Loss Leader Pricing Definition
Loss Leader Pricing is an aggressive strategy of pricing where a business will sell its product at a cost much lower than its market price to attract more customers and eventually account for those losses by selling other additional products to the same set of targeted customer and hence earn the profit in this case and make the business profitable.
Explanation
When a business enters a market this is a very common strategy. The loss leader by making initial losses will first introduce the customers to his product or services and build up a customer base to help the business secure a source of recurring revenue for the future. A loss leader strategy requires a planned execution.
Opponents of this strategy may complain it’s a predatory one and can wipe other businesses out of the market. Considering this loss leader strategy is banned in fifty percentage states of the US and some countries in Europe too. Loss leader strategy is also popular among large companies because they have a wide range of products so if they make losses in a certain segment of the product they make they earn the margin lost from other profitable segments of the product they have. Loss leader strategy is very common in the video games industry where companies offer the consoles at rock bottom prices keeping a very low profit marginProfit MarginProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. read more but equally charge more for the video games by keeping a much higher margin and compensating for the losses.
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Source: Loss Leader Pricing (wallstreetmojo.com)
Purpose
- The prime purpose of loss leader pricing is to gain market penetrationMarket PenetrationMarket penetration is calculated as how much the product or service is being used compared to its total market and how it creates a position in the market, especially in the primary stages of setting up the business.read more and attain a customer base.
- The strategy is mainly targeted to attract customers to the business by using price as a weapon to fight competitors.
- It is aimed at targeting customers, making them buy their product, spread through a word of mouth pattern, retain the customers and eventually sell them other products or complimentary products by keeping a higher profit margin. Thus what the business is doing is that first selling certain products at zero or negative profit margin and afterward selling some other products at a much higher profit margin to compensate for the initial losses made.
- This strategy needs to be properly executed as it may lead to the bankruptcy of the business if there is no proper business model or planning.
- The main purpose of this strategy is to draw more traffic from the competitors and in this way generate more sales.
- This strategy works best in the way of introducing the customer the cheapest product or services with the hope of building a bigger customer base and generating recurring revenueRecurring RevenueRecurring Revenue is a part of the Company’s total revenue or income constantly generated in the future at regular intervals (monthly or yearly). This type of revenue is relatively stable as you can predict its occurrence with reasonable confidence. read more in the future.
How does Loss Leader Pricing Work?
The strategy works with the sole aim of building a customer base by selling few products at a zero or negative margin initially and then generating recurring revenue by selling other products or complementary products to the same set of customers in near future. This strategy is a very common fact in the razor industry where the razors are sold at rock bottom prices but in the same way, the company makes up for the moss or earn even more profit margin by the sale of blades associated with the razor to customers on a repeated basis.
So this strategy is designed to woo customers from the competitors using price as a weapon and then building up a customer base and generating future recurring revenues. At times pricing a product at a loss can eventually lead to profit if the customer can be influenced or persuaded to buy other items at a higher margin during the same shopping trip. Thus, this depends on how the business markets its loss-making product and in the same way market other products which can help to compensate for the initial loss made.
Examples
Below are the examples of Loss Leader Pricing –
Example #1 – Microsoft X-Box Gaming Console
Microsoft launched its gaming console X-Box by keeping a very low margin of profit on it to give a competition to already established players in the market Sony Play-station. They designed the pricing in such a way that customers were bound to purchase the console as it was available so cheaply. But, that was not the end of the story as the console was useless without games. Here is where Microsoft played their card by pricing their games at a higher margin and make up for the losses they made during the sale of consoles.
Example #2 – Gillette Razors
A very popular example that comes in mind for every loss leader strategy is the world-famous razor makers Gillette. Gillette initially sold its razor at rock bottom prices. They were selling their mechanical or basic razors at a much lower cost than their competitors calling it an introductory offer to get hold of a bigger customer base. Eventually, a razor needs blades and requires a constant change of the blades after some usage. This is where Gillette made up for the losses and eventually earned a higher profit margin as Gillette blades were of enhanced quality and thus a bit expensive too. Customers thus who had already bought a Gillette razor preferred to use the company blade itself and in this way Gillette earned both customer base and profitability.
Loss Leader Price Advantages and Disadvantages
Advantages
- It helps the business to eliminate the competitors using the price as the weapon.
- It is a very proven way to attract and build a customer base as customers are price sensitive.
- It can be useful to help the business not just sell a single product but also related or complementary products.
- This strategy is one of the most effective strategies for new business entrants to penetrate the market.
- Customers can enjoy some cheap deals and make a lot of savings in the same process.
- Loss leader pricing is an alternate form of marketing strategy where the seller is paying the customers by the losses it incurs to enter the store or try their products.
- The seller can use this strategy to clear out old merchandise and restock the store with a newer product.
Disadvantages
- It can disrupt the industry by eliminating other competitors using price as the factor.
- The strategy requires proper execution others may lead to the bankruptcy of the business.
- Pricing perception can because of major worry as the customer expects the product to be priced the same way forever and any change to the price impact consumer behavior.
- If the business is applying this strategy on a necessary good the problems of stockpiling may occur where customers may buy all the products at once and stockpile it for future use.
- Cherry-picking may be an issue which means customers buy only the loss-making product and leave the store without buying any product which will make the business earn profit.
Conclusion
Loss leader pricing is a very effective strategy for new entrants to penetrate the market. However, saying that it also requires proper execution and planning otherwise it may lead the business to bankruptcy. At times it is really good for customers to find such high discounted deals but the business should keep in mind that the ultimate motive of the same is customer base building and eventually retaining the same customers.
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This has been a guide to Loss Leader Pricing and its definition. Here we discuss the purpose, examples of loss leader pricing along with its working, advantages, and disadvantages. You may refer to the following articles to learn more about finance –
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