Free for Profit: Why companies give things away.

24 September 2008

In a profit based business, “free” seems to be a strategic pricing mistake. However, there are situations when it makes sense. The key is in understanding what you are getting in return for “free” and ensuring that this has sufficient value for you.

Most business people have trouble giving stuff away at a discount, let alone for free. The thinking goes that to optimizing your profits requires that you optimize every part of the business, including every sale. Selling at a loss is not the way to do it. There is a cost to anything a business provides and that cost, at a minimum, should be recovered. By offering something for free or at a discount, you are devaluing it in the eyes of the customer. This makes it difficult, if not impossible to increase the prices later on. Furthermore, if customers want what you are selling, it has some value. That value should be recognized and paid for – it is business after all.

However, the theory of the loss leader suggests that for a bundle of products the overall profit is maximized when a portion of the bundle is sold at a loss and the rest of the bundle has a high margin. As a means of attracting customers who will pay more, it has proven to be effective. A common example is in the bundling of phone services. AT&T offers a bundled wireless/land-line service with “free” wireless calls to any other AT&T customer.

 The theory starts to get weaker when the bundle is not obvious or only weakly connected. If customers can get the “free” product without having to pay for the bundle, the risks in the free offer are increased. That doesn’t mean it isn’t a good idea. The loss leader product can be used to lock in the customer to a particular recurring purchase. In this case, “leader” refers to the sale of the discounted product before the higher margin product.  Some examples include:

  • Cheap printers with expensive ink cartridges;
  • Cheap razor handles with expensive replacement razors;
  • Cheap video game systems with expensive video games;

Weaker still is the loss leader that does not provide lock in. Grocery stores provide a good example. Discounted goods are often aimed at drawing in customers who will buy other none discounted goods but there is no guarantee that the customer will play along. The store is relying on other elements that the customer values, such as the time savings of having a one-stop shop, to increase the probability of increased sales. Statistical correlation studies are required to prove that the discount had any effect on the overall sales.

It is also interesting to note that the same principle can be applied to loss followers (I’m making this term up). A good example is the Apple iTunes store which is a barely profitable loss follower for the innovative and highly profitable iPod products. The 99 cents you pay for a song on the iTunes store is mostly used up to pay royalties and Visa. Apple hardly covers its costs. And 99 cents is about all any customer would pay for digital media these days in any case. For Apple, the trick was in providing the content in a format that locked people into the iPod and in such wide volume that using the service was easy. There has been an outcry against the protected formats but millions of people still ran out to buy iPods.

The loss leader or loss follower approach still requires the company to make a profit over all. Apple’s iTunes store would not work as a loss follower if it did not at least break even. If Apple ever sold music at a loss, any profit made on an iPod would be quickly consumed as customers purchased more and more music. So discounting is OK to a point. But what about “free”.

The key to understanding free pricing is to realize that nothing is really free. There is always a fee even if the fee is non-monetary. Here are some examples:

Free information, trials or samples in exchange for trust and the beginnings of a relationship. This is the main purpose of most corporate web sites and one of the biggest benefits of the Internet.  Business is based on trust. When a customer buys something, they trust that it will work, that they will not be disappointed or cheated. The provision of information about the company, its products and services – the marketing and advertising – costs the company money but is absolutely necessary to build that trust.  This is what Kelvin Davis calls the “freeline“.

Free information, trials or samples in exchange for customer leads. There are plenty of examples where customers are asked to provide contact info in return for access to information. The information request signals an higher level of interest in the product or services offered which is valuable information to the sales channel. It also furthers the development of the relationship between the customer and the company.

Free for feedback. This is a common approach for companies that are developing products and services that depend on customer feedback. Beta testing is an obvious example but the free service can be taken one step further. Take Mikogo for example. Mikogo provides a free desktop sharing software package that allows you to share your desktop with up to ten others. It is absolutely free. However, in the company blog, Andrew Donnelly describes why there is no free lunch. Mikogo is a product provided by BeamYourScreen, a web conferencing company with a very sophisticated subscription based service. The Mikogo product is designed to elicit customer feedback and the free price is aimed at getting that feed back in volume. It seems to be working. While BeamYourScreen has approximately 1400 paying customers, Mikogo has more than 50,000 non-paying but enthusiastic users. Mikogo has also recently partnered with Skype and released a Mikogo Skype extra that will combine desktop sharing with skype conferencing.

Free for referrals and future up-sales. Another common practise for companies that are developing a market that is driven by bottom up sales. Google Docs and Zoho are good examples of products where the main markets that pay – the corporations – are hard to sell to. However, for the future employees of the corporations, the current students, the sell is trivial and viral – especially if it is free. Both Google and Zoho are counting on students to take their love of the product with them and demand that it be used in their place of work.

Free for contributions. This is similar to the open source model in software. The software is free but contributions are encouraged be they bug reports or actual updates to the product itself.

Free for advertising. I recently received a free t-shirt sporting the Ottawa Senators logo. I was supposed to wear it around like a human bill board – a pet peeve of mine. Some lucky companies get people to pay for the privileged of representing the company. If you have ever worn a visible logo on a piece of clothing, I hope you got paid for your service.  If not, I hope you purchased the garment at a discount. I certainly hope you didn’t pay a premium for it.

Free for tax benefits. A common reason for charitable donations.

As a take-away then, think about the following questions and actions when you are setting your pricing strategies.

Will offering a product or service for free be good for you? Can you identify the value you will get in return for “free”? Do you have the systems in place to realize this value and make use of it? Can you identify the costs associated with providing something for free? Can you account for these costs and determine if you are getting a profitable return on investment?

Finally, write it down. Explicitly state the reasons and policies around your pricing strategies and decisions. You will then have something to assess as your business grows and things change.

Well, that’s my advice for today. It is free for you to use. All I ask in return is a little link love.