Slashing the Official Cash Rate has got to be good for business…..

Comment and review – Matthew Bellingham

Yesterday the Official Cash Rate (OCR) was slashed by 150 base points (1.5%) from 6.5% down to 5% by the Reserve Bank Governor Allan Bollard.

There has been speculation over the past week with many initially expecting a drop of 100 base points. In the last few days the common expectation appeared to have shifted to a likely 150 base points which puts interest rates at a 5 year low.

The move has broken records for the largest drop since the OCR was introduced in 1999.

Banks have started to reduce their interest rates accordingly with Alan Bollard directly pushing for this outcome quickly;

“To ensure the response we are seeking, we expect financial institutions to play their part in the economic adjustment process by passing on lower wholesale interest rates to their customers.”

Dr Bollard also commented that “ongoing financial market turmoil and the marked deterioration in the outlook for global growth have played a large role in shaping today’s decision. Activity in most of our trading partners is now expected to contract or grow only very slowly over the next few quarters”.

The decision brings the cumulative reduction in the OCR since July to 3.25 percent, and takes monetary policy to an expansionary position. Given recent developments in the global economy, the balance of risks to activity and inflation are to the downside. Thus it is appropriate to deliver this reduction quickly to support the economy and keep inflation from falling below the target band.

So what does this mean for the average kiwi small business?  The drop in interest rates will free up disposable cash in the average household, stimulating demand.  That can only be good for SMEs in New Zealand, who have been suffering from declining sales and tightening cash flow.  The drop in interest rates is also likely to assist in keeping the New Zealand dollar low which will give our exporters a much higher return for their offshore sales as global demand for our products improve.  We see this stimulus as a major building block in the road to recovery.

The other extremely positive effect of lower interest rates is the ability for business to invest again.  Decision points become lower, encouraging more capital item investment which improves the economy but more importantly encourages innovation and gains in productivity.  Improving productivity is undoubtedly the key to long term economic growth for New Zealand.

Do we need Government Intervention?

To be frank, we have had considerable government support, with a lot more promised.  On the whole the actions taken by the government have been very positive for the recovery;

·        Government guarantee of deposits
·        Tax cuts
·        Further tax cuts announced
·        Review of the Resource Management Act
·        Significant infrastructure spend

When you combine the interest rate cuts with the central government initiatives announced and in progress, the medium term outlook for SMEs in this country is far better than it was a month ago.

Discounting in Tight Times – Resist the Urge!

Have you ever been driving to work in the morning and heard one of your competitor’s advertising discounted pricing on the radio?  Or have you been driving past your competitors premises and seen a huge sale advertised?  Or even worse, has one of your clients come to you telling you they can get a similar product from you competitor at a drastically reduced rate?  It is very very difficult to resist the urge to race in to your business and immediately cut prices to stay competitive.

The single most overused marketing strategy to bring customers through the door is discounting.  While this can be an effective strategy, for most businesses it generates a price war that they cannot afford to sustain.

We are in tight economic times, and reports are that retailers are not enjoying the traditional peak in Christmas sales.  We have already seen major New Zealand retailers discounting heavily far earlier than in previous years to try and stimulate demand.  The slow down in the retail sector then flows through to all those in the supply chain, and eventually everyone is affected.  The automatic response where the volume of sales drops off is to drop the price of the stock to attract customers. 

There is nothing wrong with discounting strategies if that’s what fits your business.  If you are using it as a strategy to bring in cash flow by clearing obsolete or unwanted stock it may well be a good strategy.  The important thing is to be careful - if you don’t understand the effect that discounting can have then you can cause a disaster in your business and its profitability.  Discounting creates a leverage impact on profits, which means that by discounting you are essentially giving some or all of profits away.  The key is to understand the impact and just how far you can go.

Consider the following examples;

• a business with a 30% gross profit margin who offers a 25% discount (certainly nothing unusual about that in today’s market) requires a 500% increase in sales volume just to maintain its same position – and in almost all cases that’s just not going to happen.  The result generally is the business trading below its breakeven point and generating losses.  And you can only do that for a limited amount of time.
• a business that trades with a 20% gross profit margin and offers a 10% discount needs a 100% increase in sales to maintain position.  Again this will not happen.  In effect the business has just given away a half of its profit and generally for little effect.

How about a different strategy?  If we look at things another way, and actually think about increasing the price rather than discounting.  Using the above example of a 20% gross profit margin, but we increase the price by 10%, sales can afford to drop by 33% before we are any worse off.

The key is that you need to understand the costs within your business and perform a break even analysis prior to making any rash decisions.  You are far better off to think carefully, analyse the numbers and make your calls based on fact rather than gut feel.

Discounting can be an effective strategy, but make sure you are not simply chasing sales at any cost.  For information on how this may affect your business, contact your advisor.