If you’ve worked in the retail industry, you’ve probably heard the term ‘loss leader’ before. So, what is a loss leader, and when should this type of strategy be used? Here’s a closer look at how loss leaders work.
Loss leaders explained
When you intentionally sell a product below its market cost as part of your pricing strategy, it’s called a loss leader. Loss leader pricing is used to stimulate sales of more profitable products or services. The theory behind this type of strategy is that small initial losses can often lead to greater profits.
Why would a business choose to sell products at a loss? They primarily do this to attract new customers and stand out from competitors. Here are a few examples:
A supermarket sells everyday staple products like milk and eggs as loss leader items to entice customers. Customers enter, attracted by the low prices on these staples. While browsing, they’re likely to purchase additional, more profitable products which puts the supermarket ahead.
Lenders also often use a loss leader strategy. For example, a credit card company might offer low introductory rates to entice new clients to sign up for a card. After the introductory period, interest rates increase.
Deeply discounted promotions like Black Friday sales are a further example of the loss leader strategy in action. Customers are attracted to the below-market cost deals, but often end up purchasing more as a result.
When should you sell loss leader items?
The overall purpose of loss leader pricing is to generate revenue and increase profit margins. But there are some circumstances in which this type of strategy makes more sense than others.
1. Your business has excess inventory to unload.
End-of-season clearance sales are stocked with loss leader items. At the end of summer, homewares retailers need to unload barbecues and outdoor pizza ovens. Once January arrives, shops have leftover Christmas stock they need to get rid of to make room for the new season. This is a great time to employ loss leader pricing, because it not only clears your inventory but also attracts customers to your shop or website.
2. You have perishable items to sell.
A similar principle crops up when it comes to perishable items. If you don’t sell them in time, they’ll be thrown out. It’s better to make some profit if you can, even if it’s at a loss in comparison to original market value. At the same time, you can direct customers to additional items in your store.
3. You’re launching a new business.
It’s very common for start-ups to offer special promotions as part of their launch. A loss leader strategy is also sometimes called penetration pricing because it gives businesses a way to penetrate a market. Drive up demand for your services or products with introductory deals showcasing your loss leader items. Grocery store samples and introductory broadband rates are examples of this strategy.
Disadvantages of loss leaders
While it certainly has its uses, loss leader pricing should be approached with caution. There is an inherent risk that your customers will purchase your loss leader items without buying anything else. It’s important to closely monitor your other sales to see if the strategy is working.
Another risk is running out of stock. Do you have enough loss leader items to offer them at such a deep discount? Finally, think about whether or not you will be able to eventually raise the price of your loss leader items. After a certain amount of time, customers will associate them with lower prices. If the price goes up, customers might avoid the store altogether.
The bottom line
Due to the challenges mentioned above, larger businesses are better able to manage the inherent risks of a loss leader pricing strategy. They can purchase stock in higher volumes to negotiate lower market costs and afford to take a temporary hit for wider financial gain.
But while it’s harder for small businesses to compete, strategically employing loss leaders can still pay off. The key is to take care with pricing, ensuring that you’re able to recover any losses over time.
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