An Introduction to Retail Markdowns – When to use them and some of the key calculations

How to calculate retail markdowns and when to use them - article from First FridayMost customers love a deal, and lots of retailers have frequent offers across their product ranges. But the process of reducing prices comes at a cost. In fact, the management of the markdown budget is a critical aspect of the merchandiser’s toolkit, it’s a complex topic and it needs to be planned and managed carefully.

In this article, I am going to give an introduction to the topic of markdown by exploring two different types of markdowns: permanent and promotional markdowns. First we’ll define the term and provide a worked calculation, and then consider when and why each type is best used.

There is so much more to understanding retail markdowns; there are lots of other types of markdowns, definitions, uses and impacts on the performance of the business – however these two core types of markdown activity provide a solid basis on which to start to build knowledge and application.

What is Permanent Markdown

Permanent markdown, as the name suggests, reduces the retail price of a product to a new permanent price. It will not go back up to the original price.

For this reason, permanent markdowns are used to clear stock that has not sold well or is at the end of its life cycle. Therefore, they are usually used in end of season sales to help clear stocks and make way for new ranges.

The action of taking a permanent markdown means that all future sales will be taken at the reduced retail price, and given the cost of goods does not change, the margin will be lower. In addition to this all the stock held at the point of the markdown (if valued at retail prices) – whether in a warehouse, on a website, or out in stores – will be devalued to the new reduced price.

For retailers who manage their business based on retail values this incurs a cash spend or cost.

How to calculate permanent markdown cost

For example:

  • If we have a product priced at £45 which we plan to reduce to £30 then we will incur a cost of £15 for every unit of stock we hold in the business
  • If we have 2000 units in stock that markdown spend (or cost) becomes £30,000
  • The value of the stock reduces as well – at full price those 2000 units were valued at £90,000 but now at the reduced price they are worth £60,000

Original price – reduced price x units of stock on hand = markdown cost

If the retailer manages stocks using cost values, there will not be a cash markdown cost to calculate, but instead a margin impact needs to be forecast.

When and why to use permanent markdownsSale - promotional markdown icon

We have seen how spending permanent markdown impacts the value of our sales and the value of our stock – this in turn means our profits take a hit.

The cost of goods is the same whether we sell a product at full price or reduced price, so our cash and % margins are reduced when we mark something down – so why do it?

We have already said that permanent markdown is most commonly used to clear residual stocks that have not sold well or are at the end of their selling life. This is a really important part of the merchandiser’s job. Even the most successful product comes to the end of its life; whether as a result of changing trends, changing technology or something better coming along.

Clearing unused stock

Chart showing where to use strategic promotions, tactical promotions, price adjustments and markdown through the phases of a product life. Phases are introduction, growth, maturity, decline and phase out.

Choosing the right time to clear out the stock, when it still has a chance of selling, is a skill.

Once stock is no longer actively part of the retailer’s range it is often called terminal stock. Most retailers will have a terminal stock target they work hard to achieve so that stock – the biggest asset for most retail businesses – is not clogged up with product that will not sell.

Spending markdown helps them achieve this cleaner stock position, both financially (on the balance sheet) and also physically, via the clearance of products across the selling locations.

Reducing the value of stocks also generates Open-To-Buy (OTB) – this is the money needed to spend on new product ranges or repeats of bestsellers to keep them in stock.

This is very useful if you are dealing with one or two poor performers in an otherwise high-performing range – the OTB can be spent on those best sellers.

However, if you have large-scale range failure, there is a commercial balance between simply marking it all down and buying all over again. The costs are likely to be prohibitive and it’s essential to understand what has caused the poor performance rather than simply using markdowns.

So, in some cases careful planning and use of markdown can still generate positive outcomes.

What is Promotional Markdown

Promotional markdowns are different from permanent markdowns. They are used for temporary events designed to generate traffic, sales and usually profit. This could be one-day business-wide events, marketing activity like student discounts or product-specific promotions like “Buy-One-Get-One-Free (BOGOF) – This weekend only.” They should be planned where possible into the Trading Calendar in advance of the season.

The key difference for promotional markdown is that it only affects the value of the sales taken during the event. The stock remains at full or original price.

How to calculate promotional markdown costs

If we use the same example as before where a product is priced at £45 and we run a promotion for one week at £30, the calculation to work out the markdown spend is as follows:

Original price – reduced price x unit sales = markdown cost

So, if we sell 150 units in the promotion, we will have a markdown cost of £2,250.

There is no change to the value of the stock.

How promotional markdown impacts profit

The impact on margin is analysed by comparing the profit made before the event – selling fewer units but at a higher margin %, versus higher unit sales at a lower margin.

Take a look at this comparison:

A table comparing key sales and margin metrics from before and during a promotion. In this example the sales units during the promotion are higher and margin is only 40% versus 60% before the promotion. The cash profit is slightly lower during the promotion.

In this example, during the promotion the sales are higher, the % margin is much lower, and we are spending some of our markdown budget to achieve those sales; but the cash margin (or cash profit) is only slightly lower than when the product was selling at full price.

Achieving the right uplift in volume sales

Managing the cost of a promotion and its impact on profit is all about forecasting and achieving the uplift in unit sales that each promotion will generate.

As the sales value is reduced (and therefore the margin is reduced), we plan for these events by expecting an uplift in the volume of sales that will result in the event being profit-neutral – and ideally profit-positive.  Often, therefore, the merchandiser will plan to buy more stock for the event in order to achieve the required uplift in unit sales.

Let’s consider the following scenario where we plan to run a short-term promotion on the same product we have used in our other examples. Initially we will model what happens if we reduce it by a third to £30, and think we should be able to achieve an uplift in the volume of sales of 50%.

A table comparing the impact of different offer prices in a promotion. In these examples marking down the product to a lower price requires a higher uplift in sales to achieve the same cash profit. Keeping the product price a little higher requires less uplift to achieve the same cash profit.

You can see that a 50% uplift protects the cash sales, but has a big negative impact on cash profit.

If a 50% uplift is all we think we can achieve, we need to make a decision

  • Do we go ahead knowing that we will lose profit?
  • Or do we change the event somehow?

We might be able to take measures which would increase the uplift – can we feature the event prominently in store, on the website or use customer focused marketing messaging?

Regardless, it’s best practice to model what the uplift needs to be to generate a break-even position for profit and consider whether this uplift is likely.

A table comparing the impact of different offer prices in a promotion. In these examples marking down the product to a lower price requires a higher uplift in sales to achieve the same cash profit. Keeping the product price a little higher requires less uplift to achieve the same cash profit.

We can work out that to break even at a third off we actually need to drive an uplift of 125% or sell at least 157 units. If that sounds unrealistic, we probably need to look again at the discount.

How about we reduce it to £10 off rather than £15 off? This is still a good reduction. Our new break-even is 58% or 111 units. That’s more realistic than 125%, but can we really achieve it? After all, we were concerned by a 50% uplift when the offer was £15 off…

It’s a constant balance of knowing your product and your customer and modelling or forecasting different outcomes. Your skill and experience lies in making a judgement on which offer represents value to them that is appealing enough to drive the increase in volume.

If a retailer runs a high number of promotions, perhaps on a rolling basis from season-to-season, they may find the cost method simpler to work with than the retail method we have just looked at. However, the principle remains that many promotions are not profitable unless the uplift in volume is sufficient for the discount being offered.

Minimising the impact of markdowns

We have seen the financial impact of markdowns and promotions; it’s often one of the biggest costs a retailer has, and has the biggest impact on the profitability of the business. Many businesses therefore control the markdown budget very tightly, with the result that the decisions the product team would like to make are often constrained or sometimes not approved.

There are a few things you can do to help:

Trading calendar

Creating a trading calendar before the season begins to show all the planned markdown and promotional events helps in a number of ways.

The marketing of these events can be planned to give them the best possible impact, but also the merchandiser can budget for the markdown cost they believe they will need to run the event. If this is agreed within the overall department plan for the season, there is a higher chance that they will be able to spend the money when the time comes.

Timing and level of reduction

Secondly – don’t wait!

If something is not selling well and needs action, recommend it for a markdown event and try to control or cancel any future intake where possible. It usually costs less to deal with a poor performing product earlier in its life by taking a moderate reduction, than waiting until the end when it has less chance to sell and may need to be reduced to half price.

Price Optimisation tools

Markdown management is a complex topic and it’s often one of the biggest costs for a retailer. That’s why there are now a variety of excellent Price Optimisation systems or tools.

These tools look at permanent and promotional reductions and some also support original price setting.  They are designed to help a retailer maximise results according to their priorities, for example whether stock clearance or profit is the priority.

Price Opimisation tools are able to take a long-term view of the target exit date and work towards it based on priorities, current and exit positions and the trading calendar of the retailer.

Learn more about Retail Price Management

Other articles in our “jargon-busting” series cover common acronyms and terms relating to calculating margins, measuring and managing stock, and sales performance.

If you found this article useful, you might also want to check out our Retail Jargon Toolkit which covers over 300 retail terms and acronyms, along with bite-sized video explainers for 14 essential retail calculations (some of which we looked at above). It’s free to retailers who book a call to review their training needs with us.

From a markdown point of view, our toolkit contains definitions (and calculations where they apply) for all of the following:

  • Clearance or permanent markdown
  • Promotional or temporary markdown
  • Realised markdown
  • Markdown support or supplier funded markdown
  • Markdown not bought

Or, if you’ve already got the basics covered, you might be interested in taking our Retail Price Management course which covers the best practice approach to setting retail prices and handling promotions and markdowns.Get a free retail jargon toolkit for everyone who needs one in your team if you book a call to review your needs. Click here.

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Clare Edwards

About the author: Clare Edwards

A Principal Consultant and Head of the First Friday Training Academy, Clare has over 30 years of retail experience which she uses to support clients to develop their commercial knowledge, technical capability and soft skills.

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