efficiency and
economy. Hopefully we won't need a layoff or
two before
the message hits home.
Owner: So if the margin percentage
we get
from our largest customer is only a third of what
we're getting
from everyone else, then we're losing money on their
business,
despite their volume?
Finance: The analysis (see sidebar)
shows
that if we dropped their business, and then
consolidated
staffing, reduced some space, sold off excess
equipment, and
thus eliminated their long-haul delivery costs, our
lower
expenses would more than offset the loss of their
gross profit
dollars. So we should push hard for a price
increase with
them, knowing that the loss of their business will not
kill us if
we have the discipline to cut back accordingly.
*****
Having made his points around the management
table, Finance
returns to the Home Front to take a call from a
member of the
Third Generation:
"Grandpa, I have a great deal for you. For school I'm
selling
holiday wrapping paper as a fund-raiser. It's a
discounted price.
You can really save money."
Finance takes a deep breath. Another generation
to
educate.
