With Black Friday approaching, we explain how retail discounts generally aren't discounts at all — they are priced into it from the beginning. Suzanne Kapner reports on the News Hub. Photo: Getty Images.
When shoppers head out in search of Black Friday bargains this week, they won't just be going to the mall, they'll be witnessing retail theater.
Stores will be pulling out the stops on deep discounts aimed at drawing customers into stores. But retail-industry veterans acknowledge that, in many cases, those bargains will be a carefully engineered illusion.


The common assumption is that retailers stock up on goods and then mark down the ones that don't sell, taking a hit to their profits. But that isn't typically how it plays out. Instead, big retailers work backward with their suppliers to set starting prices that, after all the markdowns, will yield the profit margins they want.
The red cardigan sweater with the ruffled neck on sale for more than 40% off at $39.99 was never meant to sell at its $68 starting price. It was designed with the discount built in.
Buyers don't seem to mind. What they are after, especially in such a lackluster economy, is the feeling they got a deal. Retailers like J.C. Penney Co. who try to get out of the game get punished.
"I don't even get excited unless it's 40% off," said Lourdes Torress, a 44-year-old technical designer, as she browsed the sale racks at Macy's Inc.'s flagship store in New York on a recent afternoon.
The manufactured nature of most discounts raises questions about the wisdom of standing in line for the promotional frenzy that kicks off the holiday shopping season. It also explains how retailers have been able to ramp up the bargains without giving away the store.
The number of deals offered by 31 major department store and apparel retailers increased 63% between 2009 to 2012, and the average discount jumped to 36% from 25%, according to Savings.com, a website that tracks online coupons.
Over the same period, the gross margins of the same retailers—the difference between what they paid for goods and the price at which they sold them—were flat at 27.9%, according to FactSet. The holidays barely made a dent, with margins dipping to 27.8% in the fourth quarter of 2012 from 28% in the third quarter of that year.
Customer discounts are way up. But retailers' profit margins are flat. Claudio Papapietro for The Wall Street Journal
"A lot of the discount is already priced into the product. That's why you see much more stable margins," said Liz Dunn, an analyst with Macquarie Equities Research.
Retailers including Best Buy Co. , Wal-Mart Stores Inc. and Macy's are warning this will be an unusually competitive holiday season and that all the deals could hurt margins. That can happen when chains have to fight hard for sales or get stuck with excess inventory and have to take heavier-than-planned markdowns. Stores also field loss leaders, true bargains that pinch profits but are aimed at getting customers into their stores. Most deals, however, are planned to be profitable by setting list prices well above where goods are actually expected to sell.
Retailers could run into legal trouble if they never try to sell goods at their starting price. Otherwise, there's nothing wrong with the practice. Companies can be pretty frank about how things work.

Penney, which made a disastrous attempt to move away from discounts under former Apple Inc. executive Ron Johnson, is again playing the standard discount game under new CEO Myron "Mike" Ullman. But first it has to adjust its prices.
"We must and will compete to win," Mr. Ullman said last week on a conference call with analysts. "That means initially marking up our goods to sufficient levels to protect our margins when the discount or sale is applied."
Here's how it works, according to one industry consultant describing an actual sweater sold at a major retailer. A supplier sells the sweater to a retailer for roughly $14.50. The suggested retail price is $50, which gives the retailer a roughly 70% markup. A few sweaters sell at that price, but more sell at the first markdown of $44.99, and the bulk sell at the final discount price of $21.99. That produces an average unit retail price of $28 and gives the store about a 45% gross margin on the product.
Retailers didn't always price this way. It used to be that most items were sold at full price, with a limited number of sales to clear unsold inventory. That began to change in the 1970s and 1980s, when a rash of store openings intensified competition and forced retailers to look for new ways to stand out.
Most deals are planned to be profitable by setting list prices high. Claudio Papapietro for The Wall Street Journal
Enter high-low pricing, a strategy designed to create excitement and lure shoppers by dropping prices for occasional sales. Initially, retailers practiced this strategy with restraint. At Mervyn's, a department-store chain that has since gone out of business, discounted items couldn't exceed 30% of total sales, said Mark Cohen, a professor at the Columbia Business School who worked at the company and has held other retail posts including CEO of Sears Canada Inc.
But the floodgates have opened. In a 2012 presentation, Mr. Johnson, then still Penney's CEO, said the company was selling fewer than one out of every 500 items at full price. Customers were receiving an average discount of 60%, up from 38% a decade earlier. The twist is they weren't saving more. In fact, the average price paid by customers stayed about the same over that period. What changed was the initial price, which increased by 33%.
"The silliness of it all is that the original price from which the discount is computed is often specious to begin with, because items hardly ever sell at that price, which makes the discount less legitimate," Columbia's Mr. Cohen said.
Can't wait until after Thanksgiving dinner to find all the great shopping deals on offer? MarketWatch's Jim Jelter shares the best tips and apps for scouting out the sales.
The rise of e-commerce has made it possible to track pricing on the Web and see how much time products spend at their list prices. Amazon.com Inc. is featuring a Samsung 60-inch HDTV in its 2013 Holiday Gift Guide. The TV is selling at a 45% discount to its list price of $1,799.99. But, according to Decide.com, a price-tracking firm owned by eBay Inc., the TV hasn't sold for anywhere near the list price in months. The most it has sold for in the past eight months is $1,297.85, according to Decide.com. As recently as October, it was priced at $997.99, about the same as its current sale price.
An Amazon spokeswoman said that "showing the most 'recent' price can be somewhat arbitrary and could be confusing to our customers," since the retailer changes prices so frequently in an effort to provide the best deals.
Another tactic involves raising selling prices ahead of the holidays before the discounts kick in. In an analysis for The Wall Street Journal, price-tracking firm Market Track LLC looked at the online price fluctuations of 1,743 products in November 2012. Prices climbed an average of 8% in the weeks leading up to Thanksgiving for 366, or about a fifth, of the products; the items were then discounted on Black Friday. Toys and tools had the biggest pre-Black Friday price increases—about 23%.
Mr. Johnson lost his job after he abandoned the discount system abruptly in favor of everyday low prices and sales plunged. But retail executives said he hit on an important insight, that prices had lost their integrity.
Retailers are supposed to offer items at regular prices "for a reasonably substantial period of time" before marking them down, according to the Federal Trade Commission.
Cynthia Spann is suing Penney over what she says are phantom discounts. She bought three blouses at 40% off the regular price of $30 in March 2011, according to her complaint. But instead of $30, the prevailing price for the blouses in the three months preceding her purchase was $17.99—exactly the same as the sale price she paid, the lawsuit alleges. Ms. Spann said in the complaint that she wouldn't have bought the blouses if she had known the discount wasn't real.
Through her lawyer, Ms. Spann declined to be interviewed.
A spokeswoman for Penney declined to comment on the litigation, but said the retailer's policy is to sell all items at their original price for a reasonable period of time before putting them on sale.
Similar cases are pending against Kohl's Corp. and Jos A. Bank Clothiers Inc. A Kohl's spokeswoman didn't reply to requests for comment. In its most recent quarterly filing, the company said the legal proceedings it faces likely won't have a material effect. A Jos A. Bank spokesman declined to comment on the pending litigation or the company's pricing strategy, but said two other lawsuits making similar claims were dismissed earlier this year.
Retailers, having trained customers to shop for deals, are stuck with the strategy for now. Macy's tried to cut back on coupons in 2007.
"Customers stopped shopping," said Chief Executive Terry Lundgren, "so we knew that was a bad idea."
Write to Suzanne Kapner at Suzanne.Kapner@wsj.com