Is Your Initial Markup Enough?
One question I am repeatedly asked by retailers is how to increase maintained margin. Several answers readily come to mind, the most obvious being to avoid overbuying, and therefore reduce the margin eroding markdowns that accompany such a practice. Another way of increasing maintained markup is to find ways to increase initial markup (IMU).
Understanding Markup Language
Let’s make sure we are all speaking the same language. When I say, “initial markup,” I am referring to the markup percentage placed on the goods when they are received from the manufacturer. Maintained markup is what is left after taking into account the cost of the markdowns. Stated differently, maintained markup is the difference between net sales and the gross cost of the merchandise sold. Gross margin is the difference between net sales and the net cost of the merchandise sold. Total merchandise costs include the cost of the goods, freight inward, any workroom costs, and any adjustments for earned discounts. It is clearly a different number than maintained markup.
The Correct Initial Markup is Crucial
Having the correct initial markup is the cornerstone to achieving the desired maintained markup. Have you ever wondered what the determining factors for initial markup are? Why do we double the cost? What does the term “keystone markup” mean, and where did it originate? My quest into the origin of keystone markup did not yield any definitive answers. One source at the National Retail Federation (NRF) seemed to think that there was an actual “markup key” in the early days of cash registers. This practice predated individually ticketed items, and pricing was oftentimes handled at the point of sale. One expert thought the term began in the jewelry business. Another thought more closely follows the dictionary definition of the word, which is a stone at the top of an arch that locks the other pieces in place. I suppose this makes sense, since 50 percent of a keystoned item is cost and the remaining half is markup. Regardless of origin, keystone pricing refers to a percentage markup applied to a product’s cost, although it is becoming an outdated term due to rising markups.
In my work as a retail consultant, I continually ask retailers to define their initial markup. The answers are quite interesting, and run the gambit from doubling the cost to adding $1 or $2 dollars to a multiplier of 2.2 or 2.3, as an example. These answers over time have led me to the conclusion that most retailers truly can’t explain what initial markup was intended to cover. There are three areas that IMU must satisfy: 1) desired net profit, 2) operating expenses, and 3) markdowns. Outlined below is a formula for determining initial markup given the objectives above.
IMU = (desired net profit % + operating expense % + markdown %)
100+ the markdown %
Example: Let’s say that our net profit goal is 7 percent, operating expenses are 40 percent and markdowns are 18 percent of sales. Given the formula above, the IMU percentage would have to be 55 percent to cover the markdowns, pay the overhead and still contribute 7 percent to the bottom line. If the store average is say 52 percent on average, net profit would decrease to 3.4 percent right from the start, given the example above. If you do the math, that is nearly a 50 percent reduction in profit. To restate the message, initial markup is directly related to net profit. You must begin with enough markup in the beginning, in order to have something left at the end.
It is a good practice for all stores to review pricing practices on a regular basis. Competitive pressures, changes in operating expenses and availability of promotional goods all come into play when deciding on a markup goal. Are you making markup decisions based on what a product will sell for, or what you paid for it? One way to avoid falling into the trap of cost-based pricing can be done when buyers are at market. The best time to determine what the actual selling price will be is at the time the order is written. In my previous retail career, I would often have our buyers decide what they thought they could sell a certain item for, prior to knowing the cost. Once we knew the cost, we would make a decision to buy or pass the item. Basing the retail price around the intrinsic value of the merchandise, instead of it’s cost, helped us to increase our initial markup. Perhaps this strategy would work for your store as well.
The Truth About Markdowns
The word itself strikes fear in the hearts of most retailers. Call it by whatever term you wish, “price adjustment,” “promotion,” or just plain “sale,” the translation is the same and conjures up all sorts of negative emotions. The fact remains, however, that any reduction in the retail price is really a markdown.
Most folks in the retail business have an inherent disdain for the very word. Taking too many markdowns represents failure in some area or another. Overbuying, duplication, poor timing of deliveries, and bad assortment planning are all recognized causes of markdowns. Excessive markdowns raise the cost of goods sold and result in a reduction in gross margin. When margin levels fall below those of operating expenses, the store has a net loss. To more fully understand this retail nemesis, let’s uncover some truths about markdowns.
Truth 1. Markdowns are the tuition retailers must pay for the education they receive from their customers.
A lot can be learned about how to buy and price merchandise from past mistakes. If you really want to know where you screwed up, carefully survey your markdown rack.
Truth 2. Since markdowns are a way of life, as well as an important part of the retail business, it is important that a markdown plan be established.
Base the markdown plan around the turnover goals of the company. For example, if your turnover goal is three times, it is important to make sure that stock is sold within a seventeen week period.
Truth 3. Always explain the markdown to your customer.
If you fail to inform your customer that the markdown is for a special buy, end of season clearance, weekend only promotion, etc., you risk customers not believing your prices, and every sale turning into a mini auction.
Truth 4. Overbuying is the number one cause of excessive markdowns.
Stores don’t go out of business because of high markdowns, they go out of business because they can’t pay for their overbuying. If your turnover goal is three times, you should be careful not to buy more than you can sell within a four month time frame. If you buy more than you can sell, you are predestined to experience either excessive markdowns and reduced margins, or slow turnover and poor cash flow. Faced with this option, it is always better to take the markdowns, clear the inventory and generate cash. I have never seen a store go out of business because turnover was too fast and cash flow was too strong. On the contrary, I have seen several stores go under with healthy gross margins on their profit and loss statement.
Truth 5. Most retailers have heard of, and would agree with, the axiom that the first markdown is the cheapest.
What this really refers to is that the first price reduction is an effective one. A “cheap” markdown does not refer to a low percentage reduction that does not significantly generate increased sales. A markdown of 30 percent that moves merchandise is therefore “cheaper” than a 20 percent markdown that does not produce the desired results.
Truth 6. The price you paid has nothing to do with the markdown price.
The customer does not care what you paid for the product, nor should you. When you get to this point in the sales cycle, your only concern is how quickly you can convert the inventory to cash. From time to time I encounter stores that are reluctant, and in some cases even refuse, to mark anything below cost. I have never been able to understand the logic behind this thinking. I suppose the mindset is that money is being lost, when in reality much more lost revenue is at stake by not getting cash out of slow selling stock and replacing it with new product. Worse yet is packing goods away in the back room and dragging them out again next year. Remember, your cost is not relevant in a markdown pricing decision.
Truth 7. In most cases, it is a good practice to keep markdown merchandise at the back of the store.
You want your customers exposed to new full price products at every opportunity. Exceptions to this would be storewide sale events or seasonal clearance time, when a large majority of items are on sale.
Truth 8. Nurture your good customers who do not shop you on price alone.
This is where added value comes into play. The cosmetics industry does a great job of this by offering gift with purchase items. Thank-you notes to good customers also go a long way in showing a customer that you value their patronage.
Understanding these truths and employing sound markdown management should help turn markdowns from a negative part of business into a positive.
Ritchie Sayner is Vice President of Business Development for RMSA Retail Solutions.