May 282009

Offers for Whom?

Why give discounts?

When push comes to shove there are just two reasons:

  1. To make more money immediately. The idea is to generate enough from incremental sales to pay for the cost of the offer.
  2. To make more money in the long run. Whether introducing a new product or service in the hopes that repeat business will cover the initial losses, or turning over inventory to clear shelves for new merchandise, the idea is that losing money (or realizing losses) short term will be worth it in the end.

For simplicity, let's focus on the first type of offer.

Suppose Fred runs a coffee stand, and on a typical Tuesday he sells 200 cups of coffee at $1 per cup. To keep the math simple, let's say each cup costs him $0.50 in materials. On a normal Tuesday he makes $200 in revenue on $100 worth of materials, so $100 in profit.

Fred wants to make more money and thinks by slashing the price he'll attract more business. He cuts the price to $0.75 per cup and sure enough, sales skyrocket to 300 cups. At the end of the busy day, Fred is bummed out. A $25% price cut lifted sales 50%, yet he actually lost money. His revenue went up to $225, but cost of materials went up to $150, leaving him with only $75 in profit.

Fred realizes he made a mistake. Of his normal 200 customers 150 of them buy from him every day, rain or shine. Same faces, knows them by name. What if instead of cutting the price across the board, he only cuts the price for first time customers?

This changes the math dramatically: he makes $75 in profit on the 150 cups sold to his regulars and $37.50 in profit off the 150 sold to new customers for a total profit of $112.50.

What Fred learned is that his regulars don't need an offer to buy. Since giving a discount to these folks essentially increases the cost of the promotion, it makes it that much harder to drum up enough incremental business to make the offer work.

Now, if the discount raises average order size sufficiently even selling to the people who would buy anyway could make sense. Let's run those numbers. On $100 in sales Acme has $50 in COGs. A 10% discount means what was $50 in margin drops to $40 ($100 - 10% * $100 - 50 = $40). Interesting! A ten percent discount cuts profits by 20%.

If we then ask: how much does the AOV need to increase to break even on this discount? the answer is more surprising still: AOV needs to increase 25% to pay for that 10% discount to a sure fire buyer.
{A $125 order before the discount has the same margin as $100 order without the discount. Essentially, you're selling $62.5 worth of merchandise for $112.5 which yields $50 in margin}

That's a pretty high bar, and most catalogers find that giving discounts to their most frequent buyers doesn't make sense financially. Instead, they give discounts to those who are least likely to buy without the offer which makes the threshold much more manageable.

Fast forward to the online world. To whom do retailers email offers? To the folks least likely to buy, or the folks most likely to buy? It's the latter. Most of our email files are made up of buyers and we flood their in-boxes with discounts.

What about our coupon friends? Most retailers offer discounts (via affiliates) to anyone who does a search on their brand name. Who are those people who search for a retailer's trademarks? Loyal customers walking through the door to your online store.

Seems to me that this is backwards. Giving discounts to the folks most likely to buy without them, rather than to the folks who haven't decided where they want to shop makes promotions less likely to generate profits in the short term or the long term. We not only raise the bar for short-term profitability, we condition our best customers to wait for an offer.

In an Internet Retailer article, Tracy Tee, co-founder of talks about how Tweeting offers to those who follow on Twitter has been hugely profitable. I wonder about that. She's sending offers to folks who are such rabid fans of that they follow them on Twitter!!! How many people would wager that a hold out test might prove those offers to be profit eaters?

Am I missing something?


10 Responses to "Offers for Whom?"
Jim Novo says:
You're not missing anything, a simple test using control groups will confirm a huge amount of margin being given up to people who would have bought anyway. Now, the real question is, does management know this? Because if they do and have decided they have a "strategic reason" to destroy their margins, that's one thing. But if managemnent does not know the extent of these subsidy costs, that's another story. Most people I talk to are managing to Sales / Response and not Lift / Profits, so they simply don't care they could be making a lot more money. Pretty ironic in this environment. More on this topic here:
Dave says:
Great analysis. One more thing to keep in mind is that by offering discounts to regular customers one runs the risk of actually hurting long-term sales because you are actually conditioning people to wait for a sale or a discount thereby making them less likely to pay full price at regular intervals. Every time I go through the grocery store I look for certain products that I love but will only buy when they are are sale. I've learned that they go on sale and I'm willing to wait for the sale rather than pay full price. As another example, I cannot tell you how many mattresses I saw strapped to the top of vehicles this past weekend because people have learned to wait until the Memorial Day sales to buy them. Have those stores done themselves a favor by spurring short-terms sales or do they actually cause people to delay making those purchases (i.e depressed long-term sales)? It comes down to a short- vs. long-term sales view many times and what you are trying to accomplish: make the quarterly sales/profit numbers or build long-term value in the business. ~~The Marketing Guy Who Drives Sales
TheShopper says:
You say that discounts and promotions are not effective to your loyal customers because they are going to buy anyway. As a loyal customer to a retailer, if I find out that said retailer is offering a discounted price to a new customer, someone who has not shown the loyalty that I have shown, I find that this shows a disloyalty to me, the loyal buyer. Here's an example: I pay $30 a year for a magazine subscription that I've had for five years. I see in my most recent magazine copy that they're offering $20/yr for new subscribers. It's time for me to renew my subscription and I think to myself; I've been a loyal subscriber for 5 years and I'm paying $10 more annually? In this scenario, I actually renew at the discounted price.
Jim, I think you're right. While catalogers learned the value of doing the math long ago, many of the online pure plays and brick and mortar retailers haven't learned to think like this. I don't think management sees it. They see top line numbers go up day-to-day and are elated. At the end of the month the CFO says "We lost money," and the CMO says "Hey, my team did its part, look at the sales we drove!" Dave, your point on conditioning customers to wait for the sale is right on. Who shops at Bed, Bath and Beyond without the 20% coupon they send you every month? Loyal shopper, I hear you. Indeed I look at my DISH bill every month and see the offers they're giving to new subscribers and get furious. But, importantly, I don't go through the hassle of switching, and the numbers show that most folks are like me...they're annoyed perhaps, but they continue to be loyal customers. Catalogers have known this for 30 years or more.
Jim Novo says:
Loyal shopper, I'm not suggesting the elimination of promotions to loyal shoppers. They should get a *different type* of promotion, one more appropriate to an engaged customer (and much more profitable). Special access or treatment opportunities are more in line with the engaged customer's attitude than discounts, and drive longer-term behavior.
Hey George, great article - the one element I can think of that is missing is a 'loyal customer' making an incremental purchase they did not plan on placing because of a special limited time promotion. If you can increase a customer's purchase frequency you are making a difference.
Jim, Joey, I'm with you. I think you do have to be careful with how often you go to the well of "special, act now, limited time" deals, lest folks come to expect them and wait for them. A well crafted loyalty program should increase share of wallet without eating the bottom line. Free next day shipping for 'Gold' Customer's -- Gold is passe, we're probably on to 'Plutonium' at this point -- has much higher perceived value than cost, and those 'access' ideas that cost almost nothing: 'Our Emerald Customers get first dibs on the newest (Harry Potter book, X-box version, iPhone, whatever).'


Check out what others are saying...
[...] Michie from the Rimm Kaufman Group says it well on his blog: Fast forward to the online world. To whom do retailers email offers? To the folks least [...]
[...] Se lo chiede George Michie del Rimm Kaufmann Group nel suo blog con l’articolo Offers for Whom. [...]
[...] Se lo chiede George Michie del Rimm Kaufmann Group nel suo blog con l’articolo Offers for Whom. [...]

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