Loss leader pricing strategy is a marketing tactic used by retailers to sell one product at loss (the loss leader) in a hope that it will lead to more traffic and result in higher sales and profits overall.
What is a Loss Leader?
The loss leader is the product that is sold at loss. It is usually a popular product or a basic product that sells in high quantity, so that it can effectively be used to drive a lot traffic to the store. It is different from a normal product that has been discounted to clear its inventory.
A loss leader usually maintains its low price all-year-round, because it is supposed to make this retailer popular for selling this particular product at the lowest price in the market, and so customers who want to shop for this product will prefer this retailer over the competition.
Loss Leader Advantages
Loss leader pricing strategy has been a good marketing tactic for many retailers due to the following reasons:
The main goal of a loss leader is to divert traffic from the competition, using price as a motive. Loss leaders, when implemented & chosen correctly succeed in doing exactly that.
A lot of customers who shop this particular loss leader on a regular basis become loyal to that retailer and use it for all their shopping needs, which is the ultimate goal of such strategy.
Pays for Itself
If implemented correctly, the retailer actually does not lose money by implementing the loss leader strategy. It is more than compensated for by the gross profit from other products and from the higher customer lifetime value achieved from gaining new loyal customers.
Financially speaking this is considered a cost of product (COGS), but in reality it is more of a marketing cost.
Loss Leader Considerations
Having mentioned all the advantages above, we should also note that there are certain considerations to be taken into account before implementing this strategy.
The main goal of this strategy is to drive more customers to your store. However, if this opportunity of having more traffic is not translated in more sales from the higher margin products, it will lead to a loss.
We will explain below how to choose the right products for such a tactic.
Your chosen product should not be controlled by a MSRP (Manufacturer’s Suggested Retail Price), or otherwise you will be violating the terms of the supplier of this product and might lose future supply.
Mental Price Levels
Customers tend to form mental price levels for products, based on what they see at the stores.
Take into consideration, that if you sell a product at a low price for an extended period of time, it will be very difficult to sell it at higher price in the future.
You should also not choose a product that has other variations or attributes (e.g colors) at the store sold at higher price, because this will send a signal that either this product is a low quality or the other variations are overpriced. Again, due to the mental price levels that customers have set in their minds.
Ideally your chosen product will be a unique product, and also you probably intend to use it as a loss leader for good.
Famous Loss Leader Example
Costco’s popular 4.99$ rotisserie chicken is a very famous loss leader example.
We have calculated that Costco loses around 38 cents every time it sells this product. Their CFO mentioned that they don’t mind losing 30 to 40 million $ on gross margin every year by keeping it at this price, and recently the company announced that they have sold more than 90 million pieces in a year.
The company is even standing so strongly behind it, that it is building an entire supply chain around it and taking the operation in house.
So, clearly it has been a great marketing tactic for them and most probably pays for itself.
If we look at the product itself, it is obviously a very popular product (it even has its own Facebook page and followers) that is relevant and appealing to a lot of people.
How to Pick Loss Leaders For Your Retail Store?
Now let’s see how you can pick the right products to use as loss leaders for your own retail store.
1. Analyze Sales and Inventory Reports
Start by looking into your own sales and inventory reports. Then filter by your best selling products in terms of quantity.
Note down your highest selling products, that are also at the lowest price range among your entire portfolio.
2. Pick Good Loss Leader Candidates
Now filter more by products that fit some or all of those criteria
- Low price point
- Popular or essential product (that everyone would want or need)
- No similar products
- High inventory turnover rate
- No MSRP
3. Analyze Transaction Data
Now you will analyze full transaction data for transactions that included those candidates in the last year. You can easily do this by searching by SKU number and filtering all those transactions separately and analyze all the other items that were bought with the candidates.
What you wan to see here is whether or not this product is a good candidate for upselling, cross selling or add-ons. You want to see if this product is usually bought together with other items that actually compliment it.
Remember: The whole idea of a loss leader is to lead to the purchase of other products
4. Choose & Price The Perfect Candidates
Once you have chosen the perfect loss leader (or more than one, if you plan to have one for each category), start working on the perfect price point that would draw customers to you instead of the competition and at the same time doesn’t lose you a lot of money every time the product will be sold (that’s why we have chosen low price level products)
You can use a retail price calculator or retail margin calculator like the above to test different price points and figure out the margin you are comfortable with losing every time you sell this product.
We have attached them, together with other retail math calculators to this article and you can download them from the link below for free.
5. Do The Math
You can estimate the total loss by multiplying the amount (in $) you will lose per piece by the total quantity you expect to sell in a year. You should estimate a higher quantity than your current sales quantity.
We calculated above that the loss per piece is 0.37$
We have been selling 10,000 pieces per year
When we reduce the price we expect to sell 12,000 pieces
So expected loss = 12,000 x 0.37$ = 4440 $
Don’t forget to also account for the opportunity cost of not selling this product at profit. For example, if you have been selling 10,000 pieces at 0.3$ profit, that was 3000$ you were making from this product that will now be gone.
So the amount you are losing here is actually not 4440$, but rather 4440 $ + 3000$ = 7440$
This is the amount you want to recover from the additional sales for this tactic to pay for itself from the beginning, unless you are ready to sacrifice some losses in return for new customers that will pay you down the line over the coming years through their repeated purchases ( a marketing cost).
Now using the same rationale, you will estimate how much you will gain from the additional sales that will come from the products accompanying this product and see if it will be more than the amount you are losing. This will depend on the transaction analysis you have done in step 3.
And this is how you can create and justify a loss leader pricing strategy.
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