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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 Delight.com talks about how Tweeting offers to those who follow Delight.com on Twitter has been hugely profitable. I wonder about that. She's sending offers to folks who are such rabid fans of Delight.com 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?
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