Markdowns. They aren’t what you think they are. In this two-part blog series you will learn all about markdowns: what they are, what their ramifications are, what a markdown plan is, how to implement one and how it will benefit you long term.

Markdowns are mischievous things. The percent off that a brand gives to entice purchase will lead to an even greater reduction in gross profit. To drive purchase via discount, brands must be willing to absorb a bigger hit to margin.

1. How does this percent difference work? Here’s an example:

Let’s say you have a product whose MSRP (Manufacturer’s Suggested Retail Price) is $200. The total cost of raw goods and labor to make the product is $60. So, if you sell that product at MSRP, your Gross Profit is $140 ($200-$60=$140).

Now let’s say you have leftovers of this product. You put a 25%-off tag on it, meaning now you are selling it at $150. The total cost of raw goods and labor is still $60, meaning that now your Gross Profit is $90 ($150-$60=$90).

Thus, with a 25% discount, your gross profit went from $140 to $90, a 35.7% decrease. In this situation a 25% discount on price lead to a 35.7% decrease in profit for your company. Sneaky, eh?

2. Why even do markdowns?

It’s as simple as this: to move the product.

Excess inventory ties up cash. A company acquires inventory for the purpose of reselling the merchandise at a profit. The profit generated from merchandise that sells can then be reinvested in new inventory and pay for the day-to-day expenses of the company. Excess inventory decreases this cash flow by holding the cash in goods form and preventing it from being put to use elsewhere. Thus, the less excess inventory, the better the cash flow and the more profitable the company can ultimately be.

3. So, why does excess inventory exist in the first place?

Companies rely on the desirability, timing and demand of their product to sell it to their customers, whether they are wholesalers or end-consumers. These variables cannot be controlled and instead are dependent on external factors such as economic instability, changes in consumer spending habits, unexpected seasonal weather fluctuations, climate changes and also purchasing setbacks, such as transaction errors, technology mishaps and credit issues.

About 60% of excess inventory is due to shipment delays, which are caused by processing times, order frequency and international regulations. Another 25% is due to technical challenges with system integrations, purchase orders, EDI processing, and lack of visibility into the business. And 15% is due to returns and quality requirements. So when there are disruptions to all these factors, excess inventory builds.

4. Why is excess inventory something brands want to avoid?

Excess inventory represents a loss of revenue, not simply because the brand will have to sell it below MSRP but also because excess merchandise rapidly loses value the longer it is held in stock. The demand for that product diminishes and it takes “shelf space” away from a newer product with perhaps a higher profit margin. Holding costs for this inventory such as warehousing, insurance and taxes further diminish profits. Additionally, inefficiency in monetizing inventory affects a company’s ability to take out loans at the best rates. The amount of money recovered that is currently tied up in inventory can make the difference between a bad year and a good year, and a good year and a great year.

So selling the excess product, whether it’s at a percent off first in-store, then to off-price retailers, is essential to a working brand. And thus, if markdowns help sell and move the product, most retailers will take the lower Gross Profit than the more severe consequences, such as write-offs or large incurred costs.

5. But what is a write-off?

A write-off is a formal recognition that a section of inventory has no value anymore. This is typically recorded in the finances as either a loss at the cost of those goods being made or as a non-recurring loss. Other things “written off” by a company include uncollected payments and other inactive fixed assets.

Large recurring inventory write-offs indicate that a company has poor inventory management. This usually raises red flags to investors, banks and those running the brand, and they in turn call for action to be taken to fix the issue.

So it seems like markdowns are the answer. But these markdowns need to be done strategically to limit the more severe consequences, such as write-offs, selling the product below cost, or ruining the brand’s reputation by having to sell it to certain off-price retailers. And the best way to do this is to create a markdown plan.

Time for part 2