Selecting a Loss Leader
February is upon us, and we all know what that means. The holiday spirit is overtaking public consciousness and causing people to write cheesy poems for their loved ones.
That's right. February is Haiku Writing Month, and we all need to do our part.
Here's one that I recently penned:
You see customers Maybe they will buy your goods If the price is right
Pricing Question from a Reader
My company is planning to start using loss leaders. Unfortunately, none of my fellow coworkers has much experience with them. What types of products should we select?
A warning about loss leaders
I'm usually hesitant to recommend the use of loss leaders, because they are often perceived as an admission that you need to compete on price. Using them may serve to attract price-sensitive bottom feeders and repel buyers (existing and potential) who focus upon other criteria for their buying decisions. In addition, the use of loss leaders may train customers to buy from you only when you price your offerings at unsustainably low levels.
That said, sometimes loss leaders can work unbelievably well. As you consider your strategy, you'll want to make sure that your loss-leader strategy will:
- Increase the odds that customers will buy other products that generate profit.
- Minimize the odds that customers will buy only loss leaders. Remember, there are many people who are unashamed to buy a loss leader and nothing else.
Factors that make for good loss leaders
The proper design and effectiveness of a loss-leader strategy is highly dependent upon your individual circumstances. Here are some rules of thumb that often apply. Do remember, however, that a strategy that results in substantial profits for one firm may result in incalculable losses for another.
- Products that consumers have a burning desire to acquire in the short-term - There's a reason why few companies offer thumbtacks as loss leaders. Thumbtacks just don't address a burning need or generate a sufficiently high level of excitement to incentivize an immediate purchase. Remember, if a loss leader doesn't cause a potential buyer to take uncharacteristic action, it's not leading to increased revenues; it's just leading to unnecessary reductions in profit.
- Products that build addictive habits - If use of a given product is associated with a high likelihood of future purchases, it may make sense to do whatever one can to make that first sale. This is true for physically addictive products (tobacco, alcohol, and drugs), as well as for many non-addictive goods (medical checkups, online services, and video game content). Many vendors of said products will provide a small number of items at reduced cost for each buyer in order to induce a buying habit of the particular product from the particular vendor.
- Products that allow for up-sells - Many items are particularly inexpensive in their most basic form, but rise significantly in cost when they are modified. For instance, restaurants often sell pizza for a relatively low price, only to charge quite a bit for toppings that were inexpensive for them to acquire. Many service firms provide low-cost initial consultations in order to increase the likelihood of selling follow-on services with hefty price tags.
- Products that are non-durable and non-transferable - Items such as dairy cream and dancing lessons cannot be stockpiled by consumers or resold on the secondary market. Vendors will find that hoarders and scalpers will often be ready to purchase loss leaders in bulk but make little in the way of additional purchases.
- Products that are strongly associated with a particular vendor - A loss leader in this category may result in brand loyalty or free advertising to other potential customers. For instance, the Hess toy trucks served as a powerful tool for building brand awareness. Logoed shirts, class field trips, and key chains have the potential to serve similar functions. Even electronic newsletters that offer advice and demonstrate domain knowledge like this one can work quite well (and scale beautifully as well).
- Products with strong complements - There are many products that are rarely purchased or used without an accompanying complement. The classic example of this has long been the hot dog and its bun, though the increasing popularity of the Atkins and gluten-free movements are reducing the strength of that particular bond. Ideally, the complement will be difficult or costly for consumers to acquire from other sources. In the world of physical goods, this method is known as the razor and blades method. Should the complement be high-touch in nature (such as a regular service contract), there may be opportunities for additional up-sells as well.
- Products with recurring charges and high switching costs - If an offering has a recurring cost to consumers and a high degree of lock-in, then it will often make sense to offer a limited period of discounted or even free access before raising rates. This will attract customers who can't think long-term (such as those with poor cash flow), as well those who don't think long-term (those who are unable to delay gratification).
- Products with prices that are well known to buyers - Almost everyone knows the going rate for a handful of products like gasoline and milk, but few know the price of truffle oil and cast-iron pans. As a result, discounts on the former will be far more likely to be recognized and acted upon by the average buyer.
Other considerations for loss leaders
Selecting the products to use as loss leaders is only half of the battle. It's also important to ensure that they are used effectively.
The following tips will help to ensure that you don't lose your shirt in the process:
- Create forced bundles - Requiring the purchase of a high-profit item can eliminate any potential for loss. Cell phone companies routinely advertise heavily discounted phones that are only available with the purchase of outrageously overpriced service contracts.
- Limit the availability of loss leaders to ideal customers - Access to loss leaders can be limited via loyalty programs, targeted direct mailings, or geographically-limited offers.
- Increase the difficulty for customers to acquire loss leaders - Just because a loss leader is being offered, there is no reason to make it easy to obtain by desiring customers. Restaurant owners who offer buffets often place the most expensive items toward the ends of their tables. This ensures that customers' plates will have little remaining room to hold them.
- Enforce quantity limitations - Many advertisements featuring low-priced products include fine print stating that quantities are exceedingly limited (the products under such a scheme are often referred to as doorbusters). Rather than limiting the total number of items that may be sold to customers, some firms choose to restrict the number of items that any given customer is allowed to purchase. This approach may appear to be much more fair, but it may push some devious individuals to enlist the aid of straw purchasers. Remember that quantity limitations need not be explicit. Many buffets, for instance, use smaller serving platters, plates, and utensils to subconsciously reduce customers' desires for seconds.
- Offer financing - A discount advertised for an expensive item can be more than made up for through the addition of fees, surcharges, and interest charges for customers who cannot afford them with cash on hand. It should be noted that the financing offers need not affect a firm's cash flow as loans can often be sold on the secondary market.
Using loss leaders is, in many ways, like playing with fire. You're awfully likely to get burned. Nevertheless, they can, and do, work wonders when used properly. Just make sure that you have a good reason for using loss leaders, understand your risks, and analyze your results on a recurring basis.
Questions come from readers like you. If you'd like your questions answered, send them my way.
♫This Q&A and many others are now available on the Pricing After Dark podcast.
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Notable Pricing Quote
"Why is electricity so expensive these days? Why does it cost so much for something that I can make with a balloon and my hair?" -- Dennis Miller
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