It’s the all-too-familiar statement that sales managers hear from their salespeople: “I need to give my client this discount or we’ll lose the job. We’ll make up the margin on higher volume from the client.”
While there are merits in what the frontline salespeople are saying in such situations, there is another aspect that needs to be considered. The sales manager should assess the overall situation, not only the numbers. After all, Plato once said, “a good decision is based on knowledge and not on numbers.” But the numbers also have to support the knowledge.
This article aims at exactly that: What the numbers are telling the sales manager based on simple economic theories? Should the discount be granted because the extra quantity is going to make up for the lost margin? If the price is increased instead of decreased, will the overall effect for the company be a net gain or a net loss?
There are simple but frequently forgotten rules that govern such sales and discount decisions.
What is Supply and Demand?
The first step for the sales manager to quantify whether to give a discount or not is to think about the first law of economics: the law of supply and demand. But what do we mean by supply and demand?
The supply of a product in the market is the aggregate amount supplied by individual firms. In other words, supply is the total quantity offered for sale under various market conditions.
Demand on the other hand is the total quantity customers are willing and able to purchase under various market conditions.
Along the same lines, a market is in equilibrium when the quantity demanded and the quantity supplied is in perfect balance at a given price. Surplus describes a condition of excess supply while shortage is created when buyers demand more of a product at a given price than producers are willing to supply. The market equilibrium price just clears the market of all supplied products.
Now that we know what economists mean when they talk about supply and demand, we can move to a new concept based on this foundation. This concept is referred to as elasticity.
Price Elasticity of Demand
As we have just learned, when the price of a good or service rises, the quantity demanded falls. But to predict the effect of the price increase on total consumption, we must also know how much quantity falls. The quantity demanded of some goods, such as salt, is not very sensitive to changes in price. Indeed, even if the price of salt were to double or to fall by half, most people would alter their consumption of it hardly at all. For other goods, however, the quantity demanded is extremely responsive to change in price. The price elasticity of demand for a good is a measure of the responsiveness of the quantity demanded of that good to changes in its price. Formally, the price elasticity of demand for a good is defined as the percentage change in the quantity demanded that results from a 1 percent change in its price.
The value of the elasticity tells us if giving the discount the salesperson is asking for is a good idea or not. Depending on the value of the elasticity, the total revenue can go down or remain unchanged.
Before the sales manager decides whether to grant the discount the salesperson is asking for, the sales manager ought to examine the performance of the price elasticity of the market.
The same thought process should be followed when the sales manager is contemplating a price increase.
Without considering the individual supply and demand functions, the sales manager can not decide what is in the best interest of the organization: a price increase or a discount.
It should also be noted here that this exercise is not a one-time exercise. Different types of customers can be on different parts of the demand curve. Some can drop out at a slight price increase while others may not even feel it. The sales manager should assess the price elasticity on each individual case.
Follow the Facts
The famous English writer Aldous Huxley once said “Facts do not cease to exist because they are ignored.” Sales managers and their salespeople should always strive to follow the facts dictated by basic economic principles. When deciding on very important sales leverages such as price increases or discounts, they should strive to gauge what the rules and facts are telling them, not to ignore them. The simple existence of price elasticity is one such fact that should never be ignored by sales professionals.
Ramez Naguib, P.E., is the President of Palatinco in Dallas. He has lived, worked and studied in six continents.