This article is reprinted with permission from Linda Carter with The Retail Management Advisors, and a long time friend and consultant to Smyth Retail and many of our clients. This is a great explanation of the difference between markdowns and discounts.
Generally, customers choose to shop a particular store based on the store’s reputation (brand), the perceived quality of the merchandise and price of the merchandise. With the number of choices customers have and the amount of competition for customers, retailers must use their whole arsenal of tools to get and keep customers. One way to appeal to new customers and to keep loyal, satisfied customers is through discounts and markdowns.
While both discounts and markdowns reduce the amount of profit for the item sold, there remains a significant difference between a discount and a markdown. A discount is given because of who the customer is, i.e. employee, loyal customer, senior citizen, etc. A discount is usually, but not always, a percent off the retail price. An example is a 20% discount given to employees. A markdown is a reduction in price that is usually due to merchandise issues. For example, there is excess inventory due to missed sales plans, the customers did not like the particular merchandise, there are broken sizes so the selection of an item is not as it should be, the store is having an anniversary or end of season sale or other major event.
The correct way to calculate a markdown from the customer’s perspective is to multiply the percent off, say 20%, times the selling price of the item(s). For example, 20% off a $50 sweater would be 0.20 X 50 = $10. So the customer’s discount is $10, or 20%. However, for the retailer, the percentage is more significant. The correct calculation is the markdown dollars divided by the selling price of the item. In the case of our $50 item above, the correct calculation would be $10 / $40 = 25%.
While markdowns are reported as a percentage of net sales, discounts are reported as a percentage of gross sales. Instead of being reported against merchandise performance and planned as part of the Open to Buy, discounts are reported separately on the Financial Statement. Sales Discounts can be reported as either a contra-revenue account or more specifically as promotional expenses or employee benefits. Discounts shouldn’t penalize vendor or buyer performance.
THE GOOD
The best way for a store to use discounts is in loyalty programs and here’s the good news about loyalty programs: they do bring new customers into the store and they do increase brand loyalty. A discount is an excellent and much appreciated way to say thank you to loyal customers. Statistics show that the most opened promotional emails are those sent to loyal customers with a discount announcement.
The best way to use markdowns is to clear out those few items left at the end of season. Another good way to use markdowns is to bring in some in-season purchases. Sweaters ordered last spring may be priced at $100 each with an original cost of $40; however, during the season, those same or similar sweaters may cost $25 each and still markup to a selling price of $100. A 40% off price for the customer would be a retail selling price of $60 on the $100 item. The markdown is now $40. Therefore, to calculate the markdown percent, it is: $40 divided by $60 (the selling price) and get 66.67% for the retailer.
When using an Open-To-Buy, markdowns are a part of the plan; it is the markdowns in excess of plan that tend to cause problems as markdowns and discounts lower profit. However, when used properly, they draw customers into the store and hopefully, with your well-trained staff, you can also sell some full-price items to compliment those discounted and marked down.
THE BAD
More and more I see retailers falling into the trap of using markdowns as a pricing strategy. This article is not about pricing strategies, but about discounts and markdowns and their affect on the bottom line. The bad side of markdowns is seen when they are the last recourse to selling the “dogs”-those items purchased that did not fit the desires of your customers. Perhaps the color was wrong; perhaps there was a different “hot” item that was popular (think of the Tickle Me Elmo toys from Christmases past). If mistakes are minimal, the effect of moving excess inventory is also minimal. But, if the buyer makes too many mistakes, deeper markdowns to move higher quantities of merchandise cut deeply into profits.
Consider the retailer who always buys 5% more than last year of everything. If casual pants did not perform well during the last season (and the season before that) and more of the same is purchased, excess inventory starts crowding the displays and aisles. Since cash is needed to pay for the next season’s wares, a 25% markdown on the remaining inventory is announced. Keep in mind that 25% is the markdown to the customer. The retailer will actually record a markdown of 33%.
If the 25% markdown doesn’t work, the markdown may be increased to 40%. If there is too much excess inventory to move, this can become a battle of numbers resulting in greater and greater markdowns to get enough cash to pay for the merchandise for next season. And, on top of all this, profit will be less than expected, much less. I call this the ‘Death Spiral’ of retailing. If it is not corrected quickly, the store will be reduced to having only merchandise from those few vendors who will ship to them-and then it is usually either COD or prepaid.
THE UGLY
The worst thing about using too many markdowns to generate sales is that it opens a trap to long-term use. Owners bring in merchandise that has a very high initial markup with the plan of offering big markdowns, but they feel the initial price will cover most happenings. Then the loyal customers see the deep markdowns and begin to wonder just how much the merchandise is really worth. Other customers begin to frequent the store-those driven completely by bottom-line pricing. The store’s brand suffers. Loyal customers start looking for value somewhere else. Remember the competition? It’s still out there. Now the owner is forced to cut costs and, therefore, amenities such as outstanding customer service. As stated earlier, I call this the “death spiral” of a store.
The independent retailer who finds himself in a price competition cannot win because an independent retailer cannot compete with the huge discount giants or the chain department stores by price alone. Independents cannot purchase in a large enough quantity to demand huge discounts directly from the manufacturer or wholesaler. The store as a whole suffers and starts to take on a tired appearance. Key personnel moves on and often times so do their customers-your formally loyal customers.
Keep in mind, long-term, deep “discounters” have a reputation all their own. They offer less service and keep operational costs at a minimum. Customers expect less from these retailers because they are shopping by price, not quality of merchandise or enjoyment of the shopping experience. Is this the customer you are trying to attract?
Also, when merchandise is constantly or consistently marked down, your most loyal customers will learn to wait for the sale before making a purchase. Constantly discounted merchandise leads otherwise loyal customers to believe that merchandise is over-priced even at the initial marked down price. The retailer has devalued his own merchandise in the eyes of his or her customers.
ONE LAST THOUGHT
Track discounts and markdowns separately if you want more profit. You need to know what works best and without proper data, its your best guess. Your guess may be right on sometimes and completely off at others. Track to see what combinations work best in your store. One example I found spoke of a ladies suit store. The owner offered her best customers a significant discount for any one item on their birthday. She found that most often the discount was applied toward the purchase of a nice jacket. She then was able to sell the matching pants, skirt and blouse at regular price. The discount was too much for most of the customers to ignore but not enough to purchase an outfit. She would not have known this without using her point-of-sale system and proper tracking. Her overall markdowns were reduced because there was less remaining at the end of season.
IN CONCLUSION
Markdowns and discounts are useful to retailers in the day to day operation of the business, but need to be used sparingly and planned for. Remember, the cheapest but most effective advertising is word is mouth and it can work for or against you. Therefore, maintain the value of your store, your reputation and your merchandise. It’s a package deal.
