May 31, 2013
Over Memorial Day weekend I saw this add in my local paper:
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.