Hitting the mark: Why markdowns matter more than ever

Many US retailers are reducing prices to clear excess inventory. Smart markdown strategies will make a huge difference to their bottom lines.

The US consumer, just like the US economy, has been anything but predictable over the past few years—and the rapid changes have kept retailers on their toes. After the initial shock of COVID-19, which in early 2020 forced stores to close and caused demand for some product categories to plummet, consumer spending recovered relatively quickly, rising to record levels later that year. The recovery continued into 2021 as consumer sentiment and spending spiked in tandem, resulting in consumer demand that exceeded retailers’ stock levels.

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But new challenges arose in early 2022—most notably, inflation and growing fears of recession—and, so far, there’s no end in sight. Spending growth has slowed, yielding the opposite of what happened in 2021: this time, there’s more stock than demand. Many retailers entered this holiday season with high inventory levels and declining profitability; most will need to slash prices to move excess inventory out of stores. In the coming months, getting markdowns right will be critical.

A challenging road ahead

It’s not just one economic trend or one geopolitical issue that’s creating an uncertain environment for retailers. There are a number of factors at work.

Prices are up, spending is down

Inflation has dampened consumer sentiment and made consumers more cautious about their spending. While real spending has increased since the beginning of the COVID-19 pandemic, it has recently decelerated (Exhibit 1). The overall growth in spending between the onset of COVID-19 and today is lower than it was in the prepandemic period.

Real spending in the United States has risen since early 2020, but price increases have hampered overall spending growth.
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In the past few months, inflation has become the primary driver of spending growth across categories; volume growth has started to taper off. Looking ahead to 2023, retailers face headwinds from inflation, rising interest rates, and increasingly pessimistic consumer sentiment. McKinsey’s latest US consumer sentiment survey shows that 30 percent of consumers in July 2022—compared with only 15 percent in March 2020—said they were pessimistic about US economic conditions. While more recent analysis indicates a slight uptick in consumer sentiment going into the holiday season, consumers are still looking for savings and seeking value.

Given this less-than-rosy outlook, it makes sense that consumers are taking the following actions:

  • Trading down: 74 percent of consumers (and 87 percent of Gen Zers) say they are trading down—whether it’s by shopping from lower-priced retailers, switching to cheaper brands, buying smaller pack sizes, or engaging in other money-saving behaviors.
  • Delaying purchases: Many US consumers, particularly those with lower incomes, are prioritizing essentials over discretionary goods and delaying purchases in categories like footwear, home improvement, and apparel.
  • Holding cash: Consumers are going on the defensive financially—they have twice as much in cash savings (or $3.7 trillion more) than they had in the fourth quarter of 2019. High- and medium-income consumers are continuing to grow their balances.

Mounting inventory

With consumer demand slumping throughout 2022, retailers’ inventory levels have been rising. Items that were hot commodities at the height of the pandemic—such as coffeemakers, loungewear, and exercise bikes—have been piling up in stores.

Going into the holiday season, retailers are grappling with not just high inventory levels but also declining profitability (Exhibit 2). Many retailers, anticipating aggressive markdowns to address inventory pileups, have been forced to update earnings statements, causing stock prices to take a hit. Unfortunately, the trend is far from over.

Retailers in the United States are entering the holiday season with high inventory levels and declining profitability.
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External forces converging

And that’s not all. In addition to the aforementioned forces, a confluence of other large-scale challenges is making the outlook for 2023 even more muddled. Among those challenges are ongoing supply chain disruptions, persistent labor shortages, rising fuel costs, geopolitical issues related to Russia’s invasion of Ukraine, and renewed COVID-19 lockdowns in China.

In sum, the level of unpredictability and volatility in the world today requires retailers to become more agile and responsive to stay ahead. While many retailers have made incremental investments in advanced analytics and digital capabilities to support more adaptive pricing, most have stopped short of investing in best-in-class markdown strategies and capabilities.

Traditional markdown levers leave money on the table

Many retailers treat markdowns as an afterthought—a quick way to shed excess inventory. As a result, retailers tend to use a one-size-fits-all approach, applying the same pricing strategy across a range of products regardless of item-level performance. Common missteps include the following:

  • marking down items that are performing well (that is, hitting sales targets) and that would most likely continue to sell at full price
  • applying markdowns that are deeper than they need to be to hit sell-through and/or margin targets
  • making price reductions that are not compelling enough for low-performing SKUs to hit sell-through targets

When retailers make these mistakes, it’s typically because either their process is inefficient or they lack the requisite data, analytics, and/or tools to make optimal pricing decisions (Exhibit 3).

At some retailers, the markdown cycle is inefficient and ineffective.
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When done poorly, markdowns hurt margins and erode brand equity. However, the inverse is equally true: an expertly executed markdown strategy can protect profits and become a competitive advantage. We’ve found that markdown optimization can improve margin rates by 400 to 800 basis points. Distinctive markdown strategies and capabilities help retailers do three things simultaneously: respond to customer demand, deliver value to customers, and protect their business.

All signs point to 2023 being another tough and unpredictable year. So if there were ever a time to invest in markdown capabilities, it’s now.

Getting markdowns right: Four questions to answer

A retailer’s markdown strategy should provide data-driven answers to the following four questions:

1. Selecting the right items: What items should be put on clearance, given their performance during the season?

To identify which items to mark down, a retailer should compare each item’s performance in the current season against the sales plan for that particular item. A simple data-visualization approach can help merchants easily identify which items in the portfolio are overperformers and which are underperformers.

2. In the right places: Where should items be put on clearance, given performance across store clusters or channels?

Ideally, a retailer would conduct item-level analysis for each store or store cluster rather than applying the same markdown strategy across all stores and channels. Store clusters could be derived based on, for example, climate zones, locations (rural versus urban), assortment tiers, or store sizes. An apparel retailer might find that certain swimwear SKUs sell well throughout the year in some of its urban stores in the Northeast United States. It could then apply markdowns more selectively, instead of simply marking down all swimwear in all Northeast US stores during the colder months.

Similarly, some markets might require more frequent price changes than other markets. By differentiating its markdown strategy based on consumer preferences and shopping behaviors in each location, a retailer can ensure that it is investing its markdown dollars where they’ll make the biggest difference.

The same logic applies to channels. Digital channels can more easily accommodate differentiated markdown approaches since pricing changes are easier and faster to execute digitally—and can be done without adversely affecting customer experience.

3. At the right times: When should items be marked down?

At best-in-class retailers, merchants and planners run scenario analyses to determine the timing and frequency of markdowns. Typically, they apply markdowns in phases, starting with a smaller discount—and then, depending on how the discounted items perform, further lowering prices a few weeks later. A typical mistake that retailers make is failing to revisit markdown decisions: an item could remain on the shelf for weeks if the initial markdown wasn’t deep enough.

4. At the right price: How deep should markdowns be to achieve margin and sell-through goals?

For an item identified as a markdown candidate, a retailer can derive the right clearance price—one that optimizes for both gross margin and sell-through—using consumer-centric analytical models and coherent business rules. Discount depth can vary across categories or SKUs. There are, of course, trade-offs between simplicity and precision: applying the same discount rate to all products within a category requires little effort from store associates, whereas applying differentiated discounting depths is a much more time-intensive exercise for store staff.

To optimize markdown pricing, top-performing retailers use industry-leading analytics and modeled elasticities that are grounded in full-year consumer pricing behavior, with specific adjustments for markdown.

What it takes: Enablers of successful markdown management

With a disciplined approach and the right data, analytics, and tools, retailers will be well equipped to drive value for their customers and their bottom line, even in the face of rising inventory levels. Equally important to markdown optimization are the following enablers:

  • A dedicated team: Some retailers treat markdowns as a side project—an end-of-season topic that only the pricing team, the merchandising team, or the inventory planners should care about. At these retailers, the default strategy is a one-size-fits-all approach, which is easy to execute but leaves money on the table. Instead, retailers can assign responsibility for markdowns to a dedicated (full-time or part-time) team of pricing or merchandising personnel. The team would evaluate the need for markdowns not just at the end of a season but on a weekly basis throughout the year. This will allow them to spot and capture opportunities in real time. For instance, an underperforming item could be marked down much earlier if analysis shows that the initial retail price was simply too high.
  • Strong capabilities in forecasting and inventory management: Obviously, the more accurately a retailer can forecast consumer demand, the less it will need to apply markdowns. But excellence in forecasting can also enable more effective markdown management: retailers will be better able to predict the impact of specific discounts on consumer demand. Leading retailers rely on a variety of inputs for their forecasting models—not just point-of-sale data but primary consumer research, social listening, and online search trends as well. They also invest in systems that can provide detailed real-time visibility into inventory levels and sell-through rates, so that they can immediately and easily compare individual SKUs’ performance versus forecasts.
  • Advanced analytics expertise: There are many misconceptions about analytics-based pricing. Some retailers dismiss it as opaque and difficult to understand; others believe that analytics-based pricing recommendations would be too complex to execute; still others feel that merchants shouldn’t rely on analytics but should instead use their own judgment. At best-in-class retailers, analytics-based pricing recommendations don’t replace—but rather inform and improve—the decisions of merchandising and planning teams. A sophisticated analytics function and a robust systems and data infrastructure are critical success factors in markdown management.
  • In-store execution excellence: Retailers can opt to either mark down individual SKUs and change the price tags on every SKU or apply the same markdown percentage to an entire shelf or section. While the latter requires fewer staff resources, it is less accurate and could result in overdiscounting selected items. Therefore, the most efficient retailers use electronic shelf labels, which make marking down individual SKUs much easier and allow for differentiated markdown decisions.

As the 2022 holiday sales season gives way to an uncertainty-filled 2023, retailers must take bold action. Even as they seek to clear their stores of unwanted inventory, they can continually get better at monitoring and anticipating consumer demand and delivering what consumers want—all without sacrificing profitability. The most forward-thinking retailers will take advantage of this unique moment to invest in markdown capabilities to help them pull ahead of the competition.

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