Common sense tells business owners that the way to make money is to sell products for more than it costs to make them. But like any rule, there are exceptions. Loss leader pricing is one of them. This strategy prices a specific product at an extremely attractive price, one that may not even cover the cost of goods sold for the seller. The expectation is that buyers of the loss leader product will also purchase additional goods and services where the business will make a healthy profit. The gain on these additional sales more than offsets the loss on the loss leader. Beyond the anticipated increase in sales, loss leader pricing can also drive new customers to your business, increase viral marketing and help sell excess inventory.
The loss leader strategy works across multiple sectors:
- Retailers use it with obsolete or slow-moving inventory;
- Food service companies offer discounted prices on certain appetizers or 2-for-1 meal offers;
- Healthcare providers offer certain popular screening tests at loss leader prices; and
- Service providers use it with initial audits or diagnostic exams.
Loss leader pricing should be used on commodity products or on products that are approaching the end of their product cycle. It should not be used on new, innovative products. By using a loss leader strategy on new products, you are sacrificing the best opportunity to make your highest margins. When a product is new, demand will be high. The early adopters of your new product are not going to be very sensitive to pricing. It would be a waste to sacrifice this opportunity with a loss leader strategy.
You should also think twice about using a loss leader strategy if your company’s cash position is low. If the strategy proves far more successful than you imagined, you may generate too many unprofitable sales. You may need to use your cash reserves to replenish your inventory and continue operating the business.
Risks with loss leader pricing
Like any good pricing strategy, loss leader pricing has some risks. “Cherry picking” occurs when bargain hunters travel from store to store purchasing only loss leader priced products. Many share tips and information via email and online groups to alert other interested consumers to these deals. This undermines the overall profitability of the strategy.
It’s also important not to confuse loss leader pricing with price wars. Sometimes competitors react to loss leader pricing by reducing prices on multiple products. This “mission creep” into overall discounts defeats the purpose of the loss leader strategy. It can make raising prices more difficult in the future as customers become accustomed to the discounted pricing.
Finally, if your plan is to use a loss leader strategy with a branded product provided by a supplier, consider discussing your strategy with them. Some manufacturers have minimums below which their products cannot be sold. This is done to protect the brand and the reputation of the products. Implementing a lower price without informing them first ma result in their refusal to continue doing business with you.
Mike Periu is the founder of EcoFin Media, LLC an independent producer of financial, economic and entrepreneurial content for television, radio, print and the internet. Over the past ten years he has started three companies and advised over 50 companies on financial strategies including fundraising. Mike also hosts regular small business webinars on a range of topics relevant to business owners.