When business is booming and we can barely keep up with demand, there is always a customer asking for a discount. While it’s easy to “pass on the opportunity” when we are busy, when business slows, that discounted rental price starts to look a lot better. Of course, when business slows, every customer starts asking for a discount. While discounting to increase business in slow times can be necessary, discounting also can debilitate a business and undermine current and future profitability.
Discounting is not necessarily bad. However, it is very important to understand the impact of a discount on a financial statement before agreeing to a discounted price. In order to make a fact-based decision to accept or decline a discounted price, you must understand your direct and indirect costs. The American Rental Association (ARA) Cost of Doing Business Report can assist you in this type of analysis.
Some costs occur regardless of your level of business. Rent, heating, lighting, insurance and, to some extent, labor are costs that occur without regard for your revenue level. These are called indirect costs because, while they must be paid for by rental revenue, they are not directly related to the rental. Fuel, maintenance, direct labor and cleaning are direct costs that occur only when a piece of equipment is rented. When deciding to extend a discount, the direct cost is the most important of these costs. While indirect costs must be paid, they will occur regardless of rental volume. While cash collected from a rental will be used to pay these costs, they are only indirectly related to the discount decision.
As an example, let’s assume that the direct cost of renting a particular piece of equipment is 50 percent. This means that $50 of each $100 of rental revenue will have to be consumed by the rental itself. This leaves $50 of gross margin to offset other costs. If a 20 percent discount is granted for a given rental, this reduces the gross margin in our example by $20, leaving $30 to pay indirect costs. On the surface, this looks like a great deal because at least $30 will be collected to offset fixed indirect costs. However, while this decision does generate positive cash flow, it also reduces the overall gross margin. In order to recoup the margin that has been lost by granting this discount, you will have to increase your rentals on this piece of equipment by 67 percent in order to generate the same amount of gross margin to pay fixed costs. In short, a 20 percent discount has resulted in a need to generate an additional 67 percent of revenue to achieve the same result on the income statement.
For example, a 20-ft.-by-20-ft. tent is expected to rent 10 times per year and has a direct cost of 50 percent of its revenue. In order to generate additional revenue, a rental operator decides to lower his price by 20 percent. While this decision may generate additional rentals, the same tent will have to rent 16 times in order to generate the same amount of gross margin that it would have generated at the original price.
While there is always pressure to lower prices or grant discounts, this pressure grows dramatically during challenging economic times. There are times that discounts or price reductions make good sense. However, before entertaining price reductions, it is very important to understand the impact of these discounts on your income statement. Whenever possible, it is better to provide additional services and upgrades, ideally those that do not increase additional direct costs. It is far better to provide the nicer chairs for the same price or include the use of free pallet forks for a skid-steer, than to give an equivalent monetary discount.
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