Retail discounts and the illusion of success

I came across a blog post for a retail software product (which I will not name here), which said the following: "We have achieved great success with our product implementation at a European online auto parts retailer. Our product was able to deliver a 15% sales lift with an effective discounting of only 2.17%..."

I thought that sounded very good.

But then I indulged myself in a thought experiment: 'What sales lift does a retailer need to breakeven on an initiative which discounts the price by 2.17% below the regular price?'. Stop for a moment and answer that question within 5 seconds without pen and paper....

Now let's look at the math behind a 'successful' promotion

If you are an online retailer with gross margins of 20%, average CPA commission of 1% and net shipping costs (shipping costs less shipping charges to customers) of 6% of revenue, then your 'effective' margin is 13% of revenue.

To breakeven on a 2.17% discount, you would require a sales lift of 20% (!!!).

Here is a What-if scenario table which calculates breakeven sales lift for various levels of effective margin and discount:

Said in another way, to breakeven on a 2.17% discount with a sales lift of 15%, the European retailer would need an 'effective' margin of 16.7%. With 1% average CPA commissions and 6% net shipping costs, they would need a gross margin higher than 23.7%.

I doubt whether the European retailer broke even on the discount, because my thought experiment doesn't even include the cost of the software (which claimed 'great success').

The thought experiment is an eye-opener for eCommerce and retail companies who are willing to spend a lot on discount programs. Remember that even a harmless looking 5% discount requires a sales lift of 63% if your 'effective' margin is 13% (refer to the table above).

So that set off another thought in my mind: "What long-term strategic reasons would merit making an apparent loss on a discount program?"

Here's what I think are potentially valid strategic reasons for any retailer:

1) It is a short life-cycle/ shelf-life product (clothes, shoes, books, mobile phones, cameras, laptops, perishables) which is approaching the end of its season/life-cycle/ shelf life. As a retailer you are taking a strategic call that the cost and the risk of carrying inventory beyond the end of the season/life-cycle/ shelf life would be too high. However it is critical to distinguish long life-cycle products in short-life cycle categories (e.g., plain blue jeans, basic dress shoes, text books, reference books, etc) and ensure that you are not discounting those as much as the short-life cycle products.


2) Competition is discounting the same product heavily and you assess that you will not be able to sell the product at a 'regular price' later. This reason may often play along with reason 1. However it makes sense to use price comparison frequently (at least daily) to ensure that you are not pricing well below competition.

3) By discounting the product and taking a short-term loss, you estimate that you will be able to acquire new customers who will be loyal beyond the short-term. Many eCommerce companies seem to be thinking this way. My good wishes for pulling this strategy off :-)

Would love to hear your thoughts. If you need a copy of the spreadsheet behind the breakeven table (which has a more detailed working based on gross margin, CPA commissions, and shipping costs), please email me at raj AT knowledgefoundry.net

JC Penney's pricing experiments (continued)

I had written about JC Penney's failed experiments with reducing discount sales a few weeks ago (click here). I had made 4 points:
1) Everyday Low Price needs to be tested before being implemented
2) Need to continue store-in-store concept
3) Need good exclusive designers
4) Website needs major overhaul

I heard that they are getting discount sales back in the store (click here). They are also showing price comparisons for comparable products and maximum suggested retail price for each product.

While I think this is a good move, it will take significant effort to turn-around JC Penney. They will have to convince shoppers who have struck JC Penney off their shopping list to visit the store again...and that's not an easy task.

Should Abercrombie discount its wares?

The Wall Street Journal reported earlier this week that Abercrombie & Fitch is pursuing a strategy of not discounting its apparel (fashion brands targeted at young people) during the current recession (click here). The article mentions that their competitors (American Eagle Outfitters, Aeropostale, QuikSilver, Pacific Sunwear) have discounted their apparel significantly.

While competition has seen same-store sales decline by 10-11%, Abercrombie's November same-store sales fell by 28%. However Abercrombie enjoys the highest gross margins (66%) compared to competitors who have much lower margins (AEO:41%; Gap:38%; J Crew:43%, Pacific sunwear:29%). The management insists that discounting will lead to long-term erosion of brand value.

I can't help but ask myself: Should Abercrombie discount its wares?

I think there is a strong case for Abercrombie to consider pricing lower selectively. Here's why:

• Abercrombie's target population has been hit hard by the recession due to potentially reduced pocket money from parents (for younger teens) to bleaker job prospects (for recent graduates) to higher tuitions and costlier student loans (for college students). Clearly, the target customers will cut back on apparel spending, especially on premium brands.
• Abercrombie has a 66% gross margin (Yep, you read that right: their average cost of goods sold is only a third of the average price). However its fixed costs (marketing and distribution expenses) run to more than $450 MM per quarter (~54% of sales in the Nov'08 quarter). This is much higher than the comparables for most competitors.
• Assuming that marketing and distribution costs remain largely fixed, Abercrombie will make a loss if its sales decline a further 15% from Nov'08 quarter levels.
• Based on current sales and inventory numbers, Abercrombie is carrying more than 50 days of inventory. This is a fairly high level in Abercrombie's history. Inventory pile-up could force it to discount later(as winter-wear will need to be sold off before spring).
  
• Although there is a strong case for brand equity dilution, Abercrombie could consider structuring the discount selectively on products that are slow-moving. Also it can be relatively discreet about its discounts so that it does not impact brand image.

Let me know what you think....

My thoughts on Nielsen's "Top 10 Retailer Mistakes on Black Friday"

Nielsen published an article earlier this week on "Top 10 Retailer Mistakes on Black Friday".
According to Nielsen, the mistakes include:

• Sticking to traditional categories
  
• Not having a retailing objective
  
• Not measuring your objectives
  
• Leaving a bad first impression with new shoppers
  
• Missing loyalty opportunities
  
• Sticking to Friday morning
  
• Not having door-buster merchandise in stock
  
• No sense of urgency
  
• Shallow discounts on door-busters
  
• Not scouting the competition

While I agree with most of these points, I do have some disagreements:

1. It may be a bad idea for retailers to try out new categories. I think it is OK for an electronics retailer to offer free soda and chips during Black Friday, but selling these items is a very different proposition.
2. Most retailers do have sales objectives (by category) for Black Friday. I think what they also need to have are gross margin objectives. Given the hectic pace of Black Friday, it is often not possible to have targets for 'new customer footfalls'.
3. Retailers need to be careful about passing discounts to the most loyal customers. Many of them are willing to shop with the retailer without the discount. On the other hand, many Black Friday shoppers are active discount seekers.

Here's wishing all of you a happy Thanksgiving

Black Friday deals: Do they work for the retailer?

The US holiday retail season this year is expected to be the worst in the past few decades. Many retailers have started offering Black Friday discounts in advance.

The website Black Friday Ads tracks some of the hottest discount deals being offered by retailers. They have a page which tracks the scanned advertisements of most big US retailers. Some retailers are offering online deals at prices below Black Friday prices.

I couldn't help wondering how retailers can use analytics to maximize their Black Friday sales and gross margins. Here are some suggestions :

• Designing the black friday deals:
  

1. Analyze market surveys to understand what products people want to buy during Black friday (computers, HD TVs, iPods, hard disk drives, digital cameras, GPS devices, clothes, toys) this year
2. Benchmark prices against competition based on information available daily to ensure that you have enough traffic-pullers...these get the people into the stores.
3. Ensure that your deals are spread across the aisles/ departments. This ensures that customers are exposed to more categories whil picking up the doorbuster items and that all doorbuster products are not picked up just by the first few customers. An analysis of previous years' transaction data will yield numbers on how many customers got a doorbuster product (typically a few hundred per store) and how each of these customers moved through the aisles.
   

• After Black Friday: Analyze the baskets of transactions during Black Friday:

1. Customers who buy doorbuster products often pick up other items that may not have significant discount. Calculate the sales and gross margin on baskets that have a doorbuster product. Retailers often lose money on the first customers in line.
   
2. Customers often come in after the doorbuster products are sold (Each store usually stocks 5-15 units of each doorbuster). They often pick up products with lower discounts. To calculate the halo effect of the discount, calculate the sales and gross margin lift for Black Friday baskets without a doorbuster product
3. So long as the total of the above has positive sales and margin impact, the retailer made money on the Black Friday deals.
4. The learning from Black Friday can be used to better structure deals for the rest of the holiday season.

This season, retailers may have to resort to a long period of discounting with dynamic moves based on competition and sales performance on a daily basis. Getting the process of discount pricing will be very critical.