Discounts and Cannibalization

I am writing this on December 26th. In much of the Commonwealth today is the biggest shopping day of the year. December 26th is Boxing Day, which was originally a day to give gifts to the poor (and your servants), but has long since morphed into away for merchants to unload excess inventory from Christmas at deep discounts.

As far as pre-planned deep discount days go, Boxing Day makes a lot of sense. A lot more sense than other days like Black Friday or Cyber Monday. The reason has to do with Cannibals.

As I talked about a little in my Attribution post, any sales you attribute to a marketing activity are either over- or under-stated. If you under-state the impact (Best example: Television Advertising) we use the term “Synergy”. The spend is helping other marketing activities in a way you aren’t giving it credit for. If you over-state the impact you are claiming the activity (or channel) is doing something, when it is really just stealing credit from a different activity you are ignoring.

Getting attribution perfectly correct is impossible. Smart companies do the best that can, then they guess whether what’s left is synergistic or cannibalistic and use that to decide roughly if they should spend more or less on those activities.

This doesn’t mean never spending on cannibalistic channels or throwing money at synergistic ones. If you have a channel that you measure as creating $1 in marginal profit for each $0.10 you spend, but you are pretty sure it is very cannibalistic, you are likely okay. Unless the channel is 90% of more cannibalistic, you are still making money and likely shouldn’t stop.

Which brings us back to discounting.

Discounts by their very nature are cannibalistic.

Let’s use a very simple example:

Imagine a world where there are 100 people and they all buy toothpaste every week. Everyone buys one tube from their normal brand for the normal price, use it up over the week and then repeat. Lets say there are two brands: Crest and Colgate and they each have 50% of the market. They each sell their tubes for $1.

Crest decides they want to run a discount to take share from Colgate. They discount their price by 10%. Crest now costs $0.90 per tube.

The first thing that happens is that the 50 people who were buying Crest keep buying Crest. Only now they are paying $0.10 less than they were before. Crest has immediately lost $0.10 x 50 = $5 in revenue. Even worse, they have lost $5 in profit, since there was no costs associated with the price being $0.10 higher.

If Crest were able to produce toothpaste for free (i.e., no marginal costs of production – obviously unrealistic for something like toothpaste), they would need to sell $5 more worth of toothpaste to break even. In this example that would mean 6 additional tubes (6 x 0.9 = $5.40). If their cost of production and distribution was $0.50 per tube, they would need to sell 13 tubes (13 x 0.4 = $5.20). They would need to move their market share from 50% to 63%. And that wouldn’t get them ahead – it would just get them to break even.

And it doesn’t end there.

They get hit two other ways.

The first is Colgate’s reaction. Imagine if Crest did this and you are Colgate. Are you just going to sit there while Crest drops your market share to 37%? No way. You offer your own price discount. And when you do you steal share right back from Crest.

Either we get to a new equilibrium where both tubes are $0.90, both brands are back to 50% share and everyone is making less money, or they go back and forth offering discounts with their shares jumping around from week to week. In either scenario Crest is in a lot worse place than they were before. (This would be solved by collusion between Crest and Colgate – which is why it is illegal, but still happens from time to time)

The second way they get hit has nothing to do with Colgate. Some of the loyal Crest buyers may ‘buy forward’. Instead of buying one tube when it’s on discount, they buy two (or ten!). They don’t increase their consumption, they just move it. So instead of one week of cannibalization, you could end up with a half dozen weeks. Those pre-buyers just don’t buy the next week (or the next ten weeks).

If ten percent of your loyal buyers decide to buy ten weeks in advance, you lose another $0.10 x 10% x 10 = $0.10 per buyer (on average). That means you need another 13% increase in market share just to break even. Do you really think your 10% discount will move your market share from 50% to 76%, and not cause your competitor to react. Even if you do, that just gets you to break even. We haven’t even talked about supply chain costs of causing a spike in demand yet.

Discounting is ugly.


Should you ever discount?

Yes. Let’s walk through cases where discounting makes sense.


Zero Marginal Costs

If your product costs you nothing to make, discounting isn’t so bad. In the above example, if Crest was free to make (“Virtual Crest”), you only need half the market share gain to hit your break even. This is the case with a lot of online services.



Want to try Netflix? You can sign-up and get your first month free. Netflix wants you to try their product. They know that some percent of the people who try it will stick around. Since their marginal costs are pretty close to zero, it doesn’t cost them very much to let you try before you buy. To a lesser extent this can work with any product. Maybe Crest wants Colgate buyers to try Crest just once. They are so convinced of the superiority of their product they think most of those people will stick around. If those 13% keep buying Crest (and don’t even switch back to Colgate when Colgate discounts to $0.90 the next week), they will have achieved a big win. Unfortunately most products just aren’t that much better.


Low Market Share

If you have no base business to cannibalize, discounting can make a lot of sense – especially combined with ‘trial’. If Crest only had 1% market share to Colgate’s 99%, then discounting to $0.90 to gain 13pp of share sounds like a fantastic deal. They only need to get their share up to 1.06% to break even.


Expandable Categories

People generally only use so much toothpaste, but that isn’t true for chocolate. If you have a 50% share in the chocolate category and you get people to buy a bunch more of your chocolate in a given week, even if they ‘buy forward’ it is unlikely to hurt your sales significantly in future weeks. People will eat what they buy. The issue happens when you start convincing yourself your non-expandable category is expandable. When I was at P&G we told ourselves (and had market research data to back us up) that if people bought more toilet paper, they would use more toilet paper (I will leave it to your imagination how that could happen). I believe that is likely true on the margin (“Oh. I’m running low, guess I better use less squares per wipe until we get to the grocery store…”), in no normal world is toilet paper an expandable category. But it makes sales people a lot more comfortable when they run deep discounts.


Excess Inventory

If you have product that is going to be thrown away, you don’t have a cannibalization problem. In these situations you want customers to forward buy their toothpaste. If they don’t you are going to throw it away. This is really an extreme example of zero marginal costs. In fact it’s negative marginal costs, since you will likely have some costs to bear on the disposal. The best example of this is the fashion industry. Whatever you don’t sell at the end of a season is worthless for (or worse), which is why you see big blowout sales of post-season clothing. The last 15 years have also seen the growth of a fashion-industry business model that exists with just-in-time inventory so they don’t have the excess inventory at the end of the season. This lets them charge lower prices for their non-discounted product during the season and steal share.

This is also the reason why, in general, Boxing Day sales make more sense than Black Friday sales.


Discounts and Prejudice

In my experience many business people have in-going prejudice on whether discounts are good or bad. Some people are convinced discounts drive their business. Others think that discounts dilute their brand image and just degrade their margin without any upside. The truth is more subtle than the two extremes.

I did a lot of work in telecom trying to reduce customer churn (including building those save desks that everyone hates). We would often do this with discounts. We would get a lot of push back from telecom executives that thought we were just throwing money away. But let’s look at the math:

Let’s say you offer a 50% discount for a month to a customer. Let’s say you can target that discount so it hits people that are 50% likely to churn if you don’t do something. Let’s say that gets 50% of those customers to stick around for another month. Let’s also assume that if you get them to stick around past this ‘churn’ period their future churn rate is much higher than your average (say 4x higher), but definitely not 100%. Let’s say these customers are spending $50/month on your service and the average customer lasts 4 years. We’ll say there are 100 customers like this for calculation purposes.

If you do nothing: 50% of your 100 customers go away. You are down 50 x $50 x 12 months x 4 years = -$120,000

If you discount 50% to all 100 customers you end up with:

50 people discounted that you didn’t need to. This cost you 50 x $50 x 50% = -$1250

25 of the 50 churners you lose anyway = -$60,000

The other 25 you discount for one month (25 x $50 x 50% = $625). This keeps them around, but they still churn in a year (instead of your 4 year average), so you are still down 25 x $50 x 12 months x 3 years = -$45,000

So with your discount program you are down $106,875. But that compares favorably to the $120,000 you would be down without doing anything.


Obviously all these numbers are made up, but they are all fairly reasonable.


Discounting is Easy?

The first step in winning in the discount war is understanding cannibalization. Then you need to understand why you are discounting. If you are doing it just because everyone else is, you are likely making some pretty big mistakes. But if you take a few minutes to think about why you are doing it and determine if it fits into the five reasons I give above for discounting, then do some basic theoretical math on what you you would have to believe for it to make sense, you can start making some much smarter judgement on whether a specific discount is a good idea.

Most of the time the answer should be fairly obvious. Like most things, if the answer is really hazy and unclear, it might be ROI positive, but there are likely better things for you to do with your time and effort. It should be obvious discounting is a good idea, otherwise go and put your effort somewhere else.


Disagree? Know other reasons why discounting is a good idea? Comment below.