Some companies believe in loss leaders – products or services that you sell to a customer for less than the cost of making that product or service. This belief may come from supermarkets who are famous for loss leaders – enticements to get you in the store, knowing that is unlikely that you will leave only with those loss leaders.
Listen to the discussion I had with Kevin Price on this subject.
As a small business owner you can’t afford loss leaders – unless the profitability of your other products and services are so great that you can overcome the loss.
First, let’s look at what cost really is. For products, it is the direct cost of making the product (labor, materials, etc.) plus the piece of overhead assigned to that product. Every product you make and sell, or buy and resell, must have a sales price high enough to pay for your company’s overhead (rent, utility bills, gas, and other business costs you have even if you don’t sell anything).
Many direct selling companies have a suggested retail price which is higher than the cost of the product they sell you. The difference between the two is gross profit. You have to subtract your overhead costs from the gross profit to earn net profit. Can you sell enough products to cover your overhead costs?
For services, total cost is the cost of providing the service (labor and materials) plus overhead costs. Some service companies have no material costs and simply provide people to perform projects. Service companies do have overhead costs.
Now let’s look at the lost leader misconception. If you discover that your product costs $100 to produce including overhead, and you are selling it for $90, you are losing $10 for each product you sell. Assume that you sell 20 products per month. Your monthly loss on this product is $200.
Here’s the misconception. You think that you just need to increase revenue by $200 to cover this loss. That’s not true.
If your net operating profit is 10%, you have to generate $2,000 in other sales just to make up for this loss.
Can you afford it?