Editor’s Note: This article was originally published by Web Marketing Today. Practical Ecommerce acquired Web Marketing Today in 2012. In 2016, we merged the two sites, leaving Practical Ecommerce as the successor.
The retail business model that is practiced in thousands of shops and strip malls in cities all over the world is widely understood. However, many fail to understand that the Internet e-tail business model is substantially different. Some of these differences are obvious, while others only become clear later — sometimes when it is difficult to respond to them. Here are the differences I see, along with the barriers and benefits found in an online store business model.
Retail vs. Mail Order
The retail model involves leasing a display room, ordering products into inventory which are stocked on display shelves. Shopping is either do-it-yourself or salesperson-assisted. Goods are purchased at a cash register, packed in plastic bags, and carried out with the customer. The e-tailing model, on the other hand, has much more in common with catalog mail order sales than with retail. Customers shop with little assistance in an online storefront, pay via credit card, and products are shipped or drop-shipped to them via a parcel courier or postal carrier. When you think about it, the business models are really very different. Let’s look at the contrast between these models a bit more carefully.
Shopping — Tactile vs. Non-Tactile
Retail stores allow shoppers to see and touch the products, to make sure they are getting what they want. Shelves carry boxes containing products, shoppers read product information on the box, and perhaps open the box to examine the contents. Usually a shopper can ask questions of a store clerk, while, in some stores, salespeople actively try to assist.
Online stores, however, only allow the shopper to look at pictures and read product information. The best online stores, though, are able to provide more product information online than a retail shopper might find. Sometimes this wealth of information can make up for the absence of a salesperson. But the better stores are providing some kind of live chat or instant phone call to answer questions. While retail shoppers can see and personally examine the product before purchasing, online stores need to make special efforts to help shoppers get what they want, or face expensive product returns after delivery.
Market Scope and Competition
The competition that retail stores face is mainly from other stores within driving distance. It may be fierce on the local front, but at least the number of competing stores is finite. For online stores, on the other hand, the competition can seem almost infinite. Since geographic barriers pose little limitation to shoppers, an online store is forced to compete with every other similar online store in the entire country, and, at least in some niches, with all similar stores globally. The competition online is indeed staggering. It is difficult to rise above the clutter to even be noticed, and the store’s position on search engines may be buried beneath 20 or 30 others.
But before you despair, realize that the vastness of the Internet is also its great strength. Instead of just relying on a customer base within driving distance, your customers can come literally from your entire nation, and, to some degree, from around the world wherever your language is spoken. Yes, the competition is great, but the market is absolutely huge. With good marketing, a local store might be nicely profitable, but an well-marketed online store could serve a much large clientele and earn huge profits.
The key for the online storeowner is to find and perfect a marketing mix that is within her budget, but also effective in bringing in customers. Though the competition seems intense, if you poke and prod just a bit, you find that most of the competition is flabby. Their storefronts are a sham, the lights are on but nobody is home, and the storeowners aren’t working it very hard or have given up. If you work both smart and hard, you can conceivably carve out a substantial slice of business within your niche, despite of the competition. On balance, I would rather have lots of competitors and still have access to a huge market, than limit both, since entrepreneurial skills can move a business toward the top.
Inventory and Real Estate Costs
The typical retail store business model requires several thousand square feet for inventory displayed in a pleasing manner on shelves, a checkout stand, and a backroom for extra inventory. And since the retailer is trying to attract walk-in traffic, this real estate must be zoned commercially, requiring high lease costs per square foot.
E-tailers, on the other hand, since they never meet the public face-to-face, can occupy space in a home office, a garage, less expensive office space, or lower cost light industrial warehouse space. This saves substantial overhead.
No matter the differences in the models, however, there remains the need for inventory space. E-tailers meet this need in one of four ways:
- Warehouse Inventory. This is the typical e-tail approach: purchase inventory and place it in warehouse space where it is accessible to employees who pick, pull, pack, and ship to customers. This approach is expensive, since you are paying for both warehouse space, and have capital tied up in inventory on the shelves. But this method allows the best quality of customer service, since shipping and inventory records are maintained in-house. This is Amazon.com’s current method, having built five large regional warehouses in key but low-cost areas of the US near shipping depots.
- Local Distributor. After receiving a day’s orders, the e-tailer purchases the products from a local distributor, and then transports them to his own facility for packing and shipping. This was Amazon.com’s original method of fulfillment when it was small, using an Ingram book distribution outlet in the same city. The method only works where the distributor can keep an adequate stock on hand that the e-tailer can obtain quickly. The advantage is that the e-tailer doesn’t have capital tied up in inventory or unneeded warehouse space, has all the shipping records on hand, and has a good idea of the distributor’s stock. The disadvantage is that the e-tailer is very dependent upon his distributor’s supplies, and may not be able to accurately reflect available inventory to his shoppers before they purchase.
- Drop-Shipping. Some manufacturers and distributors will allow e-tailers to fax an order or send an electronic order. The manufacturer or distributor then ships from its warehouse to the customer, using the e-tailer’s packing slip and labels. This saves the e-tailer from investing in expensive inventory and warehouse space, but the e-tailer pays a higher than normal wholesale price for the product, cutting the e-tailer’s margins. Many e-tailers use this method because it requires little start-up capital. The problem is difficulty in providing good customer service, since the e-tailer doesn’t always have good communication with drop-shippers about product availability, back-orders, and shipment dates. Many e-tailers keep an inventory of their best selling products and sale items on hand, and rely on drop-shipping for less popular products. This way they can provide good customer service most of the time on popular items but make a comprehensive line of products available for their customers to order.
- Fulfillment Houses. Some businesses specialize in providing full warehouse, inventory ordering, customer call center, and shipping services to mail order merchants and e-tailers. While the e-tailer doesn’t lease his own warehouse, he pays for inventory that is stored in the fulfillment house’s warehouse, and fees based on the space required to store it. The advantage is that e-tailers can outsource product fulfillment to those who can do it most efficiently. This works best with unique products that have higher profit margins. With commodities, there just isn’t enough margin to pay for fulfillment house services.
Retailers provide product fulfillment to their customers by stocking shelves, providing shopping carts with real (not virtual) wheels, checkout stands, and plastic bags in which shoppers carry purchases to their cars. E-tailers’ costs include shipping department employees, boxes, tape, internal packing, shipping costs (usually passed on to the customer), and order tracking.
Of course, fulfillment costs are closely related to the inventory method selected. If you carry inventory in-house and have your own shipping department, you are betting that your costs will be lower this way than outsourcing to companies that are set up to do this very efficiently. Many analysts believe that fulfillment costs, along with customer acquisition costs, will determine whether an online store can stay in business or not. This is a big, unseen e-commerce key. The more efficient your shipping operation, the better your overall profit margin. The more time and money consumed by inefficient operations, the more likely you are to fail.
Customer Service Costs and Returned Goods
Closely related to the method of fulfillment you choose is the level of customer service you can provide. Smaller retail stores designate one or two key employees who handle time-consuming customer inquiries, complaints, and returns. Larger stores have a customer service desk where customer service inquires are handled. There is no money to be made here. In fact, bins behind the customer service counter contain many returned items that are a drain on profits. The purpose, however, is to retain customer confidence and good will. Smart retailers follow the dictum that the customer is always right — even when he is wrong. A displeased customer can easily decide to both (1) never shop in the store again, and (2) tell several others how badly he was treated. Customer trust is ground-zero for business success.
E-tailers often neglect customer service. The large e-tailers learned the miseries of poor customer service during Christmas 1999. But many smaller e-tailers have yet to take customer service seriously. Instead of a customer service desk, e-tailers usually provide a customer service e-mail address. Smarter e-tailers provide a telephone number where dissatisfied customers can quickly speak to a real person. Live chat can also provide instant real-person attention. Customer service can sometimes be outsourced to call centers or fulfillment houses. But great customer service is the second big key to e-tailing success. Since customers are so expensive to acquire, to make any money, existing customers must be retained at whatever cost — since that cost is very likely to be lower than customer acquisition costs.
Customer Acquisition and Retention Costs
The customer acquisition cost is a very important figure to retailers and e-tailers. It is based on the total cost a company spends on advertising and marketing promotions divided by the total number of new customers obtained through that spending. If a retailer spends $2,500 on a newspaper display ad that brings about 300 customers into his store over the weekend, and 65% of them make a purchase, he has a customer acquisition cost of $12.82 [$2500/(300*.65)=$12.82]. An e-tailer that spends $2,500 for keyword banner advertising on Yahoo may purchase 100,000 impressions. A 2% click-through rate brings 2000 shoppers, and a 5% conversion rate (percentage of buyers to shoppers) means that 100 will make purchases, producing a customer acquisition cost of $25. [$2500/(100,000*.02*.05)=$25].
One difference between retail and e-tail is the rather low conversion rate in online stores compared to their brick-and-mortar cousins (though my 65% conversion rate for retail stores is just a guess). Another difference is the relatively high customer acquisition costs for online stores. Here were some 1998-1999 acquisition costs:
|Various E-Commerce Sites||
The implications of these staggering amounts compared the average customer’s initial purchase mean that many e-tailers who advertise regularly will lose money on a customer’s first sale. The only way an e-tailer can recoup these losses is by retaining that customer and selling to him again and again.
If customer acquisition costs are bad news for e-tailers, customer retention costs should come as good news. Once you have a happy online customer, you also have his e-mail address in your customer database, and know something about his interests. If you can leverage this database to produce e-mail messages every few weeks, then you can build the relationship and encourage him to come back for additional purchases at a very low cost advertising cost.
Larger businesses must invest hundreds of thousands of dollars in CRM (customer relationship management) software, but small e-tailers may be able to do this by downloading order information into a Microsoft Access database and then using queries to produce select lists to which targeted e-mails can be sent via an e-mail merge program according to type of product previously purchased, etc. Several lower-cost systems are available. You can use other Microsoft Office products (Access, Outlook and Word), or MessageMedia’s MailKing software (http://www.messagemedia.com/solutions/mailking/), or Gammadyne Mailer (http://www.gammadyne.com/mmail.htm). If you don’t need to be quite so precise, you can always e-mail specials and sales to your entire customer list for only pennies per message (or nothing, if you don’t count the value of your time).
The lesson here is that e-tailers MUST retain their customers and sell to them again and again if they are to make a profit. Those that sell a few high margin products may not need repeat customers, but e-tail storeowners with average margins MUST retain customers and find inexpensive ways to market to them.
Under the Clinton Administration we’ve had a moratorium on new Internet sales taxes, and online businesses have flourished as a result. But state governors have become increasingly restive when they see Internet companies locate in states without sales taxes or offshore tax havens and then sell to consumers in states with sales taxes. Currently US law requires companies with a corporate or physical presence in a state or states to collect sales taxes from residents of those states only. But I don’t think this will last. I expect to see laws requiring Internet merchants to collect appropriate state sales taxes from each of their US customers, and remit that tax to the respective state government. This will have three effects: (1) tax calculation will increasingly be outsourced to companies like Taxware.com, http://www.taxware.com (2) paperwork could become excessive so merchants will outsource tax collection and distribution to third party firms, and (3) consumers won’t have the same incentive as before to purchase online. End-user prices on the Inter
net will no longer look so attractive. I don’t look forward to this, but I see it coming. After all, George W. Bush has been a state governor.
The retail industry typically pays sales clerks low wages. E-tailers have the advantage of being able to locate in low wage areas, or outsource to virtual workers in low-wage areas. But virtual workers typically possess computer equipment and skills that allow them to demand higher wages, especially as contract workers (in contrast to employees). But e-tailers don’t need cashiers, since online shoppers complete their own sales transactions unaided. Customer service and fulfillment personnel are still needed, however. All but the smallest e-tailers will need to keep their staffs lean in order to stay competitive.
While brick-and-mortar retailers may have difficulty opening a small store for less than $50,000 in inventory, furnishings, signage, lease, etc., the small e-tailer can often set up shop for 10% to 20% of that amount or less, then grow as profits make growth feasible. Many of the larger dot-coms have spent millions on computer infrastructure, custom programming, and in-house servers. Smaller e-tailers, however, can often outsource e-commerce hosting for $40 to $400 per month, and can often purchase “off-the-shelf” e-commerce software that includes most or all of the capabilities they need. Compared to a retail store, a Mom and Pop online store can be set up on a shoestring, and run very profitably as a family business.
The Bottom Line
The reason I’ve compared retail and e-tail is to help dispel the myth that e-tailing is just like retailing but without the hassles. The differences between retail and e-tail are significant, and you must thoroughly understand them in order to stay in business. True, e-tailing can cut start-up investment, as well as some sales and marketing costs. But in the final analysis the basic business rules still apply. E-tailing NOT easy. To make a profit you must get several crucial elements right:
- Excellent customer service that delights the customer and retains him for future sales.
- Repeat sales from existing customers at low incremental advertising costs.
- A reasonable customer acquisition cost that drives an adequate number of first-time sales.
- A product fulfillment system that keeps fulfillment costs low and enables excellent customer service.