Markups and markdowns

What Are Markups and Markdowns?

Markups and markdowns are fundamental pricing adjustments within the broader field of Pricing Strategy that businesses, particularly in retail, use to manage their inventory, revenue, and profitability. A markup is the amount added to a product's cost to determine its selling price, representing a business's gross profit margin on that item. Conversely, a markdown is a reduction from a product's original or current selling price, often implemented to stimulate sales, clear excess Inventory, or react to market changes. Both markups and markdowns are crucial for a business's financial health, directly impacting its Revenue and ultimately its Profit Margin.

History and Origin

The practice of adjusting prices, encompassing both markups and markdowns, has roots in early commerce and bargaining. However, the systematic application of markdowns as a retail strategy gained prominence with the advent of larger retail establishments. Edward Filene, a pioneer in scientific retail management, is credited with developing the concept of the "automatic bargain basement" in the early 20th century. His innovative approach at Filene's Basement mandated that merchandise unsold after 30 days would be marked down, with further reductions applied if items remained on shelves. This formalized a process for clearing unsold goods, influencing modern retail pricing strategies. The evolution of pricing strategies in retail has continuously adapted to factors such as technology, consumer behavior, and market dynamics, moving from fixed pricing to more dynamic and flexible approaches driven by data and analytics¹³.

Key Takeaways

• Markups add to a product's cost to set the selling price, contributing to gross profit.
• Markdowns reduce a product's selling price, typically to boost sales or clear excess stock.
• Both are essential tools in Inventory Management and play a direct role in a business's Profitability.
• Effective markdown strategies are crucial for maintaining healthy Cash Flow and avoiding losses from obsolete or slow-moving goods.
• Accounting standards dictate how businesses record markups and markdowns, particularly for inventory valuation.

Formula and Calculation

Markup Calculation:

Markup is typically calculated as a percentage of the cost of the product.

[
\text{Markup Percentage} = \frac{\text{Selling Price} - \text{Cost}}{\text{Cost}} \times 100%
]

Alternatively, it can be expressed as a percentage of the selling price, which is often referred to as the Gross Profit margin.

Markdown Calculation:

Markdown is usually expressed as a percentage reduction from the original selling price.

[
\text{Markdown Percentage} = \frac{\text{Original Selling Price} - \text{New Selling Price}}{\text{Original Selling Price}} \times 100%
]

For example, if an item with an Initial Cost of $50 is sold for $100, the markup is $50, or 100% of the cost. If that $100 item is later reduced to $75, the markdown is $25, representing a 25% markdown.

Interpreting Markups and Markdowns

Interpreting markups and markdowns involves understanding their implications for a business's financial performance and operational efficiency. A high markup generally indicates a significant Gross Margin, suggesting strong pricing power or efficient Cost of Goods Sold management. However, excessively high markups can lead to low sales volume if consumers perceive the price as too high.

Conversely, markdowns signal a reduction in expected revenue per unit. While they can boost sales velocity and clear undesirable inventory, frequent or deep markdowns may indicate issues with purchasing, demand forecasting, or competitive pressures. Analyzing the extent and timing of markdowns provides insights into a retailer's inventory health and its ability to respond to changing Consumer Behavior and market trends. They are a critical component of Retail operations.

Hypothetical Example

Consider a small boutique, "Chic Threads," selling a new line of designer handbags. Each handbag has a Cost of $150. Chic Threads decides to apply a markup to achieve a 100% markup on cost.

Markup Application:

• Cost per handbag: $150
• Markup amount: $150 (100% of cost)
• Original Selling Price: $150 + $150 = $300

For the first month, the handbags sell steadily at $300. However, after three months, a new fashion trend emerges, and sales of the original line slow considerably. To clear the remaining 20 handbags and make room for new arrivals, Chic Threads decides to implement a markdown.

Markdown Application:

• Original Selling Price: $300
• New Selling Price (after markdown): $225
• Markdown amount: $300 - $225 = $75
• Markdown percentage: (\frac{$75}{$300} \times 100% = 25%)

By marking down the price by 25%, Chic Threads aims to accelerate sales, recover a portion of the investment, and free up capital and shelf space for more profitable inventory.

Practical Applications

Markups and markdowns are pervasive in commerce, particularly within the Retail Industry. Businesses strategically use markups to establish initial selling prices that cover costs and achieve desired profit margins. This involves considering production costs, operating expenses, competitive pricing, and perceived value to the customer.

Markdowns, on the other hand, are critical for Inventory Turnover. They are applied across various scenarios:

• Seasonal Clearance: At the end of a fashion season, retailers markdown items to clear stock for incoming merchandise.
• Slow-Moving or Obsolete Inventory: Products that are not selling as expected or are approaching obsolescence receive markdowns to minimize holding costs and potential losses.
• Promotional Events: While distinct from discounts, markdowns can be a component of broader promotional strategies, albeit as a permanent price reduction.
• Competitive Response: Retailers may implement markdowns to match or undercut competitor pricing.

In 2022, major U.S. retailers like Walmart and Macy's faced challenges with ballooning inventories, prompting them to implement "aggressive" price rollbacks and deeper promotions to clear excess merchandise. This illustrated the real-world application of markdowns in response to shifts in Consumer Demand and supply chain dynamics¹². Similarly, in late 2023, concerns about inventory gluts and potential discounting spirals arose in the luxury sector due to a slowdown in spending¹¹.

Limitations and Criticisms

While essential, markdowns present limitations and can draw criticism. From a financial perspective, excessive or poorly timed markdowns can significantly erode Gross Profit and overall profitability. If a business consistently relies on markdowns, it can condition customers to wait for sales, thereby diminishing the perceived value of products at their original price and potentially damaging brand integrity¹⁰.

From an accounting standpoint, markdowns, particularly inventory write-downs, have specific rules. U.S. Generally Accepted Accounting Principles (GAAP) and the Financial Accounting Standards Board (FASB) require companies to value inventory at the lower of cost or net realizable value (NRV). If the NRV of inventory falls below its original cost, a write-down must be recorded, creating a new cost basis that cannot subsequently be marked up, even if market conditions improve⁸, ⁹. This accounting rule ensures that assets are not overstated on the Balance Sheet and provides a more accurate picture of a company's financial health⁷. The process of "markdown optimization" attempts to mitigate these risks by using data analytics and machine learning to determine the optimal timing and depth of price reductions, though its implementation presents challenges due to the complexity of factors like competition and customer demand⁵, ⁶.

Markups and Markdowns vs. Discounts

While often used interchangeably by the public, markups and markdowns differ fundamentally from discounts in their nature and purpose within a business's Pricing strategy.

A markup is a forward-looking calculation applied to the cost of an item to establish its initial selling price, reflecting the desired profit margin. It's an internal operational decision.

A markdown is a permanent reduction from an existing selling price, typically triggered by an item's inability to sell at its current price or due to factors like obsolescence or end-of-season clearance. Its primary goal is to clear inventory and recoup capital.

A discount, conversely, is generally a temporary reduction in price offered for a specific purpose or to a specific group of people. Common examples include employee discounts, student discounts, promotional offers (e.g., "20% off for a limited time"), or bulk purchase incentives. Discounts are often planned in advance as part of a marketing or sales strategy, aiming to attract customers and increase sales volume without necessarily signaling a permanent change in the product's value or an urgent need to clear stock⁴. The key distinction lies in the permanence of the price change and the underlying motivation: markdowns are typically reactive and permanent for inventory liquidation, while discounts are proactive, temporary, and used for promotional purposes.

FAQs

Q1: How do markups and markdowns affect a company's financial statements?
A1: Markups directly influence the Selling Price and, consequently, the gross profit and revenue reported on the Income Statement. Markdowns reduce revenue and gross profit. Significant markdowns can also lead to inventory write-downs, which reduce the value of inventory on the balance sheet and are recognized as an expense on the income statement, impacting net income³.

Q2: Why do retailers use markdowns if they reduce profit?
A2: Retailers use markdowns as a strategic tool to manage Inventory Risk. Holding onto unsold inventory incurs costs (storage, insurance, potential obsolescence). Markdowns help clear slow-moving goods, generate cash, make space for new products, and prevent even larger losses that would occur if the inventory became completely unsellable.

Q3: Are markups and markdowns regulated?
A3: While businesses generally have discretion over their pricing, the accounting for markups and markdowns, particularly when they lead to inventory impairment, is subject to Accounting Standards set by bodies like the FASB in the U.S. and overseen by regulatory bodies such as the SEC for publicly traded companies¹, ². These standards ensure consistent and transparent financial reporting of inventory valuation.