“How do Category promotions actually work, or function?”

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Short Answer:

When you create a Category promotion, it sets the sale price of all the items in that Category to the correct discount percentage. 

Detailed Explanation:

Some important rules on how Category sales function:

If there was already a “sale price” on a particular Item to begin with, then the Category sale will override it with the new sale discount.  In essence, creating a category permanently updates the sale price for all items  in that category.

Other situations that you may encounter:

If you edit an Item’s “sale price” after a Category sale  was applied to it, then you will override the Category sale’s price for  that particular Item. 

Once you remove a Category sale, the sale prices will return to the regular  price, including any “sale price” that you may have had on Items  previously (meaning, if you happened to have sales prices for some Items previous  to running the Category sale).

If an item is in a category sale, but you have also assigned that product  to another category, then the category sale price will still exist for that  item.  

If you have applied a category sale to another category in which that items  exits, then that will override the first category sale price for that item.