Pricing

Pricing Below Cost: Does it ever make sense?

By Christine Carragee
May 31, 2013

Over Memorial Day weekend I saw this add in my local paper:

Below Cost Sale

The advertisement reminded me of the “Broke” episode of The Office, when Michael meets with an account to review the finances of his paper company.  Michael Scott paper company has been buying market share from Dunder Mifflin by selling below marginal cost.  The accountant explains that “At these prices the more paper you sell, the less you money you make”. At this point Michael asks him to “crunch the numbers again” in hopes of a better outcome.

http://www.youtube.com/watch?v=i0O3pMUfl_E : <— 28 second clip of The Office

The irony of the situation is clear enough to be amusing to a large audience. It’s intuitive, even to those who have never had a formal introduction to Micro Economics, that when you sell each unit at a loss you can’t “make it up on volume”.  So why is my local liquor store pricing below unit cost?  Is this ever a profit maximizing decision?

There are five situations I can think of off the top of my head where pricing below cost is actually a profit maximizing behavior:

Loss Leaders – Some products are sold or given away below cost to induce the sale of other high margin complimentary products – think razors and blades here or printers and ink.  If you did a strict SKU profitability analysis for each of these products you’d think the pricer had gone mental, but when you roll up to customer level profitability you’d see an entirely different, more rational picture.

Introductory Offers – Sometimes when a novel new product is introduced the initial pricing is set below cost in order to establish a market.  Once customers are hooked on the product and have first-hand experience of the value associated with it pricing can be raised to recoup costs.  When you see those cute Red Bull vehicles roaming around at athletics events giving away their product this is the strategy in play.  There aren’t too many legal products more addictive than caffeine.

Obsolete products – Let’s say you’re paying to warehouse a large quantity of product that is no longer in production.  The cost to manufacture the product is now sunk, regardless of how long you hang on it to you can’t reverse the costs incurred to produce it.  It may make sense to firesale this product to make room for something else.  The caution here is that you want to make sure you aren’t discouraging the sale of higher margin substitute by pricing the obsolete product very low.  An example is consumer electronics, if the iPhone 4 were $25 and the iPhone 5 was $400, a lot of customers would trade down and buy the iPhone 4 because the price differential was greater than the value they attached to the new features on the 5.

First Mover Advantage – Similar to the Introductory Offers category, for products or services where it’s imperative to grow adoption or the user base quickly, before a competitor becomes established, low pricing can make sense.  This is a common case in software or anything services where the network effect is at play.  A common theme here is large upfront investments, but low marginal costs.

Co-development/Market testing – It is standard practice to give a product or service away free if you need some test customers in order to see how it’s being used or what the potential customer value will be.  Think about medical trials here, where high quality care is given for “free” or participants are actually paid in exchange for being human guinea pigs.

Regardless of the justifications you can find for pricing below cost in the short-run, its clearly not a viable long term business strategy.  Sorry Michael Scott, guess you’re going to have to go beg for your job back at Dunder Mifflin.

    Christine Carragee

    Christine has a diverse background in pricing analysis and implementation across industries. As a pricing practitioner, she has worked in both B2B and B2C environments and collaborated across functional areas to improve margin performance. Applying her passion for data analysis, Christine has helped Vendavo customers to anticipate their data and reporting needs during requirements gathering in anticipation of the on-going the value realization process. Another component of her work has focused on corporate education and training; ensuring strong project ROI through user adoption and increased pricing understanding.

    Post Comments 3

    kevin Jun 5 2013
    Many times we forget that stock can have zero or negative value. i.e. in the real world nowadays, it costs to get rid of things. Trash is not free. It also costs to hold onto things. Opportunity cost, because you don't have room for something else. Or maintenance cost. Sometimes you have to pay to get rid of things..like free delivery. So in terms of whether you're making money, sometimes, you have to price things to stop losing money. It's important for the "cost" function to include all ownership and opportunity costs. Why sell at negative cost? Because it's worth it, sometimes. Also remember that "value" varies by person. It's not a constant. It's a function that depends on the owner.
    Bob Jul 29 2013
    This can depend on what you are selling. Suppose that you are selling seats for a concert. The ticket sales are not what was expected. The cost associated with a ticket is the expenses divided by the number of available seats. The concert is in a couple of days. Selling tickets below the calculated cost makes sense because these tickets still add on to the total income for the concert. The day after the concert the tickets are worth nothing. Of course the risk here is that people will hold out buying the full-price tickets with the hope of getting a ticket for less the day of the concert. Any time that there is a sharp drop-off in value it may make sense to sell the product for less than cost. Another example of such a drop-off is a grocery store reducing its price for package goods approaching their sell-by date. After that date the store can no longer sell the product.
    Christine Jul 30 2013
    Great input Bob. Your grocery store example is where the term "spoilage" comes from to describe this scenario. Its also highly applicable to the airlines and hospitality industries.