Markdown – What is a markdown?
In finance, a markdown is a reduction in the price and value of an asset.
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Markdowns are designed to increase sales, so they usually occur when a business can’t sell a product at its current price.
By reducing the price, a markdown makes a product or service more desirable for customers. After a markdown, each unit has a lower profit margin, but overall sales revenues are higher because more units are sold.
Markdowns and pricing
When setting a price for a particular good or service, it’s important to value the product accurately.
According to the theory of supply and demand, if the price of a commodity is too high, fewer units will sell. As such, if a business overestimates the market value of a product, it will struggle to make sales. On the other hand, if the price of the product is too low, it could become unprofitable.
Markups and markdowns are used when businesses under or overvalue a product. A markdown adjusts the price of a product to reflect the price consumers are actually willing to pay – it’s therefore the devaluation of a product.
If sales don’t increase after the first markdown, it might be necessary to continue marking down the price of a product until it sells at a profitable rate. There should be enough time between markdowns to sufficiently test the impact of the new price.
Types of markdown
As well as misvaluing a product, there are a few reasons why a company might use a markdown.
If a retailer doesn’t plan on restocking an item, it could be more cost-efficient to sell the product at a reduced price than to pay for storage. By reducing the value of a product, clearance markdowns speed up sales and therefore get rid of excess inventory.
Damaged goods markdowns
If a unit of a product is damaged, it’s unlikely to sell for the same price as a non-damaged unit. It’s therefore common to reduce the price of any spoiled or defective goods.
Also known as price-matching, competitive markdowns occur when a business reduces the price of a product to match its competitors’ prices. If two companies sell the same product at different prices, the company with the higher price is likely to sell less.
Example of a markdown
Markdowns are common in many industries and are frequently used in retail. For example, a clothes retailer produces a new line of jeans, which are sold for £50. After three months of poor sales, only 20 pairs of jeans have been sold for a total of £1,000.
The retailer reduces the price by 20% to £40. Three months later, 50 pairs of jeans have sold for a total of £2,000.
Although the clothes retailer makes less profit per pair of jeans, overall profits increase because more units are sold as a result of the more attractive price.
Markdown vs. discount
Markdowns and sales discounts are similar concepts, but there’s one important difference: a markdown is a reflection of value whereas a sales discount is not.
Both markdowns and sales discounts involve the reduction of price – but for different reasons. A markdown is an adjustment of price to reflect a lower market value, whereas a sales discount doesn’t change the valuation of a good or service.
Instead, discounts are reduced rates offered for specific reasons – such as seasonality, customer loyalty or demographics (such as discounts for students or pensioners).
Both markdowns and discounts can be temporary or permanent. If a product sells much better than expected after a markdown, the price might be adjusted again. This could be because the markdown was too much, or because of external factors such as an improving economy or a change in market trends.
Markdowns for brokers and investors
Although the term ‘markdown’ is usually used to refer to a reduction in price, it might also be used when talking about investment and brokerage. In this context, the markdown is the difference between the price the broker or investor pays for an asset and the price they sell it on for. This type of markdown might be considered commission.