Retail Diary: Retail 101: Math & Financials - Chapter 2

We've mastered the basics, now let's dive into markdown strategies and end-of-life-cycle promotions and liquidation.

Just a heads up: The info shared here is all about general learning, insights and personal opinions, not pro accounting advice. If you're diving into business stuff, it's smart to chat with an Accountant. Cool?

If you haven’t seen Retail 101: Math & Financials (aka Part One) I’d suggest giving that a quick read. ¹

Types of Markdowns

In retail there are different types of Markdowns. For today’s newsletter I will focus on “Hardmarks” or permanent markdowns, and promotional discounts (think of “take an extra 20% off sale” or a “friends & family” event.) For promotional the price is only discounted for a limited time. For a Hardmark², you discount the product and don’t plan to take the price back up. Both will impact your margin (the difference between all costs to acquire and make the product less the retail price the customer pays) but if financials for the ownership of inventory in the accounting books is done at Retail vs Cost there is a significant difference.

There are multiple reasons why retailers/brands might discount items. When stores have items that aren't selling as quickly as they hoped, they lower the prices to encourage people to buy them. It helps the retailer clear out old stock to make room for new stuff. Perhaps they want to drive revenue for a brief period of time (hit a monthly sales plan and it doesn’t look like they will as forecasted.) Or a trend is over or the season is changing (oh my, leather gloves at the end of winter - this is bringing back many flashbacks!)

Accounting Basics for Retail/Buyers

Before we get in to markdowns I also want to give a baseline of accounting methods since a reader reached out with a great question. Some retailers use Cost Accounting to own the inventory and others use Retail Accounting to own the inventory. This means your accounting books holds the inventory at the cost price or the retail price. If a shirt costs $25 and retails for $50, the Cost Accounting would own at $25 ($25x100 shirts =$2500 worth of inventory on hand) and the Retail Accounting would own at $50 ($50x100 shirts = $5000 worth of inventory on hand.)

Owning Inventory at Retail:

When retailers decide to own inventory at retail, it means they're valuing their inventory based on the selling price to customers rather than the price they paid for it. Here's why they might choose this approach:

1. Simplicity: Owning inventory at retail can simplify accounting and financial planning processes. Since the retail price is what matters most for revenue and profit calculations, using retail values directly in accounting can streamline calculations.

2. Reflects Market Value: Retail prices fluctuate based on market demand, trends, and competition. By valuing inventory at retail, retailers get a more accurate picture of the current market value of their stock.

3. Better Reflects Profit Margins: Retailers often focus on margin rather than the COGS³. Valuing inventory at retail directly aligns with this focus, as it shows the potential profit they can make on each item sold. For forecasting methods it is important to understand how much money the retailer/brand can generate.

4. Useful for Retail Metrics: Many retail metrics, such as gross margin⁴ and inventory turnover⁵, are based on retail prices. Owning inventory at retail allows retailers to calculate these metrics more accurately.

However, there are some drawbacks to owning inventory at retail:

1. Potential Overvaluation: Retail prices can fluctuate, and they're typically higher than wholesale or cost prices. This means that valuing inventory at retail may overstate its value, especially if/when prices drop or your crystal ball isn’t working (you think a trend will take off and it doesn’t.)

2. Complexity in Cost Management: While it simplifies some aspects of accounting, owning inventory at retail can make it harder to track and manage costs. Retailers still need to monitor their costs to ensure they're making a profit - and often for shareholders and investors sake, as much profit as possible.

Owning Inventory at Cost:

Conversely, some retailers choose to value their inventory at cost, which means they record inventory based on the price they paid to acquire it from suppliers. Here's why they might opt for this method:

1. Accurate Cost Tracking: Valuing inventory at cost provides a clear picture of how much money the retailer has tied up in their inventory. This is crucial for financial planning, budgeting, and managing cash flow. Your cost really shouldn’t fluctuate like retail.

2. Conservative Valuation: Cost-based inventory valuation tends to be more conservative. It avoids potential overvaluation that can occur when using retail prices, especially in volatile markets. Post recession 2008 and during COVID “Retail Apocalypse” in 2020 it became much more accurate and stable to use cost-based accounting.

3. Useful for Cost Control: For retailers focused on cost control and efficiency, owning inventory at cost helps them monitor and manage their expenses more effectively. It allows them to identify areas where they can reduce costs and improve profitability.

4. Compliance and Reporting: In some cases, regulatory requirements or accounting standards may recommend or require valuing inventory at cost for financial reporting purposes.

However, there are also challenges associated with owning inventory at cost:

1. Market Value Discrepancy: Inventory valued at cost may not reflect its current market value accurately. If market prices fluctuate significantly, the reported value of inventory may not reflect its true economic worth.

2. Potential for Lower Profit Margins: Since cost-based inventory valuation doesn't consider potential profit margins, it may not provide a complete picture of the profitability of the inventory. This could lead to suboptimal pricing decisions.

The decision to own inventory at retail or cost depends on various factors, including the retailer's business model, objectives, industry standards, and regulatory requirements. Both methods have their pros and cons, and the choice often comes down to what best aligns with the retailer's needs and priorities. It likely has more to do with the stability of the industry and/or the likelihood that the products will be sold for close to retail value or need to be markdown greatly.

Most of the examples here will assume we own the inventory at Retail for our make believe Retailer. According to a survey in 2022, 70% of Retailers used the retail accounting method. ⁶

Markdown Tactics

• First, why might you need to markdown product? Here are a few examples:

  • It is seasonal and you need to reduce your inventory level to make room for other inventory coming in. End of season and you need to sell the remaining winter coats to make room for bathing suits coming in.⁷

  • Missing sales goals and having a Sale or discounting product will drive revenue.

  • Planned promotional calendar. Think of Amazon Prime Day or “Friends & Family” at your favorite Retailer like Nordstrom Anniversary Sale. This sales event is planned in advance and inventory might even be bought for it especially for the event (for Nordstrom Anniversary Sale it is.) Having the sale helps drive revenue.

• How much do you mark down the product? This is another spot to be strategic. You probably don’t want to go right to 50% off or deeper unless you really need to move the inventory. You can start with a POS (point of sale - see more below) and then go lower later once you see how much inventory you can move with a smaller discount. This is where having data and forecasting sales is important and helpful.

• Markdowns will eat into your profit, but you can’t be so reluctant to discount. If it isn’t selling, getting a $20 profit on an item you typically get $50 profit on is better than $0 if it isn’t selling. Plus, as a Merchant it would open up more inventory dollars to spend towards product that would hopefully be more profitable. Using your COGS, you will want your markdown price to be higher so you aren’t selling at a loss.

• Will you ever sell at a loss? Maybe - and for many DTC brands, brands with a lot of VC investment or brands just starting out, this happens more frequently than you might think. If potential consumers don’t know about your brand, or you are trying to get it into customers hands so they can help spread the word you might try this. An example is when Girlfriend Collective first launched and sold their leggings just for the cost of shipping. First, this gave the brand major press and second it took away the hurdles of trying the product. Who could pass this opportunity up? Then the customer tried it, loved it, told their friends and bought more. In this example selling at a loss really helped build the foundation of their business (and they likely used marketing dollars to cover the loss of profit.)

Promotional POS vs. Hardmarking

• Promotional POS (Point Of Sale) is when the product is discounted for a limited time period only when the product is sold (aka rung up.) This is when you might see “20% off all swimwear” or “take an additional 30% off all sale.” This is for a limited time period and doesn’t reduce the retail price of the inventory - only reduces for the items that actually sell at the discount. For accounting reasons listed at the top of this article, if you own at Retail and run a promotional event you aren’t reducing the dollar amount of your ownership. You only take the discount on the items that are sold during the event.

• A hardmark is when you reduce the retail price of the product but it isn’t taken back up to “regular price” at the end of a time period. If you are in a retail store the price is usually changed on the price tag and online it is marked down and not taken back up at the end of the sale period.

• When products are marked down significantly or at the end of the season we often see Final Sale because the cost to mark it down is so significant the retailer can’t manage bringing it back to the selling floor or they are liquidating the product.

• For many products, you might see the merchandise be promoted consistently as a selling tactic. Many retailers will do this for basics or replenished merchandise. An example is something that is generally not completely liquidated. Think of diamond stud earrings that a department store will carry year round and year after year. They might have a 10% off all diamond stud earrings during limited sales periods but there would be no reason to liquidate the inventory and mark it down/reprice it forever at a lower price point. This is also often done with “buy more, save more” programs. Example, buy 3 pairs of socks the 4th is free.

A reader asked: “very curious to learn more about how retailers decide what to markdown, when to do it, and by how much.”

I hope I was able to answer some of this above, but I want to dive into it a little more. There are a variety of reasons for deciding when to markdown, what to markdown and by how much. If you are “making plan” or hitting your revenue and inventory goals you might not be pressured by those factors to need to discount. But if you are missing sales you likely need to figure out how to generate more sales - discount product or liquidate inventory you currently have to bring in items that will sell better.

When to do it is also cyclical and based on sales and inventory planning. Think about seasonal product - swimwear is often slowly starting to sell for Resort Wear (aka Spring Break, think February through April) then by Memorial Day you want to own all your styles for the season and really be driving sales since it is “in season.” You might have another push around July 4th but after that you need to really move into Back to School Clothing. So if sales are slow that season you might start to promote earlier in the season to drive more sales and liquidate more inventory at a more generous rate.

As for how much to markdown (both how many SKUs to markdown and how much of a dollar amount/percent to reduce it by) it is also a projection. Will 10% off move the needle enough? Can you afford to reduce all Western Boots 30% off when the trend starts to taper off? Will one vendor agree to take back the inventory instead of requiring you to markdown? Brands will also support markdowns by covering some of the margin loss so this could help a Retailer afford to markdown deeper because the Brand wants to help you have a profitable business so you will buy from them again in the future. It is all about what the Buyer can afford and/or how much revenue they need to generate, how much inventory can be reduced by etc.

A Merchant and Inventory Planner is constantly looking at sales, stock levels and margin to understand which levers they need to pull to nail their projections. You always want to make or exceed goals!! This is the part that I have fun with - it is a game and both an Art and a Science.

I hope this helps understand a little bit more. We’ve now tackled Retail Math & Financials and Markdowns. For future Retail 101 Series I’m planning Markup & Pricing Strategies, Negotiations (which would include liquidating product besides markdowns) and How to Sell or get a Buyers Attention.

Any other topics or questions you have? Please add to the comments.

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1. Background: This is going to be a different type of newsletter. For Retail 101 Series I’m going to get into the basics of retail. Understanding the math and financial side of the industry. I fell in love with Retail when I was studying at Syracuse University and discovered that I was 1) actually really good with numbers and financials and 2) this is an incredibly dynamic, creative and exciting industry. I then spent 15 years in Buying Offices running my P&L and built a strong foundation understanding the levers to pull and run a business successfully. I use this in every facet of my work and strategy today.

My goal with Retail 101 Series will be to share the foundational parts of retail. It can be for someone looking to explore the industry more, someone who works on the creative side but wants to understand how the other operates OR for a consumer who is super curious and maybe wants to be an even more informed shopper.

2. Sometimes I wonder if the retail vocabulary I know is specific to retail, a retailer I worked for or words everyone knows??? The things we store in our brain.

3. COGS = Cost of Goods Sold

4. Gross Margin = the profit left over after you've covered the COGS

5. Inventory Turnover = how many times you sell through your stock in a given time period

6. If you want to dive even deeper into accounting review insights from this report.

7. Another method to reduce your inventory is to negotiate to send inventory back to the brand/designer - we can discuss this in a future Negotiations 101.