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Retail Markdowns: A Service to Consumers, or an Industry-Wide Scam?

Are retail discounts a service to consumers? Or are they an industry-wide scam?

Conventional wisdom stipulates that markdowns occur in two circumstances. First, they are a response to a problem of overhung inventory; if a product fails to sell at its original price, a markdown can entice an otherwise uninterested shopper. This kind of markdown, essentially a strategy to correct an item poorly priced or overstocked, raises the cost of that good for the retailer beyond the scope of its original expectation. However, the retailer makes a calculation that accepting a smaller gross margin per item is superior to failing to sell that item at all.

Sometimes, markdowns are planned in advance as part of an overall strategy to excite sales for a specified period of time. In this case it’s a planned devaluation of a product to increase sales during a challenging economic environment or over the course of a special shopping season, like Back to School or Holiday.

Given the current economic malaise and the paralyzing effect it has had on consumer activity, lots of retailers having been attempting to lure foot traffic into their stores with the promise of heavily discounted products on a regular–if not perpetual–basis.

But, according to a recent article in the Wall Street Journal, aggressive promotions are largely a matter of smoke and mirrors, since the markdown is already accounted for in the original price of the product. They are more a matter of “retail theater” than genuine markdowns, or an “engineered illusion.” In other words, retailers employ a “high-low” pricing strategy in which the original cost is grossly inflated for the sake of generating a largely illusory discount later on. Columbia Professor of Business Mark Cohen said, “The silliness of it all is that the original price from which the discount is computed is often specious to begin with, because items hardly ever sell at that price, which makes the discount less legitimate.”

Liz Dunn, an analyst with Macquarie Equities Research, agreed, “A lot of the discount is already priced into the product.”

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The sum result of the faux-markdown is that even though discounts are historically on the rise–according to they have risen 63 percent since 2009–this increase has had only a nominal effect on retailers’ operating margins, which have held steady at approximately 28 percent over the same period.

But is this analysis correct? One cause for suspicion is that a familiar narrative, largely espoused by retail research firms, is that the principal challenge of this holiday season will be the downward pressure exerted on margins due to steep discounting. The Morgan Stanley study, “Expect Coal: We Predict the Weakest Holiday Since 2008,” expressed anxiety that a  maelstrom of promotional offers might trigger a chain of comparable discounts from their competitors, forcing down gross margins for the entire industry. The study likened the domino effect to the hitting of a “panic button,” which sends anxious reverberations across the entire soft-line retail sector.

The report even specifically cited JC Penney as the prime mover at the start of an industry killing causal chain. “We predict JCP will offer extremely deep discounts early in the season…putting pressure on other retailers to do the same,” the report said. Of course, promotions necessarily translate into downward pressure on gross margins. Paul Lejuez, analyst with Wells Fargo Securities, observed that the retailer’s margins winnowed by 40 basis points to 39.2%.

And retailers themselves generally relate a very different tale. While a small handful of the biggest companies can leverage their influence to demand “markdown money,” or kickbacks when they are compelled to discount products, or even simply return the unsold inventory to vendors for a full refund, most stores don’t have the power to broker these arrangements. And more often than not, the decision to discount a product is made ad hoc in response to disappointingly tepid consumer demand. According to Steven Alan, owner and CEO of the retailer of the same name, the markdown process is essentially a matter of prudential judgment: “At the end of the season, I just walk around the floor and do it. A lot of people don’t realize that we sell stuff at a loss, but I’d much rather sell something at a loss than get rid of it.”

And the Wall Street Journal story leaves out the torturously complex decision making process that underlies pricing, as if every product arrived on the shelf perfectly priced. Most retailers, stymied by their inability to consistently price well, have turned to software programs developed by airlines , Walmart and tech firms for computational assistance. These systems make amazingly precise micro-calculations about the cost, price history and general class of merchandise in relation to other products within different selling seasons. And still, it’s very difficult to anticipate how the markdown of one product will impact the salability of another; for example, how does discounting a pair of slim fit jeans affect the allure of slim fit cords?

The stakes for retailers are dramatically high because of an idiosyncrasy in the industry: the regular release of financial data that influences their stock valuations with often alarming volatility. Most retailers release their comps on a quarterly basis; Walmart does so weekly. Incompetent (or just plan unlucky) pricing can have a significant, if short-term, imprint on these periodic financial reports, encouraging investors to short a stock or buy call options on a retailer. If the Wall Street Journal article were correct, retailers wouldn’t be so vulnerable to these unpredictable fluctuations since the assumption of the piece seems to be that retailers generally capture the price of a product they originally forecast.

Right now, a pall of gloom hangs over the retail industry as most analysts predict a historically sluggish holiday season. The aforementioned Morgan Stanley report anticipates an anemic 1.6% rise in same-store apparel retailers. One big reason for the stagnant performance is the stubbornly frugal consumer, still slow to spend faced with an uncertain economy. The National Retail Federation expects that the average holiday shopper will spend about 2 percent less than they did last year, with 51 percent saying that economic worries are constraining their spending habits and 80 percent planning to spend less this year than they did last year.

The study confirms the result of another report recently issued by the CFI group, a search firm headquartered in Ann Arbor, Michigan, “Holiday Retail Spending Report 2013,” which paints a dour picture of the challenges this year’s shopping season promises. At least in part, the less than stellar forecast is attributable to consumer wariness in response to an intractably uncertain economy. A mere 21 percent of consumers plan to spend more on gifts than they did last year. The bulk of would-be shoppers reported they intend on spending less, guided by a spirit of frugality rather than holiday cheer.

A growing number of retailers have more latitude for markdowns because they source their own merchandise, and are cutting the wholesaler, or “middleman” out of the supply chain. From specialty chains like Gap and Ann Taylor to larger stores like Kohl’s and Macy’s, retailers are making private and exclusive branded merchandise a bigger part of their assortments, and are thus able to weather the diminished margins that issue from promotional stimulus.