At Macks Advisory we often meet with Directors that come for advice regarding the financial difficulties of their companies, seeking a quick fix strategy because their previous strategy of dropping their price to convert stock to cash has not worked.
Directors by their nature are optimists and often think they only have a short term problem that can be easily fixed by a strategy that involves “cutting the price” on goods or services to sell more volume or use up excess capacity. In reality, this strategy can do a lot of long term harm for the following four reasons:
1. The cost of capital
When a company makes a sale on credit terms, it is in effect lending the purchaser money for the purchase price. When the company considers its own cost of capital, a low margin sale may in fact be a sale at a loss or a sale at such a low margin as to not make it worth the credit risk.
2. The opportunity cost
If sales or services are negotiated at a low margin, the volume of stock that is moved or the capacity that is used up is lost for sales at a full margin, should the opportunity subsequently arise.
3. Disaffected customers
Should word get out to the customers of the company about the company selling to some customers at a lower price than they get, these customers may become disaffected and the company may lose them.
4. Lowering the market price
The market for goods and services always looks to buy at the lowest price. If the company sells at a lower than usual price, it in effect creates a new competitor in the market and this may cause problems to the company if it subsequently seeks to raise the price. Or it may cause competitors of the company to drop their prices, lowering the overall market price.
This lesson has been learnt by some companies the hard way and reinforces the view that price-cutting should always be avoided if possible. Remember that cutting prices may be the first step towards insolvency rather than the cure for it.
Members with queries are invited to contact Peter Macks at Macks Advisory on 08 8231 3323 or [email protected]