Price cuts: Proceed with caution

Q. When your customers see an offer from a low-priced competitor, what do they consider?

A. Their relationship with you.
B. Their own business prospects.
C. Whether to throw you over immediately, or after lunch.

Price cutting is in the news. Toshiba is slashing the cost of HD-DVD players to try to stem Blu-Ray's rising tide. Sony may cut tariffs on its PS3 game console because it can use cheaper lasers. There are many more examples of prices falling for a variety of reasons, from email services trying to expand their markets to flash memory makers trying to remain competitive.

Should a small business facing discount competition cut its own prices in an attempt to stay healthy? Probably not, and certainly not without considering alternatives. A price cut like Sony's makes sense when matched with cost cuts. As a strategic move that won't endanger the company if it fails, a move like Toshiba's can be worth the risk.

What makes price-cutting so dangerous is that even moderate cuts can require astounding increases in volume to avoid hurting profits. Here's the math: You sell widgets for $1,000. Each costs $750 to make and sell, so your profit on each is $250. You pocket $4,000 for every 16 sales -- enough for that vacation in Bali.

Then sales drop. So you cut your price 10 percent to $900. Profit slides to $150 per unit. That's a 40 percent drop -- and now the leverage kicks in with a vengeance. You have to sell 27 widgets at the new price or earn less than your previous $4,000. Unless the 10 percent discount pulls in 69 percent more orders, your next vacation will involve driving to Peoria to visit the in-laws.

Because of the devastation price cuts can make on profits, most entrepreneurs are better off embracing other strategies such as bundling, differentiating or repositioning. Consider a creative example such as Salesforce.com's new 99 cents-per-login deal to get people to try its hosted software offering. After a year at the introductory price, it jumps to $5. Do the math on that and see what happens to profits. And if a customer looks likely to jump ship to a budget brand, consider trying something besides cutting prices, including just letting them go. But do it before lunch.