The Capacity Trap

A veteran entrepreneur explains why cutting prices to sell unused capacity is not as good an idea as it may seem.

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Cutting prices to sell unused capacity may look like a good idea -- but it's the first step on the road to bankruptcy

Every business faces temptations, and there is none greater than the temptation to go for the easy sale. Of course, the easiest way to sell anything is simply to cut your price, but most businesspeople are smart enough to realize they can't do much of that without getting into serious trouble.

There is one form of price cutting, however, that even experienced businesspeople fall victim to. I've seen it wreck entire industries and bring down established companies. I'm talking about the practice of selling unused capacity at a discount in order to make sure it doesn't go to waste. I call it the capacity trap. Why is it a trap? Because at first glance, it looks as though you're making a sound business decision. In fact, you're putting yourself on the road to bankruptcy.

I'll give you the classic example of the guy who leases a truck, hires a couple of workers, and goes into the freight-hauling business. He charges the standard rate -- say, $45 an hour -- and books three days a week of business. Then he hits a dry spell. He can't find anyone else who wants to buy his service at that price. Finally, a customer shows up and offers $25 an hour for the other two days. The guy thinks, "Why not? I have to pay for leasing the truck anyway. I might as well get some income out of it."

He accepts the offer, which brings in an extra $400 a week in sales. The guy is satisfied. He's getting full use of his truck. He's not letting capacity go to waste. What could be wrong?

Plenty. For openers, he's no doubt making less money on the sale than he imagines. That's because he's focusing on one factor: capacity -- what it costs to lease the truck. Meanwhile, he's ignoring all the variable costs he incurs only when he uses the capacity: gas, wear and tear, and, above all, labor. He might actually do better by letting the truck stand idle those two days, but he wouldn't know it because he's looking only at sales, not profit. That's a common failing among people starting out in business. Unfortunately, it's often a fatal one.

But let's assume this guy has taken his operating costs into account and figured out he can make a small profit on the sale. It's still a bad idea for him to do the deal at a lower price. I'd argue that it's always a bad idea to cut prices simply to avoid having unused capacity, for four reasons.

First, there's the cost of capital. Whenever you make a sale, you are, in effect, lending money to a customer, at least until the bill gets paid. It's like making an investment in the form of credit. You need to make sure you're getting a good return on your investment -- that you're using your capital to generate enough profit to keep you going. It's a mistake for any business to waste capital on low-margin sales. It can be suicide for a new business, which has limited capital by definition and will never get beyond the start-up phase if its capital runs out. (See "How to Succeed in Business in Four Easy Steps," July 1995, [Article link].)

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