The Economics of 'E'

Mass market retailing is an expensive business. Rents, staff, inventory – the average brick and mortar retailer struggles along with barely visible net margins (spontaneous dancing is known to happen at 5%). With thousands of stores, hundreds of warehouses and over two million employees, Wal-Mart has in the last five years managed a profit margin of just 3.5%. The story is no different for any other major brick & mortar retailer, American or desi. Cool-kid-on-block Internet retail, on the other hand, thumbs a nose at the old-fashioned ways and gives the distinct impression that it can do much better.

There's just one small problem.

The bellweather Amazon, for all its buzz, seems unfortunately to have done much the same (indeed, a little less at 2.48% over the same period); nor has any other sizeable virtual retailer done much different. What gives?

The law of unintended consequences, that's what.

Lets take two of the most discussed items – rent and inventory. Mind you, this post isn't to discuss the benefits of not having inventory or rent– there are many of those. This is to point out, to all ye budding armchair Amazonians, that every cost you reduce often has side effects that are – well – unintended.

Location, Location, Location

A store has to be in the right place; unfortunately landlords usually know this too. High rents per square foot are a cost for sure, but they are usually strongly correlated to more customers, higher footfalls and better sales. Reduce rent costs too far, and you could be diddling your thumbs in the more unvisited bits of a desert. Location plays many roles – footfalls, segmentation, branding – and a rent is an easy proxy for all of that. A railway station, an upmarket mall, an airport – decide where you want to be and a whole package of segmented customers with known spend patterns will land up at your doorstep.

The Internet has no rent; it also has no location. Any part of the Internet is pretty much as good as any other; the person watching your latest Victoria Secret collection may come from Sweden or Somalia. This boundary-less nature has plenty of advantages, but having no catchment to rely on is also a serious drawback for an e-retailer. Most would pay rent if they could; location a more reliable way of acquiring customers than the stuff online guys are forced into – mass market advertising, search keywords, link tracking and such other esoteric nonsense. What you save on rent you lose (and more) on customer acquisition and segmentation.

Products Products Products

Then there's inventory. Physical retail has to go through the tedious process of loading up the shelves with all manner of products. This costs money, and can be even more troublesome to the retailer than rent; stocks have a nasty habit of piling up, going bad, getting stolen, being wasted or simply being of the wrong kind. Words like markdown and clearance nip nastily at the heels of store managers.

Like rent, however, inventory is more than just a cost. It turns out that dangling an actual apple under the consumers nose works better than a picture of the same apple. Modern retail works by tempting users into buying more and higher; if people only bought the minimum things would be quite bleak for all concerned. E-retailers have to spend to overcome this, with better product detail or droolworthy photography – and sometimes that costs more than the product itself. Online, apparel sells best when photographed on real models but as you can imagine, that is not inexpensive. Then, there's the cost of poetically describing the stuff, getting its sizing charts right, putting on your website all the stuff that customers in stores would read off the label for free.

Brick & mortar stores have learned over the years to use inventory as bait; the extra cost of abundant stocks being made up for by the increased conversion and larger spends. Its not unusual for a supermarket to have conversion ratios (people walking in to people actually buying) in the upwards of sixty percent or even the nineties. Many e-retailers, on the other hand, would praise the heavens if they saw 5%. Worse, Low conversion rates exaggerate those aforementioned customer acquisition costs.

The Bottom (traditionally a line)

This scenario happens far more often than you would think for a business model that is finally in danger of becoming older than its CEOs (Amazon, after all, is nearing twenty). Blinded by the obvious benefits of not paying rent or stocking stores, e-retailers sometimes forget to account for the much higher spends on related costs – acquisition, conversion, product information. E-retail cost structures are different from brick and mortar, but not much more generous.

Learn to live with it, and look carefully before funding anything that tells you otherwise.