What’s it: Loss leader pricing refers to a pricing strategy when a company aggressively discounts the price to stimulate sales. In fact, the company posted a loss for loss leader products when adopting this approach.
Profits and overall success depend on the company’s ability to encourage customers to buy other, higher-priced products. If successful in doing so, the company can maintain overall profits.
Loss leader pricing is also called predatory pricing if it is more aggressive. In this case, the company sets the selling price below average cost and incurs the loss. Its primary purpose is to remove competitors from the market. If successful, the company will enjoy monopoly power.
Reasons for loss leader pricing
You can find examples of loss leader pricing in the retail industry. Companies like Amazon and Walmart are adopting this strategy. By charging low prices, they expect more visitors to the retail store. The more visitors, the higher their chance of buying other higher-margin products.
For example, retail clothing provides lower sales prices for some brands. For other brands, they may increase the price a little or keep it at its current price. When visitors enter the store, the retailer directs them to the non-discounted brand.
Consideration factors in adopting price leader pricing
The success of loss leader pricing depends on:
- The price elasticity of demand. Discounted products should be elastic. In this case, the customer is responsive to price changes. When the price falls, say 5%, it will result in an increase in demand of more than 5%.
- The company’s ability to shift attention to other, higher-margin products. It’s crucial to maintain overall profits. Sales of higher-priced products compensate for the loss leader products. For example, retailers may place higher-margin products near loss leaders, encouraging impulse purchases by customers.
- Product life cycle. Loss leaders are a common practice when a business first enters the market. And this strategy is somewhat similar to price penetration. The company introduces new products to the market in hopes of building a customer base. The company can then increase the selling price when its market position becomes stronger.
Selectivity in choosing loss leader products
Companies should be selective in choosing which products to discount. Among the possible options are:
- High build-up products. They may not sell well and accumulate in the warehouse. Low prices will increase their turnover and lower costs associated with warehouse management.
- Products that have high-margin complements. When buying, companies expect customers to buy complementary products. That way, complementary product margins can subsidize discounted product profit margins.
- Short useful life products. They run out quickly, and therefore, customers will likely buy them regularly.
Advantages and disadvantages of loss leader pricing
The loss leader pricing strategy involves the pros and cons. It is essential to increase short-term sales, reduce inventory costs, and maximize overall profit.
However, challenges also arise. Customers may not be willing to buy other, higher-margin products. They will probably only buy up discounted products.
Advantages of loss leader pricing
Companies can take some short-term benefits by adopting a loss leader approach.
The first is a higher sales volume. It’s not just for discounted products, but other, higher-margin products. The more customers visit the store, the greater the chance to increase the overall sales volume.
The second is an increase in overall profits. Companies can encourage consumers to buy other goods. The higher-margin product compensates for the loss leader product. Combined with an increase in sales volume, that ultimately leads to higher overall profits. Of course, in this case, the company must have multiple product lines.
The third is an increase in market share. Low prices are a powerful weapon for increasing sales and stealing customers from competitors. That way, the company can improve its market position.
The fourth is the savings in advertising costs. Low prices usually entail lower promotional costs. Companies don’t need to customize marketing messages to accentuate product quality. Also, low prices typically encourage word of mouth promotion among consumers.
The fifth is a reduction in warehouse costs. Higher sales volume increases product turnover. The company can clean up old merchandise and replenish it with newer products.
Disadvantages of loss leader pricing
A loss leader pricing strategy is unsuitable if the business aims to generate long-term profits. It’s hard to be sure customers will buy a higher margin product.
Competitors can adopt the same strategy. It can lead to price wars, which threaten the profits of all players in the market.
Well, I will discuss some of the disadvantages of loss leader pricing.
First is possibly low repeat purchases. Customers may buy bulk to take advantage of the sizeable discounts. That way, they have some stocks at home and no longer purchase products at a later date.
Second, customers only buy products at a discount, instead of purchasing higher-margin products. That ultimately increases the company’s losses. Additionally, companies may face more significant stockpiles for higher-margin products.
Fourth, loss leader pricing weakens the company’s brand image. Customers expect to purchase a lower price at any time because they expect companies to hold on to it for a longer time. If the company suddenly stops the loss leader, they are disappointed with the company.
Also, lowering prices aggressively gives the impression of a low-quality product. Instead of buying, they prefer alternative products.
Fifth, loss leader pricing can jeopardize long-term relationships with stakeholders in the supply chain. Suppliers may be forced to keep prices low, following loss leaders. If profit pressure is higher, suppliers may prefer to sell products to competitors and get better profit margins.
Sixth, this strategy is illegal in some jurisdictions because it violates antitrust practices. Critics argue this strategy can bankrupt competitors and exit the market. It will increase the monopoly power of the loss leader. And, such anti-competitive behavior will usually receive tighter scrutiny from the authorities.