Why do outlet stores exist? The answer may seem obvious to most shoppers—they are places where companies get rid of factory seconds or outdated merchandise at fire-sale prices. Read: bargains, bargains, bargains. And indeed, that may have been the case when the stores first appeared in the 1930s, usually located in rural areas near the factory and selling damaged or irregular clothing, often to employees themselves.
Even though most apparel manufacturing has long ago moved overseas, outlet stores have continued to exist—despite not having any "outlet" to speak of. And far from just selling cast-off merchandise, some companies even design specific product lines for sale there. So what's going on?
“We take for granted that outlet stores exist, but if you think about it, it's a little weird”
"We take for granted that outlet stores exist, but if you think about it, it's a little weird," says Donald K. Ngwe, an assistant professor in the Marketing unit at Harvard Business School. "Why don't companies just sell this merchandise closer to their customers? Why do some companies have a lot of outlet stores and some don't have any? What's the difference between having these stores and just having a sales rack in the back?"
As a doctoral student in economics at Columbia, Ngwe was fascinated by the incredible range of products that retailers offer to consumers, and wondered just how this practice developed. He began to suspect that it had more to say about consumers than it did about the companies. "Companies must know something about the way we behave that causes them to adopt these retailing strategies," he says. "I look at retailing as a way to study consumer behavior outside the lab."
Ngwe's research has been aided by the fact that companies are capturing more data on customers than ever before—recording not only demographic information, but also details on every product purchase they make. "So much attention is being put on retail analytics that it's like drinking from a fire hose," he says. "Companies have more data than they know what to do with."
Do Outlets Cannibalize?
One leading product manufacturer in the fashion apparel and accessories category agreed to provide Ngwe with consumer data in return for a detailed analysis of its customers. Behind the company's interest was an anxiety about whether its outlet stores were cannibalizing customers from its main retail stores, says Ngwe.
"In the business press, it's fashionable to talk about how going down market to outlet stores damages the brand," he says. "Anytime a company makes a foray into outlets, they are going to gain in the short term but damage brand image in the long term."
To see if that was the case, Ngwe separated customers by a variety of characteristics, revealing that in fact, those who shopped at retail stores and outlets were virtually identical in terms of demographics, including income and zip codes. They differed, however, on two important variables: their willingness to travel, and the degree to which they cared about "quality," which in fashion often means the newness of a particular item's design.
Ngwe found an almost perfect inverse correlation between the two attributes. In other words, the more likely a customer was willing to pay a premium price for the newest fashions, the less likely were he or she willing to drive a long distance to an outlet—and vice versa. "People who were most willing to travel happened to be the same people who cared about quality the least," says Ngwe. Importantly, that consumer behavior went not only for older items but also for brand-new items produced in older, less-fashionable designs that companies continued to produce for their outlet stores even after they stopped making them for their main stores.
"The companies were actually making more of the old stuff, because if they made more of the new stuff for the outlet stores, that would cause cannibalization," says Ngwe. "You don't want to expand the market to have more lower-value consumers at the expense of losing your higher-value consumers."
By selling lower-quality designs for cheaper prices at the outlets, the companies could avoid cannibalization of the latest designs at their main retail stores. In effect, the travel distance between the retail stores and outlets serves as a buffer to separate the two different types of consumers and maximize profit overall.
Trick Or Treat?
"By virtue of going to an outlet, you are revealing something about yourself to the seller," says Ngwe. "By the fact that you drove there, the [retailer is] going to offer you a lower-quality good." That doesn't mean that companies are "tricking" consumers, however. In truth, says Ngwe, consumers win out in the end by having greater choice.
"From the consumer point of view, the fact that there are products to match different preferences is an improvement over a more limited selling strategy," he says, which allows consumers to buy cheaper, if less-trendy items at a lower cost just by driving a few hours.
Ngwe has also used the same data to look at other pricing strategies by companies—including the ubiquity of listing items as "on sale" that are almost never offered at the actual price on the tag. "A company will offer a $300 blouse for 30 percent off, but you couldn't buy the blouse for $300 even if you wanted to," he says.
Rather than deceiving consumers, Ngwe says, such pricing actually communicates information about the quality of the item, causing customers to be much more likely to buy a $300 shirt sold for $200 than a shirt listed regularly for $200. (It's what former JC Penney CEO Ron Johnson found to his chagrin when he did away with sales and offered merchandise at everyday low prices, causing sales to drop precipitously. He was ousted in 2013.)
In fact, Ngwe found, there was an exponential increase in sales the more the "original" price differed from the "sales" price, with no leveling off within the range of prices examined. "This implies that these original prices are credible, saying something tangible about the product characteristics to the buyer. There is content in that price, whether or not it is genuine."
Grocery Store Pricing
At HBS, Ngwe plans to continue to looking into the pricing, investigating what it says both about companies' selling strategy and about their customers' buying preferences. His latest research explores grocery stores—a much more complicated and competitive environment than apparel.
"I want to see what happens, for example, when Whole Foods comes to town—does that make consumers better off by providing greater variety, or do they lose out because other grocery stores then increase their prices?"
Ngwe's research is helping lift the veil on the sometimes mysterious world of how companies price their products and, in doing so, revealing not only what it says about companies but what it says about us as well.