Loss leader pricing is the practice of selling a small number of products either at or below cost. This is done on the assumption that buyers will purchase other products at the same time that are considerably more profitable. The resulting combined sale transaction is assumed (or hoped) to be profitable.
The loss leader concept can be used to bring customers into a physical store location or to access a website - in either case, selected merchandise that is much more profitable will be positioned near the loss leader product, so that buyers have every opportunity to make additional purchases.
Correct merchandising is a key part of the use of loss leaders, so that buyers must walk past many other items in a store before finding the loss leader item. Conversely, inadequate merchandising would place these items near the front of a store, where someone could buy them and proceed directly to the cash register without purchasing anything else.
The concept can also be used to attract entirely new customers. In this case, the assumption may be that the seller will initially incur a loss, but will earn a profit in aggregate over the course of several subsequent purchase transactions.
Example of Loss Leader Pricing
One of the heaviest users of loss leader pricing is grocery stores, which routinely advertise low prices on selected items. This practice is also used by the manufacturers of ink jet printers, as well as a variety of stores just before Christmas, when they advertise deep discounts for early-morning shoppers.
Advantages of Loss Leader Pricing
The following are advantages to using the loss leader pricing method:
- Sales increase. When buyers purchase other items in addition to the loss leader, the seller can make a larger profit than would have been the case if it had not offered the loss leader.
- New stores. Loss leader pricing is an excellent way to attract shoppers to a new location, since they might otherwise never enter the store, but will do so to take advantage of a particular pricing deal. Thus, it can be used to build a customer base.
- Merchandise elimination. The strategy can be used to clear out older merchandise, so the seller can restock its warehouse with newer products.
- Marketing. Loss leader pricing is an alternative form of marketing, where the seller is essentially paying customers in the amount of any losses sustained on its loss leader products to enter the company store.
Disadvantages of Loss Leader Pricing
The following are disadvantages of using the loss leader pricing method:
- Risk of loss. A company may incur a substantial loss from this pricing strategy if it does not closely monitor sales of other items positioned alongside the loss leader; the risk is that customers may buy only the loss leader, and in large quantities.
- Stockpiling. If the loss leader price is unusually good, and it is for a necessary item that a consumer may use in bulk, it is possible that each buyer will purchase the largest possible quantity of the item, and then stockpile it for later use. A seller can avoid this issue by limiting purchase quantities or only offering products that have a limited shelf life and which therefore cannot be stockpiled.
- Pricing perception. Retaining a deep discount for too long can give buyers the impression that a product should have a lower price at all times, which can reduce its unit sales once management stops the loss leader promotion and returns the product to its normal price.
Evaluation of Loss Leader Pricing
This is a reasonable and well-tested approach for building traffic to a store or website, but you must monitor it carefully to ensure that it is actually generating an incremental profit, rather than a substantial loss.