Loss leader pricing: A comprehensive review for startups
If you’ve ever purchased an inkjet printer—and printer ink cartridges—you’ve seen the loss leader pricing strategy in action. Today, inkjet printers seem like a steal due to the industry-wide low prices and frequent sales. Some manufacturers may even include a free ink refill.
At first, this sounds like a great bargain on a necessary business expense for the office. But that’s because the manufacturers aren’t counting on printer sales to generate the bulk of revenue. They’re relying on the ongoing income from your inkjet cartridge purchases for as long as you have your printer. This scenario captures loss leader pricing in a nutshell.
Loss leader pricing is a pricing strategy for firms ranging from new small businesses to trillion-dollar corporations like Amazon. It’s often used by startup founders to stand out from a crowded market and lure customers away from competitors.
In this article, we’ll explain what loss leader pricing is and how it’s practiced in the real world.
Defining loss leader pricing
Loss leader pricing is a marketing strategy that involves selling a product or service at a loss or a narrow margin to increase customer traffic to a business.
The economic philosophy is straightforward: The product or service being sold below the market cost is called a loss leader. Loss leaders—such as an inexpensive phone case or a perishable food item—draw in customers.
When customers buy loss leaders, they’re objectively saving money on goods. The hope is that customers then decide to spend these savings on a few more full-price items while they're shopping your business. This applies whether they're in a physical retail environment or buying online.
The loss leader strategy is even stronger when the sale item is connected with another needed or desired good, especially in a way that’s meaningful to the consumer. Take our inkjet printer scenario. The printer (i.e., the loss leader) simply can't operate without ink cartridges.
For a connection to a desired good, think of items with broad appeal—an item that a customer can easily throw in their cart while shopping. Some examples include a newspaper or candy in the checkout aisle, inexpensive accessories like earphones, or a software feature add-on.
Loss leader pricing is also known as penetration pricing. This strategy is championed by many early-stage startups or companies launching their second product. It allows founders to build a vital customer base until they have a few high-profile clients or methods of winning business on a larger scale.
Loss leader pricing, predatory pricing, and the law
It's important to note the difference between loss leading, which is illegal in 50% of U.S. states, and predatory pricing, which is banned nationwide.
Predatory pricing also involves setting prices low to attract customers, but there's a fundamental difference. Businesses practicing predatory pricing are explicitly trying to prevent competitors from entering their market or eliminating the competition altogether.
As we've covered, the loss leader pricing strategy relies on introducing new customers to a product to secure recurring revenue in the future.
Let’s examine Disney+ as a modern example of using loss leader pricing to enter a new market.
The digital streaming wars as an example of loss leader pricing
Disney reported that 10 million users had signed up for Disney+, the entertainment conglomerate's new streaming service, within a day of launching. But Disney's end goal is 90 million users by 2024. Their game plan? The loss leader strategy.
Disney+ joins the already saturated streaming market, populated by new and established players like Netflix, Amazon Prime Video, HBO Max, and Apple TV+. With around one billion dollars in free cash every quarter, the company has plenty of resources to price its platform aggressively low and shave off some of Netflix's market share.
At $6.99 per month, Disney+ undercuts Netflix's cheapest plan by $2. This is in addition to offering a bundle that includes Hulu and ESPN+, essentially treating both services as supporting loss leaders. Netflix has already lost 1 million subscribers to Disney+ in just a couple of months.
Other examples of loss leader pricing
- Perishable items: Grocery stores often place their loss leaders, such as milk and eggs, at the back of the store. This is in the hopes that customers will grab a few more profitable goods—placed at the ends of aisles—as they walk through the store.
- Seasonal retail clearance: Central to retail business, and even more so with the fast fashion segment, is the constant need to clear inventory. Apparel stores will heavily discount clothes to move product and avoid severe losses on seasonal merchandise.
- Software: Google offers services like Gmail at a loss to remove barriers to customers adopting the entire Google G Suite. Loss leaders might also include premium features such as added storage space and multiple users.
Advantages of loss leader pricing
Loss leader pricing attempts to prove that a low price translates to more sales and customers. Here are some of the growth-oriented benefits that would make a new business consider this strategy.
- Growing customer base: Defenders of loss leader pricing often cite this as one of its strongest aspects. Loss leaders can draw new customers because they’re perceived by consumers as a low-risk, low-cost purchase.
- Increased sales: The combined profits of loss leaders and regular-priced items can result in a significant gain on each transaction. Businesses watch and adjust the margins on loss leaders as they go along.
- Building customer loyalty: Making a discount price exclusive to rewards members may be considered an early win for some startups. Although it's beneficial to capture as many new leads as possible, a loyal customer base spends more and sticks around longer. Gated offers also eliminate the potential negative perception that the lower price is due to poor quality. With a rewards program, the customer feels valued, and the deal appears unique.
- Improved Search Engine Optimization (SEO): Some ecommerce businesses drive traffic to their website by adding popular loss leaders with a high search volume. This allows small online retailers to compete with larger companies and increase their web presence.
Disadvantages of loss leader pricing
Every pricing strategy has its drawbacks. The debate around the ethics and efficacy of loss leading is ongoing. Here are some of the disadvantages that deter new businesses from selecting this strategy.
- Cherry-picking: Cherry pickers are customers who only buy loss leaders and leave full-priced items behind. This is a leading concern for founders implementing the loss leader strategy. Customers may circumvent the plan entirely and simply "cherry-pick" the best offers.
- Stockpiling: Businesses can take a severe loss if customers buy loss leaders in bulk. A maximum purchase amount curtails stockpiling and minimizes the threat of cherry-picking.
- Negative customer perception: Running a discount for too long may cause customers to regard the original pricing with suspicion. They may think of the loss leader price as the regular price—and flock to competitors when the cost inevitably rises.
- Risk of loss: Like any pricing strategy, loss leader pricing is an experiment that business owners must carefully monitor. If loss leader sales do not create a significant increase in the purchase of full-priced goods, it could result in a loss.
A good deal is difficult to resist
The loss leader strategy relies on having the lowest prices on certain goods to incentivize the most consumers. It's a notably aggressive pricing strategy, leading to a ban in a number of U.S. states and some international countries.
For growth-focused businesses, increasing customer traffic has historically outweighed the initial losses and risks of loss leading. But founders who want a sustainable marketing strategy and stable customer base may need to look elsewhere. Like most tools at your disposal, it’s up to you to determine whether loss leading will benefit your business model.