Two Critical Profit Leaks Every Small Business Owner Must Plug to Protect Your High-Margin Tiers
Pricing Pointers, Issue #53
A price segmentation strategy is fundamentally superior to a non-segmentation strategy. By charging each customer a price closer to their willingness to pay, you can achieve significantly greater sales and profit than a uniform pricing strategy can.
But this move creates two major risks to your bottom line: diversion and arbitrage. Effective price segmentation requires protecting your profit margins from both internal demand shifts and external reselling.
Watch out for these two types of profit leakage
Profit “leaks” when you fail to capture the full value of your price segmentation strategy. This can happen in two distinct ways.
First, diversion occurs when your own product lineup encourages a customer to switch from a high-priced offer to a cheaper one. It happens when a customer who was willing to pay full price trades down because they decide the cheaper option simply offers “more bang for the buck.”
Second, arbitrage occurs when a discounted customer buys your product specifically to resell it to a full-price customer. In this scenario, one of your buyers effectively steals a high-margin sale by stepping in as an unauthorized middleman. By “buying low” from you and “selling high” to other buyers, they pocket the profit that should have been yours.
In a nutshell, diversion is a problem when a customer shifts their demand between your own offers. Arbitrage is a problem when a buyer steps between you and another customer by reselling your product and pocketing the profit. In other words, the former is a shift in interest and the latter is a shift in ownership.
If you don’t plug these leaks, you’re doing more than just losing a few points of margin. With arbitrage, you’re losing the power to charge what your product is actually worth. With diversion, you lose the ability to justify your premium tiers. This eventually forces you to devalue your entire product line just to keep your best customers.
When is your business at risk?
While both diversion and arbitrage eat into your profits, they’re rarely a threat at the same time. The risk to your business depends on how you structure your offers and what you’re actually selling.
Arbitrage is a danger when you offer exclusive discounts to specific groups. It isn’t a risk with a tiered price menu because those lower prices are open to everyone. There is no profit in reselling a product to a customer who can already buy it from you at the same discounted rate.
The one exception to this is quantity discounts. If your price menu offers deep discounts for high-volume orders, a buyer could purchase at the discounted price and resell individual units to smaller customers for a profit. In this case, your own volume purchase incentive creates a competitor.
Diversion, however, is a risk whenever you let customers choose their own price. It happens because you’ve given them a menu of options, and your premium buyers decide they’d rather save money by taking a cheaper, lower-margin offer.
Your vulnerability to arbitrage usually comes down to how easy your product is to store and move. Physical goods that don’t spoil and are easy to transport, present the greatest risk.
Services are safe from arbitrage when they are purchased and used at the same time. You can’t buy a discounted haircut and then stand out on the sidewalk to resell it to the next person for a profit. Even if I’ve already paid for the slot, my own barber wouldn’t let me “hand off” the appointment to a stranger. She’s contracted to cut my hair, not whoever offers me the most for my spot in line.
However, ticket scalpers show us that services become vulnerable to arbitrage when there is a gap between when they are bought and when they are used. Because a ticket to a concert or game can be stored and transferred right up until the event starts, it acts more like a physical product. If your price is lower than what the market is willing to pay, someone will inevitably buy that “spot” just to resell for a profit.
Diversion becomes a threat when your lower priced options are just too good. If the jump in price to your premium tier doesn’t come with an even bigger jump in value, your highest-paying customers will simply trade down. They will conclude the extra benefits aren’t worth the extra cost, giving your most profitable customers a reason to spend less with you.
Build your price fences
You protect your profit margins by building price fences. These are the rules or conditions that customers must meet to qualify for a lower price. Think of them as barriers that separate your high-value buyers from your price-sensitive ones.
You need “hard” fences to stop arbitrage
To stop third parties from reselling your product, you need to create technical or physical barriers. These tactics fall into two buckets: making it harder to transfer the product, or making it less profitable to do so.
Make reselling harder to do: Tying the product or service to the original buyer ensures the discount stays with the intended customer and cannot be easily handed off to someone else.
Example: Airlines require passengers to present identification matching the name on their ticket. While framed as a security measure, it also functions as a hard price fence. By making tickets non-transferable, airlines prevent budget travelers from reselling their discounted seats to last-minute business travelers for a profit.
Make reselling less profitable to do: If the cost of reselling (e.g., time, logistics, etc.) eats up the price gap you’ve created, the incentive for a buyer to become your competitor disappears.
Example: A garden store offers a deep discount on bags of mulch, but only for “in-person, bulk carry-out.” A customer could buy the mulch at the discount to try and undercut the store’s standard retail price, but the physical labor and transportation costs required to find and deliver to another buyer would eat up the potential profit, making the arbitrage attempt economically worthless.
While these “hard” fences block third-party reselling, you still need “soft” fences to manage the choices of your own intended customers.
You need “soft” fences to stop diversion
To stop your best customers from trading down, you need to make the lower price come with a compromise that the premium segment is unwilling to accept. These tactics often double as “hard” defenses against arbitrage by making the discounted version a non-starter for the premium segment.
Make trading down impossible: Intentionally degrade the performance or functionality of the lower-priced version so it cannot fulfill the strict requirements of the high-price segment.
Example: A defense contractor building a high-altitude missile physically cannot use a commercial-grade microchip, because it will fail in extreme cold. The cheaper version is a non-starter; the trade-down is impossible, and a reseller has no market for commercial chips within the defense industry.
Make trading down painful: Ensure that taking the cheaper option requires giving up something that your premium buyers care about deeply, even if the product could technically work. This makes the trade-down unappealing even when it’s possible.
Example: A professional chef could use a $30 home blender to make soup, but the motor would probably burn out after a few hours of continuous use. While the trade-down isn’t forbidden by the laws of physics, the “pain” of frequent equipment failure and lost productivity makes the premium, industrial-grade blender the only logical choice for the chef.
The best soft fences don’t just punish trading down; they reward trading up. By delivering additional value that only the high-price segment cares about, you make the higher price feel like a fair trade for superior results.
Closing the Leaks
Moving away from a single “take-it-or-leave-it” price is the only way to capture the full value of your market, but it requires constant vigilance. To keep your profit from leaking, you must remain the only viable source for your product at every price point.
Plug the leaks by making reselling unprofitable or difficult for your low-price customers, and by making trading down impossible or painful for your high-price ones. Remember, building and maintaining your price fences is just as important as setting the price.