+ Holiday items, including Halloween candy; Christmas trees, decorations, and cards; fireworks for the Fourth of July. before the holiday, with much deeper discounts once the holiday is over. uch items usually begin to he marked down just + Tours. A tour package typically includes both airline transportation and lodging, Although tours constitute less than 10% of leisure travel in North America, they represent a major portion of vacation travel in Europe and Asia. Atypical tour package would be six days on the Costa del Sol (in Spain), consisting of both round ‘tip air transportation and hotel accommodations. Bus travel to and from the air- port in Spain and meals might also be included. Tour operators start selling tours year or so ahead. As time passes, the tour operator continually monitors the book- ings for different tours. Ifa tour is performing worse than expected ({e., bookings are low), the tour operator may lower the price Since the price is always lowered (never raised) and the stock of inventory is perishable, the tour operator faces a markdown management problem. Automobiles. Like fashion goods, most automobile manufacturers operate on an annual selling season, New models arrive every September and must be sold within ‘year to make room for next year’s model Although some modiels may be “hot” and not require discounting, other models will not sell quickly enough at thelist price in order to clea the lot. The manufacturer and the dealer will use a mixture of promotions and markdowns to move the inventory. In general, the average selling price of an automobile (including reduced annual percentage rate, APR) tends to Gecline fairly steadily over the season. This gives automobile pricing the flavor of markdown management problem, although the markdowns are typically realized ‘through various promotional vehicles rather than as a reduction in the ist price. + Clearances and discontinuations. Almost any seller can be in a situation where he has inventory he needs to clear by a certain date. When Maytag announces that it will be shipping a new and improved model of washing machine in three months, retailers have three months to sell their existing inventory before it becomes obso- lete. Sequential markdowns are used to maximize revenue from this existing stock ‘The problem occurs a least occasionally for almost all retailers (and many whole- salers) but most frequently for those selling short-life-cycle goods such as comput- ers and home electronics. In many cases, sellers of shortlife-cyele goods mark down some portion of their total inventory every day. Markdown management is a problem that many businesses face every day and almost all businesses face sometime. In the next section, we describe some basic methods for opti- mizing the timing and amounts of markdowns 10.2 MARKDOWN OPTIMIZATION ‘We have seen why sellers might use a markdown policy. We now develop some models to determine fhow they should mark their inventory down over time. These models will be based on the following assumptions.+ Aseller has a fixed inventory (or capacity) without the opportunity to reorder. The inventory has a fixed expiration date (the owt dare), at which point unsold inventory either perishes or is sold at a small salvage value. Initially, the price of the good is seta list price. The seller can reduce the list price ‘one or more times before the expiration date + Only price reductions are allowed. Once the price has been reduced, it cannot be increased again. The seller wants to maximize total revenue—including salvage value—fom his fixed inventory. ‘Markdown optimization typically assumes that marginal costs are zero and that the goal of the seller is to maximize total revenue. This may seem surprising since the seller obvi- ‘ously paid someone for the goods. However, at the point a seller is considering markdowns, hhis costs are sunk—his inventory has already been bought and paid for. Furthermore, since the seller cannot reorder, increased sales do not result in additional future orde fore, the incremental cost of an additional sale is 0 and we can state the objective function in terms of maximizing revenue from @ fixed inventory. ‘There- Let p, denote the initial (list) price and assume that we have T markdown opportunities before the out date, For example, atypical season for a fashion item might be 15 weeks. As- suming that the item might be marked down at most once pet week, we would have p, as the price during the first week, p, as the price during the second week, and so on through the final price of py. We assume a salvage value of r that is received for all unsold items following the last markéown. This would be the price a retailer would receive from a jobber for unsold clothes, for example. If inventory entizely perishes atthe end of peviod ‘T—as in the ease ofa tour operator—then r = 0. It should be obvious that we would never set the price during any week to be less than r, since we can always wait and sell ll inven- toryatr. etx, be the unsold inventory at the beginning of period i. Then x; isthe initial inven- tory, which is given. We assume thal demand in any period is a function of the price in that period, and we let c(p,) denote the price-response function in period i The price-response functions d() satisfy all of the usual properties ice, they are downward sloping, contin- ‘uous, etc Sales in period ‘are denoted by g, Since sales in any period are constrained by the inventory on hand, we have q, = min(d(p), x]. We initially consider deterministic models, in which p, will uniquely determine d(p,} and hence q, We then turn our attention to (more realistic) probabilistic models, in which both d(p,) and q, are random variables. The starting inventory in each period is equal to the starting inventory from the prior period minus prior-period sales; that is, x,,, = x), fori = 1,2,...,T— 1. This process isillustrated in Figure 10.4. The re realizes sales of q, = min{d\(p,), x;], and his inventory at the start of the second period is, x; =X, — gy. He chooses his second-period price p, and the process continues, At the end of the season he has unsold inventory y ler stars with an inventory x, and chooses a price py. He xp~ qr for which he receives a salvage value ofr per unit, Thus, his total venue from his fixed inventory is TR = p,q, + Pag +--+ Prge + YrIni inventory List price ventory rrr’ bot soe Pesiod Peiod| Figure 10.4 Dynamics of markdow optimization, In a deterministic model, the seller finds the set of prices that maximize TR. In a proba- Dilistic model, he finds the prices that maximize the expected value of TR, that is, E[TR] 10.2.1 A Deterministic Model Since we know that sales in each period need to be less than starting inventory in that period, ‘you might think that we need a set of T constraints specifying that f=12.0T. However, withalitte reflection, itshouldbe clear that we require only one constraint, name) that the sum of sales forall periods needs to be less than or equal to the starting inventory. ‘With this in mind, we can write the deterministic markdown optimization problem as ames Dp die) +97 subject to Dale) yom & dlp) PSP fori=12,...,7 Pr We can simplify the formulation even further by substituting for y inthe objective func- tion, which gives a new objective function: max (6, dip) + 1%Since rx; is simply a constant, we can eliminate it from the objective function and write the ‘markdown management problem (MDOWN) as pmax, Dl. 2) dlp) (ao) subject to > ale) aoa) Di for = 1,2,.0..T (193) Pr (104) ‘The interpretation of the markdown management problem (MDOWN) is straightfor- ‘ward. Objective function 10.1 states thatthe goal ofthe retailer is to maximize total revenue from the inventory. This is expressed as maximizing the total increment over the salvage value received for each unit sold, Constraint 10.2 states that the retailer cannot sell more than his fist-period inventory. The constraints in Equation 10.3 guarantee that the mark- down prices are decreasing over time, and Constraint 10.4 guarantees thatthe final price is greater than the salvage value."° Example 10.1 “Aretailer has a stack of 160 men’ sweaters, and he has four months to sell the sweaters before he needs to clear the shelf space, The merchant wishes to estab- lish alist price at the beginning of the first month and then mark the sweaters down at the beginning of each of the next three months, Sweaters unsold at the end of the fourth month will be sold to an outlet store for $5 apiece. Further- more, by dint of his long experience, the seller knows that demand in each of the four months can be represented by independent linear demand curves: y(p,) = (120 ~ 1.5p,) (pz) = (90 ~ 1.5p:) dy(p,) = (80 - L.5ps) da(p4) = (50 — 2p.) where pis the price in month i for = 1, 2, 3,4. Formulating this problem asin MDOWN (Equations 10.1 through 10.4) gives the results shown in Table 10.2 che retailer had to maintain a single price during the entire four months, his, price-response curve would be the sum of the four individual price-response curves, that is, d(p) = dh(p) + dh(p) + ah(p) + di(p), and his price o tion problem would be to find the price p that maximizes pd(p) + $5(160 — <(p))". The optimal solution to this problem is p = $34.72 with d{p) = 133 so the total contribution is 133 X $34.72 + 27 X $5 = $4,752.76. The optimal markdown policy resulted in a revenue increase of about 79% over the use of aaazxpown manacuatens | 25) Tagua 10.2 Optimal solution for example deterministic markdown problem Pie Discount Demand Revense 08 56 $2,380.00 ase sLannso sat 1,950.12 ou $300.90 $35.00 $5097.42 single price. This is a bit smaller than the level of improvement claimed by many vendors of markdown management software 1 seller really knew the price-response curves for each week in the selling season, he could plug them into MDOWN and solve for the optimal markdown schedule atthe be- ginning ofthe season, and his work would be done. Since the curves ate deterministic, sales will be exactly as predicted, and there would be no need to deviate from his inital planned smarkdown schedule In reality, of course, things are not so simple. Without access to the ever-elusve crystal bal, sale are likly to deviate from expectations. The most effective ap- proach is to incorporate this uncertainty explicitly in calculating prices—an approach we take in the next section. However, the deterministic problem formulation can be used as the basis ofa simple dynamic markdown algorithm Deterministic Markdown Pricing Algorithm 1. Solve MDOWN to determine the initial price of p, 2. Observe sales q; during the first period, Starting inventory for the second period iss =a, — 4h 3. Solve MDOWN for pa, Ps, the price for the second period. using a starting inventory of. Put pin place as 4, At the beginning of each subsequent period, current inventory willbe the previous period's starting inventory minus last-period sales; that is, x, = x. — qu Solve MDOWN for p, psi.» Pr Using a starting inventory of x, Use the value of p as the price during the upcoming period i Example 10.2 ‘Consider the previous example and assume that dusing the frst month, the retailer sells 70 sweaters instead of the 56 he anticipate starting inventory of only 90 sweaters tthe beginning of month 2, Using. 90, he can use the demand curves ds(p:), ch(ps)-and d\(p,) to recalculate prices for months 2,3, and 4. The new optimal prices are py = $34.00, p, = $30.67, and p, = $16.50, He therefore sets his price for month 2 at $34.00. At the end ‘of month 2, he can observe remaining inventory and solve once more to deter~ rine the price he will charge in month 3. ‘This means he has aThis algorithm does not explicitly incorporate future uncersainty into its calculation of the current price. However, it does recalculate the price in each period, recognizing that sales to date are likely to be different from those originally anticipated, While this is less than ideal, this general approach can lead to improvements over standard practice. One study computed the results ofa deterministic algorithm similar (but not identical) to this one ap- plied to 60 fashion goods at a women’ specialty apparel retail in the United States and com- puted the predicted results to what actually occurred when the store used its usual mark- down policy. To correspond to actual practice, the algorithm only changed the discount level if the new discounted price was atleast 20% lower than the previous price. Further- more, each style had to be offered at list price for at least four weeks prior to the initial markdown. The deterministic algorithm increased total revenue by about 4.8% relative to actice, Much ofthis increase came from taking smaller markdowns sooner than usual store policy." standard store 10.2.2. A Simple Approach to Including Uncertainty A seller is facing his last markdown opportunity. He has a fixed inventory x and must set the price p for which it will be sold during the upcoming period, At the end of that pe- riod, any remaining unsold inventory will be sold for the salvage price r (Which may be 0). If he knows the price-response curve for this period, his problem is a very simple single- period special case of MDOWN. But now we add uncertainty to the mix, Specifically, we as- sume that demand given price, D(p), is a random variable whose distribution depends on p. What price should the seller set to maximize expected revenue? The problem faced by the seller is rae B[TR(p)] =p! in|D(p) x] + x= Flmin( (0), aI) e = (p — )E[min{D(p), x]] + rx (10.5) where the frst term on the right-hand side is expected revenue from first-period sales and the second term is salvage revenue Equation 10.5 is not too difficult to solve if we can model how the expectation Elmin{D(p), x] depends on p. One simple possibility is to assume that Dip) follows a w form distribution between 0 anda — bp for some a and b. Then, ifa = 200 and b = 10, de- ‘mand would be uniformly distributed between 0 and 180 when p = $2.00 and uniformly distributed between 0 and 150 for enue, and total revenue for different prices are illustrated in Figure 10,5 for the case of 4 = 200, b= 10, a salvage value r = $5.00, and an inventory of x = 60. In this case, the op- timal price is $13.29, with corresponding expected sales revenue of $440.89, expected sal- vage revenue of $134.23, and expected total revenue of $575.02. We can extend this formulation of the two-period markdown problem to create a simple algorithm that incorporates uncertainty. The idea is similar to the deterministic algorithm, in the previous s $5.00. Expected first-period revenue, salvage rev- mi, in which we solved the single-period deterministic problem t tablish « markdown price for the next period, observed sales during that period, and then solved the same problem again atthe beginning of the next period, using the new inventory value to get a new price. This time we follow a similar philosophy using the probabilistic