Markdowns: Decoding the Nuances of Consumer Behaviour

Back in the day, you could count on the local Woolworth’s to run a clearance sale once a year on slow-moving stock. Store managers were confident that these events wouldn’t cannibalize their margins the rest of the year or alter their customers’ buying behaviour. Today, discounts are seasonal or even more frequent events. As a result, consumers have been trained to be much more strategic about when they hand over their money.

Understanding how consumers make wait-or-buy decisions is essential for retailers desperate to get the most value out of markdowns. With that knowledge, they can set a discount large enough to attract new consumers but small enough to mitigate strategic waiting.

Earlier markdown strategy called for hefty 50 percent discounts; this approach assumed that consumers lacked foresight and wouldn’t become strategic outside the markdown period. The current thinking is based on a framework known as “discounted expected utility.” This framework suggests markdowns should be modest, around 10 percent, or replaced by the “everyday low prices” approach executed by the likes of Walmart and Costco.

There’s only one problem with the conventional framework: it fails to fully account for real-life wait-or-buy behaviour.

The Consumer's Trade Off

According to researchers Anton Ovchinnikov of Smith School of Business, Manel Baucells of Darden School of Business, and Nikolay Osadchiy of Goizueta Business School, the decision to buy an item at a regular price or wait for a possible markdown involves a multi-dimensional trade off. Standing at the sales rack, they say, consumers size up the value of the item, the delay in getting it, the likelihood of getting it when the prices are marked down, and the magnitude of the price discount.

The shopper who admires a sweater on a store shelf, for example, can buy it now at full price or wait several weeks until Boxing Day in the hopes of scoring a deal. If she waits, she won’t be able to wear the sweater at a party. There is also risk that by Boxing Day the sweater may be sold out in her size. “The consumer now has to trade off these three things,” says Ovchinnikov, Distinguished Faculty Professor of Operations Management and Management Science. “There’s the discount which is good, the delay which is bad, and the risk which is also bad. These are all interconnected.”

If retailers were to factor in the interplay of these “behavioural anomalies,” the researchers say, they would be able to offer higher markdowns than the conventional framework suggests and bring in more revenue.

To reach this conclusion, Ovchinnikov, Baucellis, and Osadchiy, first built a model that accounted for three well-known anomalies: sensitivity to risk; sensitivity to time; and how sensitivity to time depends on the size of the payoff. Using this model, they then applied game theory involving a firm setting the discount and consumers acting in various scenarios. Finally, they tested and validated their results in lab experiments.

Their resulting model yields a more aggressive approach to markdown management than the conventional framework. The researchers found that retailers can increase their profits by cutting prices sooner and more deeply.

The conventional markdown approach fails to allow for the fact that consumers are less patient for small markdowns and more patient for large ones

The conventional framework, the researchers say, is right in assuming consumers like price discounts and dislike the delay or the chance of losing out on the product. But this conventional approach fails to allow for the fact that consumers are less patient for small markdowns and more patient for large ones.

Consider the implied behaviour of a consumer who pays full price. “People who are buying at full price are afraid of risk or delay,” says Ovchinnikov. “So for them, adding a little risk (of losing out on a product) to no risk is very painful.” Now consider the consumer who is not willing to pay full price and is comfortable waiting until the product is marked down. “People who are strategically waiting are already experiencing delay and risk of item being unavailable and a little more isn’t that painful.”

Knowing such tendencies, a retailer can exploit this impatience and offer deeper markdowns without sacrificing sales at the full price, says Ovchinnikov.

Small Adjustments, Big Payoffs

How retailers manage markdowns involves big stakes. They may be great for attracting new customers but they also mean that customers willing to pay the higher price are now paying the markdown as well. That hurts margins.

It has been estimated that nearly one-third of unit sales are generated by markdowns. Given the typical retailer’s margin is roughly three percent, “if you can increase the revenue from markdowns by one percent, you will increase the profit for the retailer by 30 percent,” says Ovchinnikov.

That’s why the new model developed by Ovchinnikov, Baucells, and Osadchiy shows such promise. “This effect comes not from massive changes but from nuances in consumer behaviour,” says Ovchinnikov. “Being aware of the behavioural regularities surrounding this (wait-or-buy) decision and incorporating them into markdown management offers substantial revenue opportunity for retailers.”

— Alan Morantz