Discounting: How it impacts your Profit and Loss statement

Know your contribution margin

Understanding contribution margin is a non-negotiable for eCommerce operators. It reflects your ability to turn a profit by showing how much each additional sale, after deducting variable costs, contributes towards covering your fixed operating expenses and then generating a profit.

In a previous article, we put the importance of contribution margin under the microscope. Here's a quick recap of the formula:

contribution margin = net selling price - variable costs to deliver each sale

In this article, we'll look at the impact of discounting on your contribution margin.

Approach discounting with a clear mind

As high-stakes periods of the eCommerce calendar approach, most notably BFCM, the allure of discounting becomes almost irresistible. The rationale is clear: cut prices to attract the masses, hoping the surge in order volume and the lifetime value of these new customers will compensate for thinner margins. You know the market is buzzing with anticipation, consumers are poised to snag a deal, and competitors are gearing up for a showdown on prices. You don't want to miss out on the action.

It's an exciting time, but also a dangerous period where brands are most susceptible to throw caution to the wind and forget the fundamentals of unit economics. Instead, you should proceed with caution and approach discounting with a clear mind. Don't discount indiscriminately just to make more sales. Have a very intentional approach. Are you willing to take a hit on profitability to boost brand visibility and acquire new customers? Or should you opt for a more conservative approach that protects your margins?

Understand where discounting impacts your contribution margin

Discounting is a constant balancing act. Each markdown can attract more customers and boost sales volume, but also chips away at your contribution margin. By its very nature, discounting reduces the sales price per unit, but should improve your marketing efficiency (MER) by converting more customers than you would've without the offer. You charge less, but you spend less on ads per sale. How this trade-off materialises is hugely important.

To assess how discounting can shift your contribution margin, let's first establish a baseline scenario without a discount. For argument's sake, we'll assume your performance marketing budget is fixed at $150,000.

At a selling price of $100, the contribution margin, after taking all variable costs into account, is $37 per unit. It costs $30 in ad spend to sell each unit, so with a budget of $150,000, you should sell 5,000 units and generate an overall contribution margin of $185,000 for the business.

Now let's introduce a scenario where you discount your product by 20% in a bid to sell a higher volume of products:

At a discount of 20%, the net income is reduced by $20. But further down the profit and loss (P&L) statement, paid ads become more efficient with a discount in place, now costing $6 less per unit. In this instance, the improved marketing efficiency hasn't fully counteracted the reduction in selling price, so overall contribution margin reduces by $14. With the same ad budget of $150,000, you sell more units as expected: an additional 1,250. But the total contribution margin earned has fallen to $143,750.

So it's settled, right? Ditch the discount? Well, not so fast. You need to go one step further and consider the lifetime value of new customers you've just acquired.

Take new customer acquisition and lifetime value into account

It's probably unrealistic to assume that all of these units were purchased by new customers, but let's assume 70% had never purchased a product from you before. Continuing the above example means you'd have acquired an additional 875 new customers by running the discount than you would've without it. Again, it's a game of trade-offs. You've lost out on $41,250 in contribution margin by running the discount, but could you recoup this by selling more to the new customers you've gained? Those repeat purchases would likely have a higher margin too, because you'd be sending them an email nudge for effectively zero cost as opposed to acquiring them via an ad.

Discount strategically to clear slow-moving stock

Slow-moving stock can start to eat into margins as you rack up storage costs with your fulfillment center. You can use discounts strategically to clear this stock. Instead of letting increasing fulfillment costs decay your gross margins, take a short-term hit and use slow-moving products as bait to acquire new customers who may buy higher-margin items in the future.

Decide if discounting is right for you

So, is it worth discounting? Once again, it's a balancing act. The answer lies in calculating the impact on your contribution margin and whether this can be justified by the lifetime value of new customers you bring in. You should be able to run the numbers upfront and confidently stand over any price cuts you've made. You also need to think about the broader impact on your brand. If you indulge in perpetual discounting, it becomes synonymous with your brand and customers won't be willing to pay full price again.

In short: be strategic, not reactionary.

Calculate the impact of discounting on your business

Use our calculator below to assess the impact of various discounting scenarios on your contribution margin. First, complete the baseline case to see your original contribution margin, then complete the remaining inputs to calculate the impact of a discount.