It’s a dilemma that almost every retailer faces. For seasonal goods or limited stock goods, you need to forecast demand well ahead of the season, and it’s far better to get in early and get out early than be stuck with a bunch of goods that you need to mark down. The markdown losses loom large on the P&L–it’s a huge expense line item against an already slim EBIDTA margin–if only markdown losses could be reduced by X%, just imagine what would happen to the P&L–it would all flow to the bottom line, right?

Not so fast.

This is one of those times where the accounting standards really hurt an objective analysis of a business. We treat markdown losses as real losses, and show them on the P&L as a cost of sales, but we don’t do the same for other promotion expense or pricing decisions. In a sense, normal promotional pricing gets zeroed out—sales are typically reported as net of discounting—and for good reason—but the inconsistency poses a challenge to accurately prioritizing opportunities for a pricing or merchandising operations team.

Let’s take a stylized example: we’re going to sell widgets at the Everyday Low Price of $10. We bought the widgets for $9. Let’s say we sell 100.

Net sales = $10 * 100 = $1,000

Cost of Goods Sold = $9 * 100 = $900

OK, now what happens if we change our business model to High/Low? We sell half of the widgets for $11, and half on sale for $9 (we sell at cost to drive traffic and price perception)

Net sales = ($11*50 +$9*50)=$1,000

Cost of Goods Sold = $9 * 100 = $900

Looks the same right? Where is the cost of the discounts? How come nobody has to show the Difference between the $11 and the $9? Shouldn’t there be a cost of $2 * 50 = $100 in discount expenses?

We don’t show that anymore on P&Ls. Otherwise people could artificially inflate same store sales pretty easily… just raise the prices 10% and then discount it all back as cost of sales and boom—double digit revenue growth!

But markdown pricing is different. Most retailers use the Retail Inventory Accounting Method (RIM). https://accountingexplained.com/financial/inventories/retail-method It basically means every time we mark down the goods in seasonal merchandise we have to explain that as a reduction of sales.

Here’s a simplistic example of how it’s different. I’ll disclaim in advance that it is leaving out a bunch of things—let’s not get into the cash flow considerations, potential alternative revenue that could have been generated in the space, salvage value of selling to an off-price retailer the clearance goods, labor costs of manual repricing/tag changes, etc.

Pretend you’re selling Y2K T-shirts in December 1999. Demand is fixed—after Jan. 1, 2000 the market value of these T-shirts is $0. You needed to order these T-shirts 6 months before you started selling them, so all costs are already sunk. You paid $9 a shirt for the goods and you bought 3,000 units.

There are 3 weeks left in the year. Potential weekly demand is consistent for all 3 weeks, and if you don’t sell a shopper a t-shirt in a week they won’t come back the following week and buy. The demand function looks as follows:

@$12 you’ll sell 900 a week

@$10 you’ll sell 1,000 a week

@$9 you’ll sell 1,100 a week.

Which pricing approach is better for your business?

In Method 1 I could see having a panic attack… All I’m going to clear in profit at the end of the year is $3,700 for my 3,000 t-shirts that I bought for $9 each, yet my markdown expenses are nearly $5,300! If I could just address those markdown costs I could nearly triple my profits!!!!

Yet in Method 2 I achieved 0 markdown, and I made $700 less.

Maybe you shouldn’t care all that much about markdown cost savings.

This is a common trap, and can be explained by Behavioral Economics. The Salience heuristic suggests that “what you see is all there is.” Nobel Prize Winner Daniel Kahneman identified that individuals are more likely to focus on the information that’s more prominent and easier to see and ignore the things that are less easy to grasp.

That’s not to say that markdown pricing isn’t really important to get right. You want to maximize your revenue given a sunk cost of products (or limited salvage value), and you want to do so smoothly so you don’t have lots of costs mid-season in repricing tags or moving inventory around between stores that are selling out faster than others, etc. But when prioritizing business investments, it’s often the markdown pricing opportunity that looms large, when realistically for most businesses there’s a lot more to be gained from everyday and promoted price optimization. It’s just that the missed opportunities never show up on the P&L… they’re hidden in plain sight.