Does discounting improve profits in the retail fashion industry?
Are discounts used as a volume driver or to create a price anchor?
The goal is not to minimise discounts, the goal is to maximise net sales
Looking at the above graph, it is tempting to see customer discounts as the single biggest opportunity to improve contribution. Reducing the discount will increase the contribution. In reality, this conclusion is probably only partly correct.
The goal is to maximise net sales, not minimise discounts. The subtle difference in restating the goal in this way reveals two possible objectives for discounting:
- Discount to drive volume
- Use discounts to create a price anchor
What is a consumer willing to pay?
Studies in behavioural economics suggest that consumers do not necessarily understand the value of the things they purchase. Without understanding value, they look to other signals to determine how much should be paid.
This is why post-purchase rationalisations are made for expensive items: “It was 50% off, what a bargain!”
The discount of 50% is completely dependent on what the potentially inflated recommended retail price is. Value can be created in a situation where a consumer would rather pay $130 after 50% discount than $100 with no discount for the same fashion item. The $30 premium is paid for the perception of value.
If a retailer chooses to operate in this way, monitoring and reporting on the value of discounts granted is clearly a waste of time and drives behaviour that contradicts the discounting strategy.
In Australia, volume appears to be the primary objective
Our research reveals that the majority of large retailers tend to use discounting to drive volume.
If more volume is the goal, how much more volume is needed?
Why is volume the primary objective?
Retail results are studied closely by economists. Retail spending is an indicator of consumer spending. Consumer spending is the largest component of aggregate demand. It also is an indicator of consumer sentiment.
Immense pressure is put on retailers to match or better prior year sales.
However, while matching revenue may indicate stable consumer sentiment it does not necessarily help retail fashion shareholders through stable or improving profits.
In fact, it could be doing just the opposite.
Revenue is vanity, profit is sanity
Often, discounting is initiated to maintain sales levels when performance is poor compared to prior years.
The increase in sales volume required to maintain margin after discounting is much greater than the increase required to maintain sales.
Simply maintaining sales revenue through aggressive discounting can easily lead to a decline in margin if volume growth is insufficient.
If this process is repeated year after year and volumes are not increasing enough, there is a real chance of declining profit.
Evaluating the results of discounting strategies
If the primary purpose of discounting is to drive volume as opposed to engineering a higher eventual selling price per item, we would expect incremental discounts to drive incremental volume. To test this hypothesis, we need a way to measure customer responsiveness to changes in discounting.
Price elasticity of demand is technically correct but difficult in practice
The responsiveness of demand for a product relative to changes in price is referred to as price elasticity of demand and is expressed in formula form as:
|% change in quantity demanded|
|% change in price|
In economic theory, calculating the price elasticity of demand is simple. It is simple because it has few data points, it assumes informed buyers that respond reasonably and consistently to changes in price, it assumes that stock is available in the size required and there is consistent market for the product.
In order to evaluate effectiveness of discounting strategies, an alternate measure of responsiveness to price change is needed.
Considering quarterly correlation between discount and volume
Another way to evaluate how customers respond to discounting is to calculate the co-efficient of correlation between discounts granted and volumes sold. In order to account for seasonality, the time series evaluated can be broken into quarters.
The benefit of this approach is that it is easy to calculate and replicate across all fashion lines or SKUs. The output of the analysis is also fairly easy to understand and evaluate over a period of time.
Are discounting strategies effective?
When evaluating effectiveness of discounting, PCG follow a similar pattern for all our engagements that require detailed analysis.
We form high level hypotheses and then test these using enterprise data. We also evaluate the data across as many dimensions as possible in order uncover actionable, money-making insights.
We have noticed a number of trends in discounting strategies across a few retailers that indicate opportunity for improvement.
If strategies are effective, it is more likely by chance than by design
Discounting is largely a re-active process.
Reasons for discounting tend to fall into three categories:
- Scheduled sale to coincide with holiday or event
- Sale to match competitor
- Sale to bump revenues to produce comparable result to prior year.
There needs to be more sniper rifle, less shotgun
The reactive nature creates a time constraint on creating a discount strategy. Lack of analytical resources creates a capability constraint on creating a discount strategy.
The end result is a broad brush discount strategy which is as likely to erode value as create it.
Instituting store wide discounts means that lines that sell well regardless of price are reduced as well.
These broad discounts also condition customers to wait for discounting before purchasing.
Using only averages can produce average results
Even when a level of analytical rigour is introduced in creating discounting strategy, profits may not be optimised.
Unless the analytics are done at a sufficiently granular level, value eroding decisions can still be made.
- Do all stores respond in the same way?
- Do geographies influence impact of discounting?
- Do colour and sizing have any bearing?
Discounting is not the only driver of volume, and it is not the cheapest either
In retailers with a loyal customer base and effective loyalty program, we notice than direct marketing campaigns can yield significant uplifts in sales. Marketing campaigns can yield exceptional returns on investment.as the cost of the inclusion of a single fashion item in the campaign is spread over every item sold. This as opposed to discounting where every item sold attracts incremental opportunity cost.
We noticed that retailers’ reporting systems to not provide adequate feedback on stock availability. The general consensus is that they have too much stock, but deeper analysis reveals that quite often certain sizes are not properly catered for resulting in lost sales.
How can PCG help?
PCG’s analytical strength and depth of experience in the retail business
PCG has invested heavily in its analytical capability, recruiting experienced senior analysts and forming a separate group, PCG Solutions, to tackle problems which require bespoke solution development.
PCG also has extensive experience in the retail industry and is able to guide businesses on discount strategy creation and implementation.
By performing in-depth analysis, we are able to answer tough questions like:
- Are certain SKUs responsive to discounting?
- Does responsiveness to discounting change according to season?
- Are sales spikes determined by other factors such as restocking or marketing campaigns?
- Are store-wide discounts being granted on lines that sell well irrespective of available discounts?
- Is the customer loyalty program creating value?
- How are stock levels managed by store?
Knowing the answers to these and similar questions allows the fashion retailer to make informed decisions around its discounting strategy.
Discounts can be planned in focused way to yield better results than simply applying store wide discounts.