An old retail adage is "you don't take margin to the bank; you take dollars to the bank." Yet in today's very challenging retail environment - high employment, war in the Middle East, a weak stock market, and consumers reluctant to part with their money - many retailers continue to evaluate their merchandising performance based on gross margin percent.

The most current MOR/FOR data available from the NRF indicate that over 30% of merchandise is sold at clearance. This is pushing initial markups far beyond any reasonable level and today's value-oriented consumers are closing their wallets and waiting for the next sale, which they have been taught is, for many retailers, only a few days away.

Achieving higher margins and improved profitability is not about raising prices. It is about intelligently managing prices. Not initial margins, but maintained margins. Lowering prices where and when it needs to occur, and maintaining or raising prices elsewhere. The key is building consumer-centric organizations that focus on pricing to value, not to cost. 

Adding Science to the Art of Retailing

We have been working in an area that is now often referred to as "retail revenue management" at the Retail Management Institute at Santa Clara University for over 15 years "starting in the 1980s when we didn't talk about setting "optimal" prices, but rather 'best' prices. Optimization was the focus of the research we published in academic journals; best was finding ways to help retailers move beyond doing the same thing faster and start doing them better. The gap between academic research and the world of leading retailers is beginning to close, and close rapidly. This isn't rocket science, but it also can't be done on the back of an envelope.

The retail revenue management field is dominated by a handful of small software companies with expertise that bridges the academic and business worlds. Although often referred to as "start-ups" these firms all have years of experience in the development of proven, real-world "optimization" algorithms. Their success is now attracting larger, more established, one-stop software firms who profess to be "developing" solutions - something that doesn't happen overnight. 

Initial Price Optimization

True price optimization is realized at three critical phases in the seasonal planning process - pre-season planning, in-season promotions and end-of-season clearance. Developing an optimal pre-season plan is centered on a merchant's ability to accurately forecast the demand for a given assortment. There are fundamentally two types |of forecast error - purchasing less than what is demanded, which results in stockouts and poor customer service; and purchasing too much, which leads to unplanned, clearance markdowns. Further, because local market conditions vary significantly across markets a common initial price for all stores may be convenient and easy to implement, but it is virtually never optimal. For large retailers operating hundreds of stores, and in multiple channels, the complexity of determining optimal prices at the store and channel level is overwhelming, but it can and should be done. 

Promotion Optimization

Closely related to establishing optimal seasonal plans is, for most retailers, promotional planning - both pre-season and in-season. Although some retailers are not considered 'promotional', the percentage of promotion-driven retail sales across all retail sectors continues to grow dramatically. In today's world, promotions have become so common that most consumers don't even notice (or respond to) an ad unless it screams out - "50% OFF; BUY ONE, GET ONE FREE." But are these promotions profitable? Based on our experience, the answer in many cases is a resounding "no!" John Wanamaker, founder of Wanamaker Department Store in Philadelphia, is often quoted as having said "I know I wasted half of my advertising dollars, I just don't know which half." 

While the success of promotions is often evaluated based on their impact on sales (often measured as lift, accelerationor plus over normal), true promotion optimization focuses on developing a promotional plan that maximizes gross margin dollars over the season. In analyzing the promotions for a major retailer, it became very evident that many of their promotions did not have a positive gross margin contribution, although sales did increase significantly. The problem centered on those deep promotions supported by large ads that gave up too much gross margin and were too costly to ever be profitable. Such analysis is imperative in order to achieve higher margins in any systematic manner. Further, without accurate forecasts of the sales increase associated with a promotion the outcome is likely to be poor customer service due to out of stocks or reduced inventory turnover due to excess inventory which can take weeks to sell off. 

Markdown Optimizations

Although pre-season and in-season pricing and promotion optimization can contribute to profitability, end-of-season clearance will always be central to improved margin performance. Yes, un-seasonal weather factors are important, but "a dog, is a dog, is a dog" is a phrase heard too often in Monday morning merchant review meetings. If consumers don't see value in a product at this week's price, it is unlikely that they will suddenly see the light and make it a hot seller. 

Clearance markdown optimization involves determining the timing and depth, at the store level, of the most profitable end-of-season markdowns. Two of the key learnings that have been identified in our research and validated in actual implementations are: 1) the most profitable markdown is the first markdown; and 2) the most profitable markdowns need not clear all of the merchandise. Although clearance pricing clearly has tremendous potential in improving the profitability of every retailer, the complexity and number of decisions that must be made on a weekly basis is simply overwhelming for any buyer/planner team. However, the causal forecasting algorithms used by companies like Spotlight Solutions are capable of analyzing sales trends for individual items or groups of similar merchandise and generating over 10 million price change recommendations on a weekly basis. 

Optimizing clearance markdowns often requires significant rethinking of the current markdown process, but can lead to significant improvements in product profitability. A large, multi-format retailer who developed its own system a decade ago has consistently achieved a 10%-15% improvement in profitability across merchandise categories and across formats. Given that many retailers report markdowns in excess of $250 million per $1 billion in sales, generating $25-$40 million in additional gross margin dollars per billion in sales is eminently achievable. 

In today's deflationary retail environment higher margins will only be realized by delivering greater value to the customer. The "go faster" era is over - retailers are increasingly challenged to find better ways of pricing, promoting and clearing merchandise. Employing these new approaches to retail revenue management is likely the single most significant area available to senior management to rapidly improve overall corporate performance. It is not a question of "if" optimization software will be implemented; it is simply a question of "when." The payoff is unequivocal.