The Capacity Trap
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].)
Second, there's the opportunity cost. When you fill capacity with low-margin sales, you leave no room for high-margin sales. What will the freight hauler do if he finds a customer who will pay the full price? Lease another truck? Will he even bother looking for another full-price customer?
Meanwhile, by cutting his prices, he has just brought a new competitor into his market: himself. This is the third reason not to go after low-margin sales, and it's based on a general rule of business, namely, that prices always seek their lowest level. When you charge two prices for exactly the same service, you are competing against yourself. Customers are not stupid. Sooner or later, they'll figure out that you're willing to sell for less. When they do, you'll have a very hard time getting any of them to pay more.
By then, moreover, you will probably have lost your current full-price customers -- which is the fourth, and most important, reason for not discounting to fill capacity. The practice alienates precisely those customers you must have to be successful, maybe even to survive. They'll be furious when they find out you're charging other people less for the same service. They'll think you've been ripping them off all along. From then on, forget it. I don't care what price you offer them. Those customers are gone.
Understand, I'm not saying you should never offer customers a discount, but there has to be a reason for it other than excess capacity. A customer's buying in volume, for example, is a reason that everyone understands. Or you might offer a discount to a customer who agrees to certain special terms.
Better yet, maintain your price but offer something extra, a value-added service. Even if it costs you something to provide the service, at least you're putting your money to good use. You're getting a full-price customer. You're not undercutting your normal prices. And you've done nothing to alienate your existing customers. The worst that can happen is that they'll want the service, too. That's a positive, not a negative. If you get known for that value-added service, you may find that you can charge more to provide it.
Then again, you may not be so lucky. You may be sitting there with an empty, idle truck, and a customer will come along who is not interested in a value-added service or a volume discount or whatever. He just wants to pay $25 instead of the usual $45.
In that case, my friend, you go back to the first lesson of business: you can't do business with everybody. There are people in this world who want more for their money than you can provide. There's only one word you can use to deal with them, and you have to learn it, hard as it may be to say it when the customer is standing in front of you. That word is no. n
* * *
Norm Brodsky (firstname.lastname@example.org) is a veteran entrepreneur whose six businesses include a former Inc. 100 company and a three-time Inc. 500 company. His column, Street Smarts, appears every other month.
This column was coauthored by Bo Burlingham.
NORM BRODSKY | Columnist
Street Smarts columnist and senior contributing editor Norm Brodsky is a veteran entrepreneur who has founded and expanded six businesses.