"We lose money on every sale, but we'll make it up on volume."
If you ran a business, you'd rather be in technology than food retail, right? Who wouldn't prefer Apple's 40% gross profit margin over Costco's (COST 0.75%) 13%? And as the above joke points out, mass-market retailing can involve tiny or even negative profit margins that never grow into sustainable earnings.
However, a few companies have succeeded at building highly profitable businesses on razor-thin margins. And they did it with the help of a powerful strategy called penetration pricing.
What is penetration pricing?
Penetration pricing means setting your prices lower than competitors' in order to capture market share. The approach can work in any industry, but it is ideal in markets where the products aren't differentiated. For example, customers can buy many of the same groceries from Wal-Mart (WMT 0.26%) that they can find at a Target (TGT 1.55%) or Kroger (KR -0.91%) store. That ubiquity makes grocery shoppers sensitive to prices, so the company that provides the best value has a huge competitive advantage.
The penetration strategy contrasts with "skimming" pricing, which involves setting a high price that maximizes profit and applies to a smaller portion of the market. Companies use this approach when they have a highly differentiated product that customers are willing to pay up to own.
Apple's iPhone is a great example. It carries a higher selling price than that of many other smartphones, but enough shoppers pay the premium because they value the innovation and design characteristics of the Apple devices over competing brands.
Penetration pricing at work
Returning to our grocery example, you can see penetration pricing at work right now within the organic and natural foods sector. That's a desirable market for any grocery retailer since it is expanding at a double digit pace compared to the broader industry's 3% growth.
While some companies are taking advantage of that popularity to boost their profit margins, price leaders Costco and Kroger are busy moving in the opposite direction: They are aggressively cutting prices on organic food. Here's how a Kroger executive described the grocer's pricing strategy with regard to these in-demand products.
"[Our customers] don't want to have to pay a premium for natural and organics. And we're trying to make sure that they can get a good quality product at a price that's comparable to the non-organic brands and in some cases actually the same price." -- Chief Operating Officer Mike Ellis
And this is a Costco executive talking about the same category in a recent conference call with Wall Street analysts:
"We can generally provide a better savings [on organics] than others because other retailers sometimes will use it as an ability to get more margins and so we show greater savings [through lower prices]." -- Chief Financial Officer Richard Galanti
Why penetration pricing works
Penetration pricing only works to the extent that you can run your business at a lower cost than your rivals can. Otherwise, your lower prices will just drive you into operating losses.
Kroger avoids that fate mainly through economies of scale -- at over $100 billion in annual revenue, it is one of the nation's largest retailers. Thus, it can negotiate uniquely favorable deals with food suppliers. Kroger also runs its own manufacturing plants, which helps keep costs down.
Meanwhile, Costco's entire business model is organized around pushing costs lower. The warehouse retailer uses several strategies to do this, including selling a narrow range of products, operating for fewer hours, and applying membership fees toward price cuts.
Both grocery retailers' pricing strategies are paying off in spades. Kroger just closed the books on its tenth straight year of market share gains. And Costco's membership renewal rate rose by a full percentage point in 2014 to an incredible 91%. Kroger and Costco both set fresh earnings records last year as well, which demonstrates that low profit margins can still power strong returns for investors.