A Decision-Support System That Helps Retailers Decide Order Quantities and Markdowns for

Fashion Goods
Author(s): Murali K. Mantrala and Surya Rao
Source: Interfaces, Vol. 31, No. 3, Marketing Engineering (May - Jun., 2001), pp. S146-S165
Published by: INFORMS
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A Decision-Support System that Helps
Retailers Decide Order Quantities and
Markdowns for Fashion Goods
MURALI K. MANTRALA ZS Associates
murali.mantrala@zsassociates.com 1800 Sherman Avenue

Evanston, Illinois 60201

SURYA RAO FI Sofex Ltd.

surya@fisofex.com 14 Eighth Main Road
Malleswaram

Bangalore, India 560003

We developed MARK, a stochastic dynamic-programming

model-based decision-support system, specifically to help
retail-store buyers of fashion goods decide on optimal mer
chandise order quantities and markdown prices. We imple
mented MARK as an interactive software that runs
program
on users7 and can be integrated with the
personal computers
retailers' point-of-sale (POS) and other information systems.
As we show in an actual-case illustration, MARK improved
profitability and managers' understanding of the decision
problems. MARK also provides valuable insights into the in
terplay between order-quantity and
dynamic-pricing decisions.
For example, higher markdown percentages do not necessarily
mean lower profits.
The bottom-line profitability of nonstationary demand (price response)
fashion-goods retailers, for example, functions, and little salvage value at the

department stores, specialty stores, and end of their selling seasons. Ideally buyers
catalog retailers, is affected by the would order inventories of such goods in

inventory-order-quantity and pricing deci response to observed demand. Unfortu

sions buyers and merchandising managers nately, in manyinstances, long delivery
make. Fashion (or seasonal-style) goods lead times or other supply constraints rule
have short selling seasons, uncertain and out the possibility of reorders and quick

Copyright ? 2001 INFORMS MARKETING?RETAILING AND WHOLESALING

0092-2102/01/3103/S146/$05.00 PROGRAMMING?DYNAMIC, APPLICATIONS
1526-551X electronic ISSN
This paper was refereed.

INTERFACES 31: 3, Part 2 of 2, May-June 2001 (pp. S146-S165)

A DSS THAT HELPS RETAILERS

of inventory during the sea stores since the 1960s. On aver

replenishment specialty
son [Hammond 1990; Iyer and Bergen age, markdown amounts have grown from

1997]. Consequently buyers often must de around six percent of net sales in the mid
cide and order inventory for the entire 1960s to over 26 percent by the mid-1990s
season well before the item goes on sale, with markdown percentages as high as 30
on uncertain forecasts of demand to 40 percent in apparel and dress depart
relying
at planned retail prices [Eppen and Iyer ments [Fisher et al. 1994; Levy and Weitz
1997]. 1995]. The surge in clearance sales by both
In practice, lacking quick resupply op large and small retailers has received
tions, buyers tend to buy stocks of mer much press attention [Associated Press
chandise according to their optimistic fore 1997]. However, while the discounts boost
casts while planning to mark down sales, they also erode profits [Wall Street

potential excess inventory to stimulate de Journal 1997]. Most retailers know they
mand and sell out the excess by the end of need better decision aids to cope with
the season. (Here, we are referring specifi such unpredictable selling situations
to clearance or permanent mark [Pearson 1994].
cally
downs and not temporary markdowns We MARK, a computer
developed
that are offered in a special sale period, for model-based decision-support system
example, Mother's Day, after which the re (DSS), that can help fashion-retail buyers
tail price returns to its original level.) Of make more judicious opening buy and
ten demand falls short of projections, and markdown decisions that account for
the buyer must take the markdowns nec demand-function uncertainty and nonsta

essary to clear out the stocks as profitably tionarity. Typically, store policies specify a
as possible. Like the original order set of discrete price-off levels (price points)
decision, the optimal at which an item can be sold. For example,
quantity determining
timing and magnitude of sequential mark the store policy may be that the item can
downs is complicated by uncertain and be sold at the full or regular (zero percent

nonstationary demand functions and the off) price or at markdowns of either 25 or

costs associated with selling out the inven 50 percent off the regular selling price

tory too quickly or too late. during the season. Considering these per
These decision challenges have in missible price points, MARK can be used
creased during the last decade as demand to decide the optimal order quantity along
unpredictability has grown because prod with the markdown plan and budget for
uct variety has exploded on the supply the upcoming season. The markdown plan
side and consumer tastes have diversified and budget are important inputs for plan
on the demand [Fisher et al. 1994;
side ning merchandise sales and for negotiat

Pashigian 1988; Pashigian and Bo wen ing with vendors for markdown allow
in the steep rise in ances
1991]. This is reflected [Levy and Weitz 1995; Wall Stxeet
the ratios of markdown amounts (dollars Jouxnal 1998]. Further, during the selling
on units sold at the reduced season buyers can use MARK at the start
foregone
price) to net sales in US department and of each period to review and determine

May-June 2001 S147

MANTRALA, RAO

the optimal markdown strategy over the these writers focused on the form of the

remaining season based on revised de optimal pricing policies for selling out a
mand estimates and the current inventory fixed amount of inventory of a style good.

position. In deriving these solutions MARK is an operational DSS that can be

MARK can take into account a number of used to address this within-season prob
complicating supply-side factors, for ex lem of optimal markdown pricing, and
ample, inventory carrying costs, stockout also the preseason problem of determining
costs, costs of sales returns, and antici the optimal order quantity in conjunction

pated costs of shrinkage (losses from theft with any planned markdown strategies.
or damage). In this article, we focus on Model Formulations
MARK'S use to address preseason order MARK comprises two stochastic dy
quantity and markdown-planning issues. namic optimization modules with Module
Several recent papers concern the prob 1 nested inModule 2. Following Bellman
lem of marking down style goods. Gallego [1957] and Howard [1960] inModule 1
and Van Ryzin [1994] formulated a of MARK, we treat the retail buyer's
continuous-time model involving a current dynamic-pricing problem at the start of

price-dependent Poisson demand-arrival any period n of an N-period horizon as

process and applied intensity-control the determining the pricing policy (sequence
ory to determine the as of prices) that maximizes the (discounted)
optimal price path
a function of the stock level and length of sum of
period n's expected profit and the
the horizon. Feng and Gallego [1995] used maximized expected total profit deriv
a similar model and analytical approach to able over the remainder of the horizon
determine the optimal
timing and dura n +1,..., N. This is a stochastic dynamic
tion of a single price change (markdown programming problem. We call the solu
or markup). Bitran and Mondschein [1997] tion to this problem when the selling price

developed a continuous-time model in is free to go up after being marked down

which a seller faces a nonhomogeneous as the optimal unconstrained-pricing (Oli)
Poisson arrival of customers whose arrival policy, while the optimal markdown-only
rate varies with the way a store conducts iOM) policy is the solution subject to the
business over the season, combined with a constraint Pn < PM_2 for any period n =
Weibull probability distribution of reser 2,..., N where Pn-1 is the price applied
?
vation prices. They used this model to de in period in 1). Once the probability
rive and compare optimal continuous distributions of demand at different per

pricing policies
as functions of time and missible price levels in each period are cal
inventory with more realistic periodic ibrated (see below), MARK evaluates the

pricing polices. Smith and Achabal [1998] expected profit at each permissible price in
a period means of numerical
developed and investigated optimal clear by integra
ance prices and end-of-season inventory tion. The stochastic dynamic-programming

management policies that take into ac problem is formulated and solved as

count the impact of reduced assortment shown in the appendix.
and seasonal changes on sales rates. All of Module 2 of MARK enables the deter

INTERFACES31:3 S148
A DSS THAT HELPS RETAILERS

mination of the optimal total inventory prices of competitors and other goods or
(OI) in conjunction with the dynamically unpredictable weather. We assume that

optimal (OU or OM) pricing plan. Specifi these period-specific random disturbances
un are
cally, the optimize-inventory?optimal independent charged in
of the price
constrained pricing (OI-OU) process nests that period and intertemporally indepen
the Module 1model. The latter is itera dent. The detailed demand function speci

tively at each point of a discretized

solved fication is shown in the Appendix.

range of order quantity to determine the Probabilistic Demand Model Calibration

corresponding OL? policy and expected In general, forecasting fashion demand

profit outcomes. The OI-OU process then well in advance of the selling season is
determines the cumulative a little
expected profit largely subjective process because
maximizing order quantity from the given objective data exists beyond historical pat
range. In a similar way, the optimize terns of sales of similar styles. Relying on

inventory?optimal-markdown-only (O? such data alone is often impractical and

OM) process of Module 2 solves the unwise because consumers' tastes can

optimal-order-quantity problem subject change significantly from one season to

to the constraint that price can only be the next. Also past sales data on similar
marked down. In addition, the optimal or items are typically inadequate for estimat
der quantity to any fixed ing the new item's time
corresponding potentially
pricing policy can be determined by a varying price elasticities for several
third optimize-inventory?given-prices reasons:

(OI-GP) process of Module 2. MARK has (1) For any time period, there is usually
the capability to derive these solutions no objective information about what sales

taking into account the vendor's single would have been at several different price

price or quantity-discount schedule as levels other than the one actually charged.
well as any fixed merchandise procure (2) Recorded sales are less than actual de
ment budget constraint. mand when initial order quantities are in
The optimization models utilize mea adequate and there is no scope for
surements of the probabilistic period-by replenishment.

period demand functions. We conceptual (3) Retailers tend to report aggregate unit
ize the demand in any period as a sales from different price levels [Smith and
multiplicative function of the following Achabal 1998].
influences: To develop total-season and period-by
(1) The seasonal effect, given by the frac period forecasts and merchandise plans,
tion of the estimated total season demand experienced buyers usually gather addi
or sales that is likely to material tional information from such fashion
potential
ize in that period. barometers as Women's
Weax Daily and
(2) The price applied in that period. Califoxnia Apparel News, from trade associa
(3) A random disturbance representing tions (such as the National Retail Federa
the net effects of other possible influences tion), and from conferences with vendors,
on demand, such as the effects of current fashion coordinators, and so forth. Given

May-June 2001 S149

MANTRALA, RAO

baseline seasonal-demand estimates from in the following

(Appendix) steps:
historical data, the subjective judgements 1: The enters the most
Step buyer likely
of informed buyers can be used to cali estimate of the total season demand at full
brate the probability functions of as M.
density price. We denote this parameter
the demand distributions at various prices
Step 2: The buyer enters the minimum or
[Lodish 1980]. Lilien, Kotler, and Moorthy low and maximum or
high estimates of M
[1992] provide a good review of the use of such that the true value has a 95-percent

managers' judgments in calibrating chance of falling within the range of these

marketing-decision models. estimates.

low-high
MARK'S interactive software 3: The
program Step buyer enters the expected per
offers two approaches to demand-function cent distribution of total demand by
a direct
calibration: approach and a de month for the style classification. In most
mand model-based approach. In the direct cases, this information is not but
subjective
approach, buyers see of based on historical data.
graphical displays
The kinds of data elicited in Steps 1 and

must 3 are quite familiar to

Buyers often order buyers, because
they are common inputs to seasonal
inventory for the entire merchandise-sales at most retail
season. While discounts boost planning
ers 1995]. With a little ex
[Levy and Weitz
sales, they erode profits. planation, a buyer can also grasp the
Optimizing the timing and essence of the idea of placing a 95-percent

magnitude of markdowns can confidence interval around his or her esti

compensate for buying errors. mates. The data

effectively determine the
most likely demand per period isell
the category's past seasons' sales and [Mason and 1987] at the
thxough) Mayer
prices and growth trends. After they study full
price, assuming
no
uncertainty.
these data, they are asked to enter three The next two steps elicit data from the
estimates of demand (the minimum or that lead to estimates of the period
buyers
most level, the modal or most
pessimistic specific disturbance variances and the
and the maximum or most =
likely level, op price-off elasticities (denoted yin) for n
timistic level) at each permissible price 1,... N):

level in each period. These estimates can

Step 4: Given the period-by-period esti
be used to parameterize mates of modal demands at full price, the
triangular ap
proximations of the probability distribu buyer enters the minimum or low and
tions of demand. The direct maximum or
approach, high estimates of these de
however, can become difficult mands such that there is only a five
cognitively
and tedious as the number of price levels chance that the demands will fall
percent
and periods in an application increase. An outside these ranges. With these new in
alternative approach is to elicit the essen puts, MARK can derive estimates of the
tial information needed to calibrate the means and variances of the period-specific

multiplicative demand model specification disturbance terms.

INTERFACES31:3 S150
A DSS THAT HELPS RETAILERS

Step 5: The buyers enters his or her per change prices among the permissible lev

ception of the sensitivity of demand with els for all seasonal merchandise as
they
respect to price reductions from full price saw fit. The close-of-season date for the

by responding to the following question. walking shorts was the end of August. Af
"What do you feel will
be the percentage ter that date, any remaining inventory of
increase from the most likely demand at walking shorts would be removed to
full price in period n if the price were re make room for the next season's merchan
duced by 25 percent?" (This question may dise. Although the store could later donate
be repeated for another price-off level, for these leftover units to charity and receive

example, 50 percent off, to get an addi a tax deduction, the store managers
tional data point.) Given these inputs, de treated unsold goods at season's end as

riving estimates of each period's price-off having zero salvage value when deciding
elasticity is straightforward. on markdowns.

An Application Concerned about a trend of rising mark

This application took place at a local down percentages, the four store execu
store of a large US retail chain that has de tives were debating the adoption of one of
centralized markdown-planning responsi the following policies as a way of regulat
bility. A group of four executives at this ing assistant managers' recourse to
store (the store manager, the menswear markdowns:

department manager, and two assistant (1) An automatic-markdown policy would

managers) were reviewing the merchan specify both the timing and magnitude of
dise plan for a new style of men's walking markdowns during the season. Two alter
shorts to be sold over the upcoming eight natives were on the table. The first was
month (January?August) spring season. motivated by the well-known strategy fol
The planned full selling price was $19.99. lowed by the Filene's Basement Store
The set of permissible levels for the item's [Bitran and Mondschein 1997; Shuch

selling price in any month included the 1988]. Under this Filene's markdown iFM)
full price of $19.99 (zero percent off) and policy, the store would sell men's walking
reduced prices of $14.99 (25 percent off), shorts at the
regular price, that is, zero

$9.99 (50 percent off), and $5.99 (70 per percent off, inMonths 1 and 2, then 25
cent off). Based on past store-level sales percent off inMonths 3 and 4, 50 percent
data and the latest information on men's off inMonths 5 and 6, and 70 percent off
fashion trends, the chain's corporate buyer inMonths 7 and 8 of the selling season.
had recommended that the local store or The second alternative was a half-price
der 1,000 units of these shorts to be sup sale after half the season iH/H) policy.

plied in one lot at the start of the season at Under this policy, the item would be sold
a cost of $4.00 per unit. This retail chain at regular price inMonths 1 through 4 and
held a temporary storewide promotion in then at 50 percent off for the rest of the
all stores during June of every year. How season.

ever, at the start of each month, the local (2) A constant price iCP) strategy would
store managers were free to set and mean that the merchandise would be sold

May-June 2001 S151

MANTRALA, RAO

at one fixed price throughout the season. category, and had seen samples of the new
One of the managers felt strongly that the item (via satellite TV broadcasts from the
best way to control markdowns was not to were also
corporate buying office). They
allow them, and proposed that the men's informed about the usual seasonal

walking shorts be sold either at the full demand pattern for this style classification
price of $19.99 throughout the season in their store and in other stores in the
(CPO) or at $14.99, the 25-percent price-off chain.

level throughout the season (CP25). Given the managers' differing positions
(3) A two price-level policy would
permit in the store, we used MARK'S option of a
markdowns but the permissible price lev direct approach to obtain consensus de
els would be reduced from the current mand estimates via
the Delphi group
four to two, either zero percent off or 50 method [Dalkey and Helmer 1962; Jolson
percent off. and Rossow 1971]. The group's estimates
The managers were not sure whether of the minimum, most likely, and maxi
any of these policies were optimal for the mum demand at each permissible price
recommended order quantity of 1,000 level in each month converged after two
units, or whether 1,000 units was the opti rounds, and the whole exercise
Delphi
mal order quantity. Therefore, they readily took about one hour. These were unfet

accepted our proposal to use MARK to in tered demand estimates, that is, we in

vestigate these issues. structed the managers to provide them, as

Input Data suming sufficient stock on hand to meet
The only cost input we considered was any level of demand in any month of the
the item's purchase cost per unit ($4.00). season. Based on these data, we
parame

Traditionally this retailer evaluated its as terized triangular approximations of the

sistant managers based on the cu distributions of demand and
simply probability
mulative (undiscounted) gross margin used them in the analyses (Table 1).
contributions (sales revenues less purchase The managers perceived the seasonal de
cost of the units sold) of their merchandise mand for walking shorts as growing
lines. Consequently, the store manager steadily from January to a peak in June
asked us to ignore discounting and zero and then rapidly falling off by August.
out the other potential costs MARK al The most likely estimate of the total de
lowed for: the costs of holding inventory, mand for the season at full price is 698.

stockouts, customer returns, and executing Some markdowns would be needed to sell
markdown actions. out the inventory of 1,000 units by the end
As for demand input data, we used of the season (Figure 1).

managers' judgments to calibrate the prob Analyses

ability distributions of demand at the four First, we used the processes of Module 1

permissible price levels over the season. of MARK to derive optimal pricing plans,

Further, we took a consensus approach markdown budgets, and percentages for

since all four executives wished to partici the recommended opening inventory of
pate, were familiar with the merchandise 1,000 units of shorts and full price of

INTERFACES31:3 S152
A DSS THAT HELPS RETAILERS

Triangular Triangular
Month Price-off Min Mod Max mean
std. de v.

8 1 0%. 10 15 1.47
11.00
10 1 25% 17 30 4.14
19.00
20 150% 32 45 5.10
32.33
35 170% 50 75 53.33
8.25
15 20% 25 38 4.71
26.00
25 225% 38 57 40.00
6.57
2 50% 47 60 82 63.00 7.22
82 2 70% 110 137 109.67 11.23
55 30% 77 115 82.33
12.39
88 3 25% 120 162 123.33 15.15
3 50% 125 160 210 165.00 17.44
2223 70% 282 345 283.00
25.11
67 40% 92 135 98.00
14.04
1054 25% 144 192 147.00
17.79
4 50% 147 190 252 196.33 21.55
2554 70% 340 415 336.67
32.68
140 50% 180 222 180.67 16.74
1885 25% 252 302 247.33
23.33
5 50% 265 337 417 339.67 31.04
4605 70% 612 755 609.00
60.23
170 60% 215 255 213.33 17.36
2226 25% 295 345 287.33
25.25
6 50% 327 400 505 410.67 36.53
5906 70% 742 912 748.00
65.76
47 70% 63 70 60.00
4.81
7
77 25% 100 102 93.00
5.67
7 50% 105 145 174 141.33 14.14
2257 70% 285 362 290.67
28.04
22 80% 32 38 30.67
3.30
42 825% 60 65 55.67
4.94
65 8 50% 85 102 84.00
7.56
8 70% 112 160 215 162.33 21.04
Table 1: Store consensus estimates of the minimum (Min), most (Mod), and
managers' likely
maximum (Max) unit demand for men's walking shorts at permissible levels in each of
price
the months of the item's season are The four levels
eight selling displayed. permissible price
are the full price or zero percent off (0%), 25 percent off (25%), 50 percent off (50%), and 70
percent off (70%). Based on these data inputs, we calibrated triangular probability distributions
of demand, and the estimated means and standard deviations indicate the majority of the dis
tributions are skewed and managers' about demand increases as the
positively uncertainty
markdown magnitude increases.

$19.99. The policies we considered were optimal OM(2) policy when pricing is
the optimal markdown-only policy with restricted to either the full price or a
four permissible price levels iOM); the 50-percent markdown; and the optimal

May-June 2001 S153

MANTRALA, RAO
800 -i cumu
centage is given by the ratio of the
2 -o%off
y\ lative markdown dollar amount (here,
7ooj
I600 -25%/off $4,765) to the realized cumulative sales
o 500 J / \
\
g 1 -50% off \/ revenues (here $15,035). In contrast, the
g -70% Off J s^^\ \ OM(2) policy calls for the markdown to be
Q 3001 f^^ /*-^^\\ V inMonth 7. However,
taken only 840 units
jj 200 \ /^----l/^^^ ^\ are sold under this policy and although
the markdown percentage is lowered to 16
| oP^^r^T ,?,?,?^
1 2 3 4 5 6 7 8 percent, cumulative are
expected profits
Month
five percent lower than the level under the
Figure 1: The most likely or modal estimates OM policy. On the other hand, the cumu
of demand at the four price levels over the
months of the season reveal a seasonal lative expected net profit under the bench
eight
demand pattern that peaks in June. The peak mark optimal unconstrained-pricing policy
in demand in June is attributable to the time is $11,200, about 1.5 percent higher, even
of season and to the annual storewide promo
tion held in that month. though the cumulative expected sales

quantity is 16 units lower than that under

unconstrained-pricing (OU) policy. (As the the optimal markdown-only policy. Also,
store typically did not allow markups after the cumulative markdown percentage un

markdown, the optimal unconstrained der the OU policy is actually lower despite

pricing policy results

simplyserve here as there being more off-price periods than
benchmarks for assessing markdown pol under the OM policy. Therefore, more

icy results.) We also applied MARK'S flexible pricing that follows the anticipated
iGI-GP) shape of seasonal demand is clearly ad
given-inventory?given-prices
process to evaluate the proposed fixed vantageous. However, given their policy
the given inventory of of taking only permanent markdowns, the
price policies with
1,000 units and compare their expected management group found it reassuring
outcomes with those of the optimal pric that the optimal markdown-only policy
ing policies (Table 2). had a net expected profit that was not
The results for the anticipated OM pol much lower than that of the optimal

icy called for just one 25-percent mark unconstrained-pricing policy while achiev
down inMonth 3 (that is, reducing the ing a higher sales quantity.
to $14.99 at the of the Turning to the four fixed-pricing policy
price beginning
third month and keeping it there for the options under consideration, the two
rest of the eight-month season). Under this constant-price policies {CPO and CP25)

policy, the cumulative expected sales perform better than the two automatic
is 990 units and the cumulative markdown (FM and H/H) policies. For ex
quantity
expected profit is $11,035. The correspond ample, even the simple policy of sticking
ing total markdown amount (dollars fore to the full price throughout the season
on units sold at the reduced is a cumulative expected net profit
gone price) yields
$4,765, a markdown percentage that is significantly greater than that
implying
of about 32 percent. The markdown per yielded by the much-discussed Filene's

INTERFACES31:3 S154
A DSS THAT HELPS RETAILERS

Price path
of
(sequence
markdowns off

full price in Inventory Markdown Markdown

Price policy months 1-8) sold Sales Profits amount percentage

Optimal unconstrained- 25%, 50%, 25%, 97.4% $15,200 $11,200 $4,280 28%
pricing policy (OU) 25%, 25%,
25%, 0%, 25%
Optimal markdown- 0%, 0%, 0%, 99% 15,035 11,035 4,765 32%
only policy based on 25%, 25%,
four permissible price 25%, 25%,
levels (OM) 25%
Optimal markdown- 0%, 0%, 0%, 0%, 83.6% 14,470 10,470 2,250 16%
only policy based on 0%, 0%, 50%,
two permissible price 50%
levels (OM2)
Constant full-price 0%, 0%, 0%, 0%, 70.2% 14,040 10,040 0 0%
policy (CP0) 0%, 0%, 0%,
0%
Constant 25-percent-off 25%, 25%, 25%, 100% 15,000 11,000 5,000 33%
policy (CP25) 25%, 25%,
25%, 25%,
25%
Filene's markdown 0%, 0%, 25%, 100% 11,720 7,720 8,280 71%
policy (FM) 25%, 50%,
50%, 70%,
70%
Half-price sale after 0%, 0%, 0%, 0%, 100% 12,170 8,170 8,170 64%
half the season policy 50%, 50%,
(H/H) 50%, 50%
Table 2: Given 1,000 units of opening inventory, we derived the cumulative expected sales, prof
its, and markdown of seven different with the proposed DSS. The
percentages pricing policies
results indicate that unless markdown and magnitude are determined,
timing optimally taking
no markdowns is a better policy than an
arbitrary automatic-markdown policy.

markdown iFM) policy. This is the case icy that is applied without reference to the
even
though the FM policy sells out the anticipated seasonal pattern of demand.
entire inventory, that is, 30 percent more However, second, if the timing and mag
units than the amount sold with the con nitudes of markdowns are determined op
stant full-price iCPO) policy. timally, a store policy that allows mark
We drew two important practical les downs has greater profit potential than
sons from the tabulated results: First, a no one that rules them out. These
insights
markdown store policy is likely to be bet were reinforced
by the profit-versus
ter, that is, to yield higher revenues and markdown-percentage results of all the

profits than an automatic-markdown pol policies shown in Table 2. Retailers tend to

May-June 2001 S155

MANTRALA, RAO

correlate higher markdown percentages timal markdown-only iOM) policy, and

with lower net profits. However, as we the four fixed-pricing iCPO, CP25,
policies
found, policies calling for higher mark FM, H/H) considered in the previous anal
down percentages can yield higher cumu yses. Further, we used MARK to investi
lative profits. Again, the import of these gate the sensitivity of cumulative expected
results is that the retailer does not need to net profits to deviations from the optimal
control the opportunity to take mark inventory level under each of the six pric
downs but rather when they take the ing policies. More specifically, we exam
markdowns and how large they are. ined the cumulative expected profits re
The next question we addressed was sulting from applying each of the six
whether 1,000 units were the optimal or policies at selected opening-inventory lev
der quantity for the store. Observing that els in the range of 600 to 1,600 units, in
the optimal markdown-only policy at cluding the optimal level for each of the
1,000 units called for only one markdown six pricing strategies (Table 3).
of just 25 percent, two executives conjec Under both the optimal markdown-only
tured that the store could sell more and iOM) and optimal unconstrained-pricing
make higher net profits with a larger or iOU) strategies, the optimal opening in
der quantity and a more aggressive mark ventory is significantly less than 1,000
down policy, while the other two dis units. Specifically, the optimal inventory
agreed. To gain more insight into this following the OM policy is 780 units.
issue, we used MARK to determine the (With this opening stock, the optimal
optimal opening-inventory levels (order markdown policy is to stay with the full

quantities) corresponding to the optimal price until the end of Month 6 and then to

unconstrained-pricing (OU) policy, the op sell the remaining stock at 25 percent off

Opening inventory
levels (units) CPO CP25 FM OM
OU H/H

600
$9,600 $6,600 $5,320 $5,770 $9,600 $9,600
709
11,204 7,799 5,974 6,424 11,204 11,229
780
10,920 8,580 6,400 6,850 11,335 11,435
878
10,528 9,658 6,988 7,438 11,051 11,538
10,040
1,000 11,000 7,720 8,170 11,035 11,200
9,932
1,027 11,072 7,866 8,332 11,072 11,122
9,248
1,198 10,388 8,348 9,298 10,535 10,759
8,032
1,502 9,172 8,926 8,092 9,750
9,655
7,640
1,600 8,780 8,618 7,700 9,263
9,358
Table 3: Displayed are the cumulative expected profits starting with different opening
inventory levels, following each of six pricing policies: CPO (constant-full-price), CP25 (constant
25 percent off full price), FM (Filene's markdown policy), H/H (half-price sale after half the sea
son), OM (optimal markdown-only), and Ol? (optimal unconstrained-pricing) policies. With op
timal markdown pricing, the optimal opening-inventory level is 48 percent less while the cu
mulative expected profits are 27 percent greater than optimal inventory and expected profit
levels following the automatic Filene's markdown (FM) policy.

INTERFACES31:3 S156
A DSS THAT HELPS RETAILERS

inMonths 7 and 8.) On the other hand, the

optimal opening inventory is 878 if the

OU pricing policy were to be followed, re

flecting the store's capacity to sell a

greater quantity and make more profit

with unconstrained pricing.
The optimized opening-inventory levels
for the two automatic-markdown (FM and 600 800 1000 1200 1400 1600

H/H) policies are about 1,500 units and Opening Inventory Level
1,200 units respectively, both values
sig Figure 2: Cumulative expected profits are
nificantly greater than the optimal inven much more sensitive to order quantity
errors
when an is fol
tory levels corresponding to the two opti arbitrary-markdown policy
lowed than are when markdowns are
they
mized iOM and OU) pricing strategies. taken optimally.
However, cumulative
expected profits
with the automatic are much the constant-full-price policy at opening
policies
lower. For example, the profits for the op inventory levels lower than 1,500 units but
timized inventory?OM policy are nearly yields superior profits at higher opening
27 percent higher than the profits for the inventory levels.

optimized inventory?FM policy, despite Also, the cumulative expected profit

with 48 percent less inventory. curves for all four fixed-price policies are
starting
to maximize much more peaked near their optimum
Ironically, expected profits,
the poorer-performing FM and H/H poli order-quantity levels than those corre
cies call for much larger, not smaller, in sponding to the optimal pricing policies.
vestments in opening inventory than the In particular, each of the fixed-price policy

optimal pricing policies. Equally dramatic profit curves falls sharply from its maxi
differences appear between the simple mum when the opening inventory exceeds
iCPO) and FM policy re the optimum inventory level by small
constant-full-price
sults. Specifically, the optimal opening in amounts (Figure 2).
ventory under the FM policy ismore than Thus, cumulative expected profits with
twice the amount that is optimal under the these nonoptimal policies are quite sensi
CPO policy, but the FM policy yields 20 tive to deviations of the opening inventory
percent lower cumulative
expected profits. from the optimum level. On the other
Further, in general
the best-performing hand, the optimized pricing policy (OM

fixed-pricing policy changes

as the and OU) profit curves are rather flat in the

opening-inventory level is changed (Fig region of their optimum order quantities.

ure 2). Thus, the constant 25-percent-off That is, when prices are set optimally, prof
pricing policy dominates the constant-full its are relatively insensitive to deviations

price policy at 1,000 units of opening from the optimal opening-inventory levels.

inventory but performs much worse if the In particular, following the optimal

opening inventory is lower than 800 units. unconstrained-pricing policy reduces prof
Similarly, the FM policy is dominated by its from the optimal level by less than four

May-June 2001 S157

MANTRALA, RAO

percent even when the opening inventory plain the flatness of the cumulative
is more or less than the optimal level by as expected-profit curves corresponding to
much as 17 percent. Thus optimal (model the OL? and OM policies in the vicinity of
based) dynamic pricing policies appear to their respective optimal opening-inventory
errors in
insulate expected profits from levels (Figure 2). On the other hand, prof

setting order quantity. its are more sensitive to inventory changes

To explain these results intuitively, we around allocations well below or above
can recast the problem of optimal sequen their optimal levels. Such misallocation of
tial pricing of a fixed inventory as one of inventory occurs, for example, under the

optimal allocation of the given inventory FM policy. In effect, the FM policy is an

across the four (zero, 25, 50, and 70 per arbitrary rule for allocating inventory that
cent) permissible or tiers. overallocates available to the
price-off points inventory
That is, how much of the inventory should low-margin 50-percent price-off tier (ap
the store sell at each price point over the plied in the peak demand Months 5 and 6)
season? This is akin to the problem of allo and underallocates inventory to the high

cating seat inventory across fare-class margin zero-percent and

25-percent price
buckets in airline yield management off tiers. Consequently, stores require a
[Belobaba 1987; Gallego and Van Ryzin much larger total inventory to provide op
1994]. Conceptualizing the problem in this timal allocations to the high-margin tiers.

way (and ignoring more subtle dynamic Much of this larger total amount of inven
considerations), we find that the total ex tory gets "wasted" in the 50-percent price
pected revenue from any price-off tier is a off tier under the FM pricing rule, but the
concave (diminishing returns) function of inventory allocations to the high-margin
the units of inventory allocated to that tier. tiers make compensating contributions.
Then the optimal pricing solution is effec Total profits, therefore, increase up to a

tively one that allocates the given inven point, as the total inventory is increased.

tory to each permissible tier such that the As a result, the optimal total inventory un

marginal expected revenues at these allo der the FM policy is almost twice that of
cations are equal. Further, the optimized the optimal markdown-only pricing policy
inventory solution based on such optimal while yielding significantly lower total ex
allocations is effectively that inventory pected profits. Further, the total expected
level at which the marginal reve profits under the FM policy are much
expected
nue of each tier is equal to the marginal more sensitive to deviations from the cor
cost of inventory. responding optimal total inventory be
Now it is well known in the field of cause of the underlying misallocation of

marketing-resource allocation that when inventory to the various price tiers. Simi
the revenue functions are concave, the cor
larly, expected total profits are quite sensi
responding profit functions tend to be flat tive to deviations from the optimal order
around their optimal allocations, as is the quantities under the two constant-price

aggregated profit function [Mantrala, policies because, in general, policies that

Sinha, and Zoltners 1992]. This may ex allocate all of the inventory to one price

INTERFACES31:3 S158
A DSS THAT HELPS RETAILERS

tier are rather inefficient, given the esti result in significant changes in the optimal
mated demand functions. timing and magnitude of markdowns.
In conclusion, this analysis indicates Conversely, apparently minor changes in
that the amount of opening stock a store the timing and magnitudes of planned
should procure on the overall markdowns can result in significant
depends
pricing policy to be pursued, and it can changes in the optimal order quantity. In
obtain the highest profit by jointly decid particular, optimal order quantities associ

ing order-quantity and pricing policies. ated with poorly performing aggressive
were are likely to
These important insights for the par automatic-markdown policies
ticipatingmanagers, who conceded that be much larger than those corresponding
concentrated on deciding the to optimal markdown policies, which in
they usually
best markdown for a given order turn are likely to be larger than the opti
plan
quantity without giving much thought to mal order quantity corresponding to the
how the optimal order quantity depends constant-full-price strategy. Further, a
on the specified markdown plan. constant-price strategy that is more profit
Managerial Implications able than an automatic-markdown policy
Our analyses showed that even when at a low opening-inventory level may be
store managers ordered too much stock, dominated the same automatic policy
by
following a no-markdown policy would at higher opening-inventory levels, that is,

likely be more profitable than an the virtuesof any arbitrary-markdown

automatic-markdown as the total order quantity is
strategy applied policy change
with no regard to the actual seasonal pat changed. Last, cumulative expected profits
tern of demand. However, the optimal are quite sensitive to deviations from the
order quantities based on
pricing policy would likely involve mark optimal
downs. This means that pricing policies arbitrary-markdown policies, but are rela
that lead to high markdown percentages tively insensitive to deviations from the
do not necessarily result in low profits. Re optimal order quantities induced by opti
tailers generally tend to view markdowns mal markdown strategies. In this sense,
as mistakes and often express an urge to optimizing the timing and magnitude of
control them. Our analyses with MARK markdowns can for serious
compensate
show that markdowns are mistakes only buying
errors.

when they are wrongly timed or of the Issues for Future Research and

wrong magnitudes. On the other hand, Development

optimal markdowns are valuable, and re Several specific issues for further re
tailers should view them as necessary and search fall in the areas of parameter esti
welcome strategic mechanisms for coping mation, model validation, generalizations
with an unpredictable of qualitative managerial insights, and
increasingly
model enhancements.
marketplace.

Next, our analyses related to determin First, our model for preseason decision
the order show that making relies mainly on
ing optimal quantity fashion-savvy
can
fairly small changes in order quantity managers' subjective estimates of demand

May-June 2001 S159

MANTRALA, RAO

functions combined with relevant past sea One approach would be to study the per
sons' sales data. However, once the selling formance of matched pairs of fashion buy
season begins, there is an opportunity to ers for different style classifications of a re
revise prior demand estimates using ac tailer. These paired individuals would be
tual sales data from point-of-sales (POS) matched in terms of experience and per

systems. For based on the linear sonal characteristics, as well as the season
example,
ized version of the specified demand lengths, demand patterns, sales volumes,
model, we
have implemented a and margins for selected merchandise
Bayesian
approach for period-by-period updating of items. We could then randomly assign one
the prior distribution of the estimated total individual from each pair to use MARK
season demand at full price, taking all and compare his or her contribution to
other
model-parameter
estimates as fixed. that of the other individual who followed

Updating the total-season-demand param the usualpractices. A second approach

eter is reasonable because typically would be to have different buyers manage
fashion-merchandise
buyers
are most un markdowns of the same item(s) in selected
certain about this parameter, while the subsets of the stores in the retail chain,

style classification's seasonal demand and some with the help of the proposed model

price sensitivity patterns are better and some without.

usually
established. Under this approach, upcom Third, we would also like to investigate

ing periods' forecasts of unit demand at whether the insights from the application
different price levels get modified as the described in this paper are generally ap
estimate of total-season demand converges plicable. For example, do the insights re
to its true value. In turn, these periodic re garding flat versus peaked profit curves
visions correct optimal markdown paths and the relationship between markdown
for the remaining season and thereby im percentages and cumulative profits apply
cumulative (We across all classes of fashion
prove expected profits. goods?dis
can provide further information on this playing different seasonal demand charac

adaptive model and related simulation re teristics, and considering various costs that
sults.) We are working on making this were zeroed out in the case study? To

Bayesian approach
more comprehensive throw light on these issues, we could use
and automated. MARK to conduct in-depth simulation
Second, how well
do buyers actually and sensitivity analyses using demand

perform with the help of the decision sys and cost inputs from retailers of different
tem over an entire season? How well will merchandise
categories.
model users
perform relative to others, ev Last, with regard to model enhance
answer the current model is intended for
erything else being the same? To ments,
we use where
these and related questions, plan to fashion buyers cannot
reorder
conduct a model-validation study involv stocks of a merchandise item after the sell

ing controlled field tests similar to those of ing season begins. We would like to ex
the sales-call-planning model CALLPLAN tend the model to allow for situations in
carried out by Fudge and Lodish [1977]. which delivery lead times are short and

INTERFACES31:3 S160
A DSS THAT HELPS RETAILERS

reorders are possible. We could also en sible price

Pn;>
be denoted by Dnj with
probability density function for j =
hance the model to allow demand to be fnj(Dnj)
=
!/ / Inr n !/ /?. Further, let
sensitive to the level of on-hand inventory h = holding cost per unit of leftover sal
below a certain minimum level. (Smith able inventory at the end of each period,
and Achabal [1998] incorporate such a assumed to be constant per (based,
period
for example, on the known cost per square
fixture-fill effect in their clearance mark
down model but assume there is no uncer foot allocated to the merchandise).
k = stockout cost per unit, that is, the
tainty associated with demand.) However, cost of lost goodwill
notional monetary
the challenge would be to incorporate
per unit of unmet demand due to the
these complexities without sacrificing the out of stock on execu
good being (based
model's applicability and utility in the real tive judgment).
world. (The MARK DSS software is avail s = salvage price per unit of leftover
able commercially under the name stock that can be obtained at the end of

runs on 32-bit Win the season, say, from a deep-discount

"B_Line V3.0" which
retailer.
dows platforms. More information about
d = fixed fraction of inventory on hand
this package is available at at the start of any period expected to be
www.fisofex.com) lost because of damage or poor handling
In general, many other related decision (based on historical experience).
remain in the fashion-retailing u = fixed fraction of inventory on hand
problems
at the start of any period expected to be
arena, calling for more research and im
unaccounted for or lost due to shrinkage,
plementable model-based solutions. We
that is, theft or damage (based on histori
to see more such efforts in the
hope cal experience).
future. = fraction of units sold in n
rn period
expected to be returned by customers by
Acknowledgments
We thank the editors and the three the end of that period (based on executive
reviewers for their valuable judgment).
anonymous = fraction of units returned
comments on a previous version of this
Uxn by cus
tomers in period n expected to be no
We are to Surya Mantrala on executive
paper. grateful longer saleable (based
for her help in the preparation of this
judgment).
The first author thanks Profes A = average cost per markdown event
manuscript.
sor Barton Weitz and the Center for Retail (based on executive experience).
=
p discounting rate, for example, pre
ing Education and Research (CRER), Uni
vailing interest rate per period.
versity of Florida, Gainesville, Florida = discount
Wn factor for period n with
32611, for the early stages of =
supporting Wn il + p/100)-B.
=
this research (1991-1992). GQHn gross quantity of stock on
APPENDIX hand at the start of period n (which is un
Stochastic Dynamic-Programming Model known, that is, a random variable until the
Formulation beginning of period n).
= = net
Let n? denote the permissible set of In GQHn Q-d-u) inventory on
price in period
n. Let the stochastic de hand at the start of period n (after ac
mand for the item in the nth period of the counting for inventory shrinkage and
selling season, at the ;th permis damage anticipated in period n).
N-period

May-June 2001 S161

MANTRALA, RAO

Inventory Movement the retailer's purchase cost of all sold units

Suppose
we are at the start of some
pe kept by customers and all units returned
=
customers that are no
n, n longer saleable.
riod 1,... ,N, and E
suppose Pn-1 by
n?_2 was the price applied in the previous (Note that while is known, is
Ia/H D?;
period, resulting in actual (observed) de probabilistic.)
mand Dan_1. (Hereafter, we use the sub Next we specify the various other costs
script a to denote realized values of ran that must be subtracted from
G?;
to arrive
dom variables and drop this subscript at the net profit from applying
price Pn;>
when the realization has yet to occur.) / E {1, ...,/?} in period n. These include
Then the known gross quantity of stock on ?monetary loss due to anticipated dam
hand at the beginning of period n is given and in n =
age shrinkage period GQHan
by id + u)C;
- ?inventory holding cost incurred in pe
=
-
GQHa/n U^.j Mina^^D^)} riod n = Max((Jfl/n Dnj), 0) hWn;
+ Min(ifl/n _ 2/Dan _ ?sr? + Qn. (1) ?inventory stockout cost incurred in pe
-
riod n = IaJ, 0) kWn;
MaxiiDnj
That is, GQHan is the sum of the unsold ?cost of a markdown action
=
lt
AxnWn_
inventory (before returns) at the end of the where A denotes the fixed cost incurred
previous period, plus the quantity of units every time a markdown is taken, for ex
?
sold in period n 1 returned by custom the costs of rear
ample, in-store display
ers which is still saleable, plus the newly so
rangements, putting up sale signs, and
received stock Qn as per the fixed lot re while = 1when < and
forth, xn Pn;- Pn_1
ceipt schedule. (The model allows for the = 0 when Such markdown
xn Pn; >Pn_v
single order quantity decided before the costs can become quite
implementation
beginning of the season to be received in a
significant when large number of stores
one or more lots over the season.) The un
in a retail chain are involved [Robins 1993]
sold inventory in the last period is equal and can possibly influence their number,
to the net inventory on hand, ifl/?_2 at the
timing, and magnitudes [Van Praag and
start of that period less the total quantity Bode 1992]. The discount factor Where is
sold during that period. The latter amount n ? 1
subscripted by assuming that mark
is the lesser of and demand at
ifln_2 Dan_1 down costs are incurred just before the pe
Pn-i as the retailer cannot sell more than riod in which they are applied. Consider
what is available. these additional
ing costs, the random
Single-Period Profit denoted from some
profit, Rnj, applying
Consider the application of any of the E in pe
permissible price P?;, ; {1, ...,/?}
permissible prices Pn;, ; E {1, ...,/?} in pe riod n is then given by
riod n. Denoting the purchase cost per
= -
unit by C, the resulting gross contribution, + u)C
Rnj Gnj GQHa>nid

Gnj,
before subtracting inventory or mark -MaxiiIa/n-Dnj),0)hWn
down action costs is given by - -
-Max((D?y IaA},0)hWn AxnWn_t. (3)
= -
[{Min (Dnj/ Ia/n)(PnjWn C)}
Gnj Last in the terminal period n = N, there
-
-{Mm(Dnj/Ia/n)(PnjWn C)rn) is a possibility that the leftover stock at the
end of the season has some salvage value,
-{Mm(Dnj,Ia,n)(rn Urn)C}}. (2)
for example, it can perhaps be returned at
The contribution is equal to the revenues some buyback price to the vendor or sold
(discounted) from all units sold less re at or below cost in a liquidation sale. This
funds for units returned by customers less calls for the addition of the following term

INTERFACES31:3 S162
A DSS THAT HELPS RETAILERS

to the right-hand =
side of equation (3) an period
n seasonal factor, i.e., pro
= N:
when n
portion of total season demand that mate
rializes in period n such that 0 < an < 1;
+
((MaxUfl/N-DN;),0) 2an= 1.
+ - - =
Lirn))(sWN C). yin) elasticity of demand in period n
Min(Ifl/N,DN;)rN(l
with respect to price applied as a fraction
That is, the profit generated through sal of full price
is to the total of the unsold in iPnj/Pf).
vage equal = random disturbance term in pe
en
ventory and saleable units returned by
riod n.
customers in the last period multiplied by The random disturbance terms sn for n
the difference between the (discounted) =
1,..., N, are assumed to be
unit and the average cost indepen
salvage price per dent of the target item's own
current price,
price per unit. and intertemporally independent. Further,
Buyer's Dynamic Pricing Problem
we assume the disturbance terms are log
= the lead
Max Vn E[Rn + V*n + 1 (In+ 1)] (4) normally distributed, following
provided in earlier work on fashion de
mand forecasting by Green and Harrison
where Vn is the value function to be maxi
mized when the price Pn E Hn, [1973]. We have found reasonable support
choosing for the lognormal distribution
and assumption
in several trial applications of MARK. For
example, the positive skewness feature of
= the lognormal distribution is reflected by a
Max E[Rn+ 1 + V*+2Qn+2)] (5)
majority of estimates of demand at differ
ent price levels (Table 1) that were elicited
is the optimal value function associated from fashion-merchandise in the
managers
with future periods. Note that in (4) and described in the
= = application paper.
if
(5), Pn E {?,..., /?} then Rn
Pnj for; The selected demand model specifica
and the inventory level In + 1 = In + lfj,
Rnj tion effectively represents how a fashion
which is contingent on the specific price item's demand per period responds to
in n. Also, the inventory markdowns from its regular price (e.g.,
applied period
levels It, for t = n + 1,... ,N are uncer
Achabal, Mclntyre, and Smith 1990; Smith
tain at the start of period n. and Achabal 1998). Its multiplicatively
Probabilistic Demand Model form accounts for interactions
separable
Specification between the seasonal, price-off,
and uncer
Let the set of permissible prices in pe if the fashion item dis
tainty effects. Thus,
riod n be denoted as IT? = {Pnl, Pn2,..., no seasonal i. e., =
plays pattern, an 1/n,
PnJn}, where Pn;- is the ;th permissible price the total season demand at full price, M, is
in n = N. we as over selling season
period n, 1,..., Then, distributed the
evenly
sume for n = =
course
1,..., N; j 1,..., Jn,
(subject of to the random distur
= bances in each period). However, if the
Dnj anM(Pf/Pnjy(n) e? (6)
item's demand does follow a well
where recognized seasonal pattern, then the ran
=
full retail selling price fixed on dom demand in any period n at full price
Pf
=
price tag at the start of the season. is
Dfn anMzn which is increased by a
= demand in units in period n at factor when price is marked
Dnj iPf/Pnj)yin)
any price Pn; E Tln, given the full price Pf. down to
Pnj.
The parameter yin) denotes a
M = total season demand expected if markdown response elasticity that can
price stays fixed at
Pf. vary over time. Similarly, the random dis

May-June 2001 S163

MANTRALA, RAO
turbance distribution is allowed to vary ries with stochastic demand over finite hori

over time. Thus, the model allows for sto zons/7 Management Science, Vol. 40, No. 8

chastic and nonstationary demands whose (August), pp. 999-1020.

Green, M. and Harrison, P. J. 1973, "Fashion
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in the text, the specified de forecasting company using
As outlined
Operations Research
Bayesian approach/'
mand model is parameterized using man Vol. 24, No. 2, pp. 193-205.
Quarterly,
agers' inputs within the interactive model
Hammond, Janice H. 1990, "Quick response in
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