MBA Talk: Is it really a Bargain?

"Buy 2, Get 1 Free", "Buy 2, Get 20% off" - well, all of us have see such promotions while walking through the aisle in our local retail store. Sure, they are lucrative and sound impressive. More often than not, I have fallen for them.

Have you ever thought - "Why do companies discount their products so much? Aren't they making a loss or atleast cutting into their profits?". The truth behind it all is that the real discount is very minimal, if any. It just looks like a fallout bargain! It is a bigger DEAL for the company, than for you.

Let's take a simple example and try to understand. A couple of weeks back, I went to Walmart to buy a refill filter for my Brita Water Pitcher.
And here were my available options

• 1 Pack: $9
• 3 Pack: $19

Well, when I walked in, I intended to buy just one. And I walked out with the 3-pack box. And why? It's an awesome deal. I get three filters for a little more than the price of two!

So, let's take a look at why a company like Brita would do this. The most important concept behind this is 'Time Value of Money'. If I get $1 today, it ain't the same as me getting $1 same time next year. If I get $1 today, I can invest at a bank at 10% interest and make it $1.1 by next year. So in other words, the $1 next year is only valued at $1/1.1 = $0.909 today!

Now let's do the math for the case of Brita. Let's assume that a typical Brita filter would last 1 year. Next let's assume that Joe (a customer) would buy Brita 1-Pack today and for the next 2-years. This would bring in a total revenue of 3*$9=$27 over the 2-year period.

But what's the current value of the revenue for Brita. Here we go.

Year	Revenue	Present Value of Revenue
0	$9	$9.000
1	$9	$9/1.1 = $8.182
2	$9	$9/(1.1)2 = $7.438

So the $27 that Brita would earn over the 2-year period actually amounts to only $24.62 right now (i.e. $9+$8.182+$7.438)

Let's add the second twist to this equation. Let's assume that every year Brita retains only 80% of it's customer base. The rest may leave due to dissatisfaction or due to better products from competitors. This means that there's only a 80% probability that Joe will still be a Brita water filter user and will buy the replacement filter next year. Even more, there's only a 64% probability (0.8*0.8=0.64) that Joe will still be a Brita water filter user in two years and hence will buy a second replacement filter in year 2.

Now let's use this additional data to calculate the expected present value of revenue for Brita from Joe over the next two years.

Year	Present Value of Revenue (from above)	Retention Probability	Expected Value
0	$9.000	100% (buying currently)	$9.000
1	$8.182	80%	$6.545
2	$7.438	64%	$4.760

Total Expected Present Value of Revenue from Joe = $20.305 ($9 + $6.545 + $4.760)
Cost of 3-Pack Brita Replacement Filter = $19
So the real discount is $1.3 (or 6.4% of revenue) for Brita!

In face, I think it ain't a discount at all for Brita. Here's why?
1. Think over the inventory cost of storing the future filters. The future replacements were already stored and sold along with the current replacement. So there's savings in future individual transportation and storage of the filter
2. Over the 2 year span, it is probable that you may lose one of the filter. In that case, you'll buy one more anyway.
3. What about technological advancements? Say, Brita came up with an advanced filter (a faucet one) in a year and you fall for it. The replacement are a waste, but Brita already made money out of it!

So well, the next time you see a bargain, you just need to realize that the company selling the product is getting a bigger bargain!