We have all heard the term “loss leader”, and we have all heard someone say, “We’ll make it up on volume.” Most people don’t think about it much, even when we see advertisements indicating a company is selling below cost. During some recent conversations I was asked when, if ever, it makes sense to sell something at a loss. My quick answer was – rarely, but there are occasions when it is a good idea to sell below your cost.
The idea behind a loss leader is it will get customers in the door, and those customers will buy additional, profitable items. One of my favorite examples is turkeys at Thanksgiving. Prices for turkeys are always lower around the holidays, because grocery stores realize most people will buy a turkey for the big day. If the stores can attract the customers with below-cost pricing on the big birds, those buyers are also likely to buy stuffing, cranberries, appetizers, alcohol and many other items at profitable prices. When the stores calculate the profit on the entire basket of products, they make money even though the turkey was sold at a loss.
The broad concept behind a loss leader is the seller will make more than enough profit on ancillary sales to make up for the loss on the main item. We see that same concept applied with things like razors and razor blades, or printers and ink cartridges. While I don’t know the actual production costs of razors or printers, their prices appear quite low compared to the amount spent on blades and ink cartridges over the life of the product. The sellers understand they create a very high probability of future profitable ancillary sales by getting the customers onto their platform.
Another situation where it might make sense to sell below cost is introductory trials. These are designed to give new customers an opportunity to test your product or service and experience the value you bring. We see it in software with two-week trials for free or very low prices, food delivery services like Blue Apron and Hello Fresh, and car services like Uber and Lyft. To be successful, these must be products or services with very high retention rates. That is, you must be very confident that once customers are on your platform they will continue to buy full-price products or services.
You also must be clear in telling the customer it is an introductory price. Customers who believe your trial price is the normal price, will be shocked and angry when you raise the price in the near future. If customers can easily switch from competitor to competitor and there is no particular value to remaining in your network, trial prices are unlikely to succeed.
It may also make sense to sell below cost if doing so can create enough incremental demand to drive down your cost per unit such that the price will become profitable. This can only occur in situations where there is a high fixed cost like buildings and machinery and low variable costs to produce the products or services.
As a hypothetical example, let’s say you have invested $500 million in plant and equipment to produce a splooner, a self-piloting four-person aircraft. It is a highly automated process and each splooner requires only $200 in labor and materials. If you only sell 1,000 splooners, you would need to charge $500,200 each to break even. On the other hand, if that plant and equipment can easily produce 10,000 splooners, your beak-even price drops to $50,200. We can easily imagine many people being willing to pay $100,000 for a self-piloting aircraft. Your first few sales at that price would lose money, but when you produce and sell the higher volume, you will be profitable.
I obviously made up the example, and I don’t believe there is such a thing as a splooner. However, Tesla is following this approach. They have offered the Model 3 for $45,000, which is below their cost. The company is working hard to increase production volumes enough to get their break-even cost down to $35,000 each. It remains to be determined if they will be successful, but it illustrates the approach.
One last example is when you are trying to sell old models, obsolete items, or open-box items. Customers must be persuaded to buy something that is not current or somehow not pristine. That persuasion is usually in the form of a much lower price. Even if that price is less than your cost to acquire the item, it may be the only way to get rid of it.
One of the common arguments I hear from a salesperson is, “We need to give Customer X a low price now to get them to try us.” If the customer situation fits one of the examples above, it may be valid, especially if the customer has never bought from you. However, you should be careful. Some customers are simply price buyers, and they will always be looking for the lowest price. These customers may simply take your trial price for now and buy from someone else if you raise pricing for the next purchase.
Other customers are more relationship buyers, and they are unlikely to switch for your low price. More likely they will share your very low price with their current supplier and try to gain leverage in that relationship. Worse, your competitor may interpret it as greater price competition and start to lower prices to your customers.
Finally, that brings us to the need to understand the implications of considering your cost. Notice in the examples above, customers don’t ask or care about your cost. They care about satisfying a need or want, and they care about solving their problems. They want to do that in a way that delivers them value compared to their next best alternative.
The business must ask, “What costs will I incur because of this sale?” These are your avoidable variable costs. The only time you should consider selling below avoidable variable cost is when there will be significant ancillary sales to provide profit. For old models and obsolete items that will not be reordered or replaced, the money you spent to buy them is sunk and should not impact your decision. If you have already spent money on buildings and machinery, and you cannot easily reduce labor and overhead, those costs are also fixed.
Obviously, you are in business to make money, which includes covering your fixed costs. Ultimately you must be able to sell products that cover your fixed costs, or you need to lower those costs to a level that delivers profit at prices you can sell. That said, there are some situations where it can make sense to sell something below your cost, but make sure you have a pricing strategy that is based on real customer behavior, not hope and myths.
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[…] [2] Francis, S. 2019, “Is Pricing Below Cost Ever a Good Idea?”, Strategic Pricing Solutions, Available here. […]
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