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Loss leader

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For other pricing strategies and policies see: Pricing strategies.

In marketing, a loss leader (also called a key value item in the United Kingdom) is an item that is sold below cost in an effort to stimulate other, profitable sales. It is a kind of sales promotion. There are several varieties of this technique which was pioneered by Thomas Edison in the early 1880s.

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[edit] Sales of other items in the same visit

One use of a loss leader is to draw customers into a store where they are likely to buy other goods. The vendor expects that the typical customer will purchase other items at the same time as the loss leader and that the profit made on these items will be such that an overall profit is generated for the vendor. Marketing academics such as [1] have shown that retailers should take both the direct and indirect effect of substantial price promotions into account when evaluating their impact on profitability. To make a very precise analysis (see [2]), one should also include effects over time (deep price promotions may induce stockpiling effects, ...), which may invalidate the effect of such product associations, typically discovered by association rule analysis.

An example would be a supermarket selling sugar or milk at less than cost to draw customers to that particular supermarket chain. Wal-Mart uses some toys as loss leaders, leading to the potential demise of toy-only competitors such as Toys "Я" Us and FAO Schwarz. (See predatory pricing.)

Automobile dealerships also use this practice, offering a "1 only at this price" vehicle below cost in a newspaper ad. Potential buyers are usually told that the vehicle has been sold (which may or may not be true) and the salesperson then tries to sell another vehicle at a profit. The loss leader vehicle is never in a conspicuous place, and may even be on an off-site lot.

Under some jurisdictions, this is considered bait and switch and is illegal.

A related example is the practice by some auto repair shops of offering required inspections at loss-leader prices; if a problem is found preventing the inspection from being passed, they are then in an excellent position to offer to repair it.

[edit] Characteristics of loss leaders

  • A loss leader is often placed at the back of a store, so that purchasers must walk past racks of other displayed goods which have higher profit margins.
  • A loss leader is usually a product that customers purchase frequently—thus they are aware of the usual price and that the offered price is a bargain.
  • Items offered as loss leaders are often bulky or perishable, which discourages stockpiling by customers. Since is it impractical for customers to buy in bulk, they are compelled to make repeat visits to the shop.
  • In some cases, loss leaders are placed on the floor or left dirty, scratched, or broken so potential customers get additional enticement to buy the "step-up" model.

[edit] Sales of related items over time

This is also known as the razor and blades business model, referring to the most famous example. Razor handles are sold at a loss, but sales of disposable razor blades are very profitable. American businessman King Gillette famously invented this business model, in which safety razors were sold or even given away as loss leaders so that his company could profit by selling disposable razor blades.

This practice is commonly used with video game console makers that sell their console units at very low margins, or even at a loss, to achieve a higher market share. They rely on profits from software sales where the markups are considerably higher. They also receive profits from third party software companies for licensing fees. Microsoft has used this technique with the Xbox and Xbox 360. Sony has done the same with the PlayStation 3 and, to a lesser extent, with the PlayStation 2 and PSP.[citation needed] This also translates to higher prices that are charged for the games and for original console accessories such as game controllers.

Inkjet printers are also often sold to retail customers as loss leaders. Again, the printers, especially the entry-level models, are sold at a loss-leading price which seems apparently affordable to most consumers, but they pay dearly for ink cartridges and specialty papers supplied by the manufacturer. This is augmented by clauses in the printer's warranty that use of cartridges not supplied by the manufacturer may damage the printer or void the warranty.[citation needed] Some manufacturers even use technological limitations so that the printer doesn't work if it is used with aftermarket cartridges.

Similarly, some bars or concession stands will offer free or inexpensive popcorn, then sell drinks at high prices to customers made thirsty by the popcorn.

Dealers who normally use "fruitshop"-style trading methods, stocking small quantities of a variety of products, cannot compete with loss leaders by negotiating to buy larger quantities of consumables at a lower price, since they would still have to sell at a loss to be competitive.

Loss leaders can be an important part of companies' marketing and sales strategies.

[edit] History

This business model was pioneered by Thomas Edison in the early 1880s shortly after he patented the first production incandescent lamp in 1879. The lamps were costing him $1.25 each to make and he offered to make them at $0.40 if the Edison Light Company would buy all their requirements from him during the life of the patent. In Edison's words, according to Henry Ford who later wrote about it:

The first year the lamps cost us about a dollar and ten cents each. We sold them for forty cents; but there were only about twenty or thirty thousand of them. The next year they cost us about seventy cents, and we sold them for forty. There were a good many, and we lost more money the second year than the first. The third year I succeeded in getting up machinery and in changing the processes, until it got down to so that they cost somewhere around fifty cents. I still sold them for forty cents, and lost more money that year than any other, because the sales were increasing rapidly. The fourth year I got it down to thirty-seven cents, and I made up all the money in one year that I had lost previously. I finally got it down to twenty-two cents, and sold them for forty cents; and they were made by the million. Whereupon the Wall Street people thought it was a lucrative business, so they concluded they would like to have it, and bought us out.[citation needed]

Ford found this principle of manufacturing to be "most valuable".

[edit] Temporary promotions

Loss leaders can also be attempts to build a customer relationship. For example, a grand opening sale at a new store might lose money in hopes of creating customer interest and building customer loyalty. A new restaurant may serve larger or higher quality meals during its first couple of weeks of business than it plans on doing in the future. The high value meals act as loss leaders, creating a marketing buzz.

[edit] Low margin products

Some products are sold at very low profit margins, generating only minimal profit for the company. The reasoning is the same as the reasoning behind loss leaders. Technically, these products are not loss leaders because they do not generate a loss. Examples of these include:

  • The Wendy's fast-food chain has a "value menu" of low-priced items to draw customers to the restaurant, where they may decide instead to buy higher-priced sandwiches (or may buy sodas, whose true cost to the restaurant is minimal).
  • Convenience stores that sell gasoline often do so at very low margins, relying for profits on increased sales of snacks and coffee to stopping motorists. Competition for gasoline prices, especially in urban areas, is intense (especially since the prices are often readily visible to passing motorists) and as such it is hard to make a significant profit on selling gasoline.
  • Retail music sales has always generally been viewed as being a low margin category, with this becoming even more evident with the advent of digital file-sharing. As a result, some Internet-based music stores, most notably Apple's iTunes Store, also operate at low margins, with the possible intent of increasing sales of electronic devices such as the iPod.
  • Movie theaters often make almost no money on tickets—ticket sales are largely passed on to the distributor. Theaters generate revenue by selling popcorn, candy, and drinks.

[edit] References

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