Straight Talk About Loss Leaders

And What About Amazon?

As a professional pricer, I spend a lot of time talking about profit:

“We are not in business to make revenue, we are in business to make profit.”

“Revenue without profit is empty calories.”

“You think you can buy market share with low prices, but you’re not buying it, you’re renting it. That market share will go away as soon as you try to profit.”

Invariably the question comes up: What about loss leaders?

And if I say something negative about loss leaders, the response comes back: Isn’t that how Amazon got so big?

So let’s talk about loss leaders and when they make sense for a business. And then we’ll talk about Amazon.

The business argument for loss leaders is that there are certain items which customers use to decide where to do their business, and if you can win on price with those items, you will get the entirety of that customer’s business.

The classic example is that many customers decide which grocery store to shop at based on the price of milk or eggs or some other basic weekly purchase.

Grocery stores would sell milk at cost, or even at a loss, and advertise that price in order to get customers to do their weekly shopping at that store. If a customer comes in to buy $1.99/gal milk (which the store is losing $0.50/gal on) and buys three gallons of milk, but also buys $200 of other groceries at an average gross margin of 20%, the $1.50 loss on the milk will be made up for by the $40 profit on everything else.

The grocery business is a volume business. If they can capture more shoppers this week with a low milk price, and if people buy other items besides that discount milk, the profit on those extra visits will help the grocery store cover its fixed expenses like rent and wages.

When I managed pricing for Scotts Miracle-Gro, we would see sales each year in the spring when retailers like Home Depot or Lowes would offer products like bagged mulch at discounts such as 5-for-$10. These discounts priced the mulch below the wholesale price at which they purchased. However, they believed that if a customer came to a particular store to make their big spring garden supplies purchase, not only would they buy other profitable products like shovels, hoses, pots, plants, etc., but also they would continue to choose that store through the rest of the season. If you bought your mulch at a particular Home Depot in March, you’d come back to that same store to buy lumber and paint during the summer and leaf bags and rakes in the fall.

Even business to business salesmen are often tempted by the idea of “door opener” loss leader pricing. Maybe if they can get into an account with super low prices, they can then make the account profitable later.

So is any of this a good idea?

As with so many things, the answer is: It depends.

If it is true that the loss leader brings in customers who would otherwise not have bought from you, and if it is true that those customers as a result bought a number of additional items which were profitable, then having a loss leader strategy can work to increase your total revenue and profit.

However, it’s important to look very carefully at whether the loss leader is actually resulting in increased sales of other, profitable items.

Often, especially in big sales events such as Black Friday, customers show up simply to buy the discounted item.

If a store offers a digital SLR or a big screen TV below cost for a major sales event, and the result is that a lot of customers come in and buy just that one thing, the retailer has spent a bunch of money to drive news headlines and drain their customer’s wallets without actually making any money.

Similarly, if a grocery store is offering milk at a loss in order to bring in additional customers, their pricing and promotions team had better be running analysis to see if there are actually additional customers coming in and buying whole carts of groceries along with the milk. If the result is that the same customers as usual come in, but they buy one or two extra gallons of milk this week and less next week, you haven’t accomplished anything with your sale.

The loss leader or “door opener” approach becomes even more questionable when it comes to the business to business world.

I am often asked at work: “Shouldn’t we be willing to sell a few very common products at a loss in order to get in the door with price conscious customers?”

The question is, what will we do with those price conscious customers once we are in the door. If they are truly price conscious, they are not going to want to move on from buying that one product below our cost to buying others at healthy margins. They will buy that one product from us and either demand low prices on additional products or go to our competitors to get “door opener” prices on other items.

There may be exceptions. Perhaps you sell a customer one very common item at a money-losing price, and because that customer has selected you for that product, they also buy a large number of more specialized products on which you make money. If that is true, you may make money on the customer, and perhaps the “door opener” strategy worked.

But in general, the doors you open with below-cost prices are doors that only contain other low-ball offers. A customer who is not willing to pay you enough for your products for you to make a profit is a customer who does not value what your company is offering. You may just not be a good fit with that customer. They may be better off buying from another vendor who offers lower quality or less service because this customer simply doesn’t need those things.

All right, fine, so there are a lot of pitfalls in pricing products below cost to win new business. But what about Amazon? Didn’t they get where they are today by spending years selling below cost?

It’s not as simple as many think.

Take a look at this table from Amazon’s 1999 Annual Report.

The first line shows Amazon’s sales in thousands from 1995 to 1999, the period during which Amazon’s revenue went from $500k to $1.6B. The second line shows the cost of the goods sold, and the third line shows their gross profit on those sales.

Amazon showed a gross profit of roughly 20% each of those years.

While they may have occasionally lost money on individual items, they very much did price at a level to make money on the items they sold even in those early years of hyper growth.

What caused Amazon to lose money throughout its early years is that it used the capital it had access to and took the opportunity to spend more on building its operations than its revenue alone could have supported.

Amazon lost money because they were both selling at the relatively low gross margins of a mass market retailer such as Kroger or Walmart, and also building out the marketing and infrastructure which would allow it to thrive as an online retailer.

A company cannot normally sell at prices that are not high enough to pay for their operational expenses. Certainly, they cannot do so indefinitely (and Amazon didn’t.)

But in a new-growth situation such as Amazon was in, selling at slimmer margins and building out operations at a loss was a way for the company to grow rapidly.

However, Amazon was and remains reluctant to sell products below their cost. Indeed, when I dealt with selling Scotts Miracle-Gro products through Amazon, they would routinely deactivate products on their Can’t Realize A Profit (CRAP) list: products which Amazon could not afford to sell at market prices while meeting all warehousing and shipping expenses, given the wholesale price the supplier was offering. They would then ask us to cut our wholesale price to them, or else they would refuse to sell the product anymore.

Companies deciding how to price their products can definitely take Amazon’s example into account. Are they currently in a growth mode where it might make sense to sell a product at a price which does not cover the company’s full cost of operations, in the belief that by growing quickly and being known for low prices, the company could reach a scale in the future which would make the cost of operations affordable at that price level?

If so, feel free to imitate Amazon.

Sometimes a manufacturer might even sell a product for less than it costs to produce, because they know that if they can sell a high enough volume of the product, the cost per product will drop enough to make it profitable.

But again, if a company does not have a clear plan for how volume or scale will make their sales profitable in the future, they will not end up like Amazon but rather like any number of companies which grew while they were trendy but then crashed when it became clear they had not path to profitability.

---

If you enjoyed this piece and would like to read weekly pricing insights in your inbox or the Substack app, please subscribe.

There’s currently no cost, and when I do launch paid subscriptions you will still be able to access all articles free. I will never paywall these weekly articles.

If you think others you know would be interested in reading PricingEvolution, please share it with them.