How e-tailing can rise - Indiana University Bloomingtoninfo.ils.indiana.edu/~hrosenba/L561/pdf_05/mckinsey_etailing.pdf104 THE McKINSEY QUARTERLY 2000 NUMBER 3 About 20 million people

etailing on the World Wide Web has alerted the general public to the Internet’s potential for transforming business and everyday life.

Yet so far, the financial performance of most Web-based retailers has beendismal. Their experience provides an object lesson for the new economy:businesses have to make money.

As the Web continues to transform retailing, can retailers hope to generateprofits on-line? The evidence is sobering. Our recent research into the under-lying economics and competitive dynamics of Web retailing shows that itwill be structurally impossible for most pure Web retailers—unless they hitAmazon.com-like scale—ever to turn a profit, let alone to take a dominantposition. The clear advantage in retailing goes to big, highly skilled tradi-tional retailers that use the Web to extend their already potent physical pres-ence. So though pure plays may indeed be doomed, the demise of e-tailinghas been greatly exaggerated for multichannel players.

R

For contributions to this article, the authors thank Rayford L. Davis, a consultant in McKinsey’s Chicagooffice; Brad Rodrigues, an alumnus of that office; and Amna Naseer and Mariano Banos, consultants inthe New York office.

Joanna Barsh is a director and Chris Grosso is a consultant in McKinsey’s New York office, andBlair Crawford is a principal in the Boston office. Copyright © 2000 McKinsey & Company. All rightsreserved.

This article can be found on our Web site at www.mckinseyquarterly.com/electron/hoet00.asp.

How

Pure-play Internet retailers haven’t made a profit and probably never will. The winners on-line will be experienced retailers that can

execute a multichannel strategy.

Joanna Barsh, Blair Crawford, and Chris Grosso

R E T A I L98

e-tailing can risefrom the ashes

(098-109)E-tailing v4 6/26/00 2:01 PM Page 98

D. HARMS


The problem

Most e-tailers lose money on every transaction. Even the flagship e-tailer,Amazon, is losing about $7 an order on its nonbook sales after taking intoaccount product, shipping, and fulfillment costs. (Its book sales generateabout $5 an order.) Fogdog Sports, a sporting-goods outlet, loses $5 anorder. For others, the losses are even starker: Drugstore.com loses about $10 to $15 an order (Exhibit 1).

Three weaknesses lie at the core of this problem:

1. Many product categories, such as toys, start off with a big disadvantage—they are difficult to pick, pack, and ship; they attract only small orders; orboth.

2. Plain inexperience and lack of scale are inflating fulfillment costs to asmuch as $12 to $16 an order for many pure plays.

3. Inexperienced merchandising and sourcing organizations, intense pricecompetition, and problems with inventory management and productreturns give pure plays particularly poor gross margins. Established

100 THE McKINSEY QUARTERLY 2000 NUMBER 3

–11.31 –16.42 –5.20 –12.90 –4.04

E X H I B I T 1

Click here to destroy value: Incremental costs leave e-tailers in the red

Estimated $ per order, fourth quarter, 1999

1Includes consumables, health and beauty products, and over-the-counter drugs.2Net product revenue plus shipping revenue.3Includes picking, packing, customer service, and credit card transaction costs.Source: Interviews with industry experts; company reports; McKinsey analysis

Total loss per order

Totalrevenue2

Productcost

Shipping

Fulfillment3

Fogdog Sports Webvan

Drugstore.com

Front-endmerchandise1Prescription drug eToys

62.00

40.04

12.00

14.00

81.30

66.20

18.00

10.00

61.82

47.01

9.01

11.00

23.50

20.75

4.88

14.29

64.07

60.29

0.80

14.29


retailers in categories like apparel and drugs enjoy an advantage of 2,000to 3,000 basis points in gross margins. They are thus in a much strongerposition to make profits and prosper.

To post comfortable contributions on each transaction, e-tailers would needefficient order fulfillment, average order sizes of at least $100, and grossmargins of at least 25 percent (Exhibit 2).

Since money generally vanishes with each order, it follows that almost all e-tailers are losing money on every customer, for those customers generatetoo few orders or too little profit per order to cover the cost of winning them.Soaring acquisition costs of $50 to $100 a customer, generated by the diffi-culty of building virtual brands without stores or catalogs, put pure plays ina deep hole. In addition, many of them have relied on scattershot marketingcampaigns using high-profile ads that generate buzz among investors butdon’t bring customer accounts to the servers. This combination of low repeatbuys, high acquisition costs, and small orders explains why pure plays aredestroying value with every customer.

Retailers with established brands and marketing engines are relatively insu-lated from such problems, for these retailers can leverage their traditional

101H O W E - TA I L I N G C A N R I S E F R O M T H E A S H E S

E X H I B I T 2

Reading the vital signs: The keys to good health for e-tailers

1Assumes e-tailer achieves best practice levels in order size, gross margin, and fulfillment costs.

Profit per order at $5 fulfillment cost1

Good Marginal Poor

Orde

r siz

e

$100

$25

$50

Gross margin1515% 25% 40%

Profit per order at $10 fulfillment cost1

Orde

r siz

e

$100

$25

$50

Gross margin1515% 25% 40%

Specialty apparel($37.60)

Direct-mailapparel ($33.00) Department store

apparel ($32.50)Cash prescription

drug ($30.98)

Off-price apparel($19.90)

Third-partyprescription drug

($14.92)Grocery ($11.50)

Toys ($11.00) Books ($11.16)Pure-play

apparel ($7.90)Front-end drugstore($2.90)

Expected profit per order, by channel1

$1.25

$10.00 $20.00 $35.00

$2.50

–$1.25

$7.50 $15.00

$5.00

$5.00 $15.00 $30.00

–$2.50

–$6.25

$2.50 $10.00

0–$3.75


marketing mix to acquire on-line customers more cheaply. In highly brand-sensitive categories like apparel, multichannel retailers can spend as littleas one-third or even one-fourth of what their pure-play rivals pay for thatpurpose.

Fixed costs come unfixed

The lower costs per order and per customer of multichannel retailers helpthem break even. But contrary to the early business plans of many players,e-tailing doesn’t amount to a free new channel where established retailerscan test new product categories, reach new customers, and increase rev-enue. Few fixed costs are truly fixed in e-commerce. Many supposedly

fixed costs actually increase in linewith revenue growth, so that large-scale operations are very difficult to create.

Maintaining an industrial-strengthWeb site and its associated back-endsystems, for example, costs between

$15 million and $25 million annually, and this doesn’t decrease over time. If anything, expenses associated with hardware and software—about 30 per-cent of total Web site costs—increase with site traffic and therefore with revenue growth. Other types of fixed costs, such as warehousing, grow as a percentage of revenues. They are either huge, up-front hits that depressearnings through depreciation costs or smaller, ongoing expenses thatdepress earnings through rental costs. Even if e-tailers could manage tomake a profit on each order and each customer, the level of sales required to break even would remain high.

These economic realities define the arduous task facing e-tailers. Gross mar-gins and fulfillment costs must improve dramatically to make orders prof-itable, so on-line prices can’t be discounted against off-line prices. The costof acquiring customers must drop while their loyalty must rise if investmentsin customers are to be profitable. And just to break even, Web retailers mustachieve revenues in the neighborhood of $1 billion a year, especially for low-margin categories such as books. For most pure plays, these challenges willbe impossible.

For the multichannel players, however, the numbers are a great deal better:higher gross margins make the per-order economics stronger, while lowermarketing expenses make fixed costs much lower. Indeed, the breakevenpoint of a multichannel retailer is typically half the breakeven point of itspure-play counterpart.


Many supposedly fixed costs in e-commerce actually increasealong with revenue, so large-scaleoperations are difficult to create


Moreover, adding e-tailing to a lineup of sales channels creates synergies. Moreand more customers browse on-line before purchasing off-line, and early anec-dotal indications suggest that consumers increase their spending on productssold by “landed” (physical-world) retailers that add new channels. So even if e-tailing turns out to be just a breakeven proposition for multichannel retailers,it is still a worthwhile way to reinforce and extend the franchise.

Industrial variations

Although the overall picture for pure Web-based retailing is grim, the grim-ness varies a good deal by industry. Key economic drivers vary greatly amongcategories, giving some of them much higher profit potential than others. Welooked closely at four primary categories: books, drugs (prescription drugsas well as health and beauty products), groceries, and apparel.

Books

Low-margin products, such as books, must be sold on such a huge scalethat they can sustain only a couple of players. Even with an annual bookrevenue run rate of $1.2 billion, Amazon is barely breaking even in its bookbusiness. Yet with more scale and operational enhancements,the company could improve its position dramaticallyand develop a channel with more than twice theearnings, before interest and taxes, of Barnes &Noble’s store business (see sidebar, “Amazonianchallenges,” on the next page).

Amazon is increasing its scale by entering other low-margin categories, including consumer electronics, music,and toys. The intrinsic economics of the new categories are generally nobetter than they are in books, with gross margins at just over 20 percentand order sizes at about $50. Moreover, the high fixed costs associated withrunning each additional product line will keep profits low. Yet, thanks to anestablished brand name that brings scale advantages and to a relatively lowcustomer acquisition cost of $19 (in the fourth quarter of 1999), Amazonhas already overcome many of the hurdles that pure plays face. Even so,until it persuades its customers to spend more and generates higher-marginadvertising and commission revenues, it won’t have compelling returns.

Drugs

The economics of success are even more complicated for on-line drugstores.Scale matters only for pharmaceuticals; large volumes in front-end merchandise(health and beauty products, for example) are worthless. Solid contributions of




About 20 million people have shopped at

Amazon.com, and more than five times as many

US consumers recognize the brand. Conversion

rates—the percentage of visitors who make a

purchase—range from 15 to 25 percent,

depending on the season, compared with 3 to 5

percent at most other e-tailers. And Amazon’s

percentage of repeat business far outstrips that

of established rivals, such as Barnes & Noble.

The numbers are impressive for a four-year-old,

but the growing pains are hardly over. To grow

successfully, this multi-category retailer must

meet new challenges—four, in particular. Even

if Amazon falters on a couple of them, the

process will likely transform the landscape

for on- and off-line retailers alike.

1. Reaching necessary sales goals: To have sales

of about $12 billion by 2005, Amazon must

expand its customer base to more than 40

million over the next five years, raise its

annual revenue per customer to $207 (from

$117), and stretch its gross margins to 28

percent (from about 13 percent). Such growth

is difficult, but if Wal-Mart in the 1980s is an

appropriate precedent, success is possible.

2. Fulfilling demand at this level: At the desired

sales volume, Amazon will process more resi-

dential packages a day than Federal Express.

This will require a quadrupling of the com-

pany’s warehouse capacity, yet Amazon will

also have to shave off 25 percent of the cost

of fulfilling orders while rolling out product cat-

egories that offer few if any fulfillment syner-

gies. The company will also have to make

careful trade-offs between customer service

levels and profitability. Dealing with all this

simultaneously will be a formidable problem.

3. Becoming a media-like company: Amazon

should be able to generate strong cash flows

by selling access to its audience. Although

Amazon will never match America Online in

volume of traffic, it should be able to collect

about $16 a customer by 2005 through on-

site advertising, partnerships, auction ser-

vices, advertising inserts in packages, sales

of customer data, and other steps. In view

of the $2,000 per household that companies

spend annually on advertising in the United

States—$117 in the Yellow Pages—this

estimate could be conservative. But success

in these areas calls for skills different from

those that have so far propelled Amazon.

4. Increasing management depth quickly:

Amazon’s leadership is by most measures

outstanding, but the company will need more

management depth to face the challenges

ahead. A $12 billion e-tailer must sell a lot of

goods across product categories, move a lot of

boxes, and field a lot of customer calls. Besides

attracting the best young talent, Amazon

will have to turn more toward experienced

performers in the bricks-and-mortar world.

Although the company faces stiff challenges,

we remain optimistic that it will meet them. It

already boasts a powerful brand, a visionary

management team, and a new focus on

profitability. Indeed, it may end up as the only

pure-play e-tailer to matter in the long term.

Amazonian challenges


about $15 to $25 per order—and plenty of orders—make prescription salesan attractive business once an e-tailer reaches sufficient scale. However, toreach a profitable level of prescription sales, drugstore e-tailers must get theright to fill prescriptions covered by insurance. This right is generally con-trolled by prescription benefit-management companies (PBMs), whichadminister employee drug benefits for companies. The major PBMs typicallyhold back access to the lucrative 90-day prescriptions they sell through theirmail-order businesses and give poor deals on the less attractive 30-day pre-scriptions that people otherwise pick up at drugstores.

Making money on the front end is more difficult still. Most high-marginconsumable products, including tobacco, can’t be offered on-line. Smallorders and low margins for most consumer health and beauty productsdepress their per-ordereconomics to less than$3. To profit on thefront end, drugstoresmust therefore sellgoods such as high-endcosmetics, hard-to-finditems, and over-the-counter drugs withattractive margins. As a consequence, the typi-cal on-line drugstore isfundamentally differentfrom its landed coun-terparts, relying moreheavily on prescriptionsto drive profitability(Exhibit 3).

Despite this need for aprofitable prescriptionbusiness, on-line drug-stores have lackedaccess to customerswith insured prescrip-tions. The pure playswill have to develop better relations with PBMs, insurers, and doctors. Bycontrast, the traditional retailer CVS looks like a powerhouse: it is alignedwith WebMD and a leading PBM, Merck-Medco. Pure plays put themselvesat an even greater disadvantage by running scattershot marketing campaignsand offering many unprofitable front-end products.


E X H I B I T 3

A different kind of drugstore

Percent

1Assumes $2.7 billion in annual revenues.2Gross margin after product cost, shipping, and receiving and warehousing.3Includes consumables, health and beauty products, and over-the-counter drugs.Source: Company reports; McKinsey analysis

42.4

Revenuemakeup

Typical landed drugstore

Cashprescriptions

Insuredprescriptions

Front-endmerchandise3

48.4

9.2Prescriptions• Cash prescriptions

(9.4%)• Insured

prescriptions(31.6%)


41.059.0

Drivers of profitability: Share of gross margin2

40.0

Revenuemakeup

Typical on-line drugstore1

Cashprescriptions

Insuredprescriptions


30.0

30.0 Prescriptions• Cash prescriptions

(39.1%)• Insured

prescriptions(26.1%)


65.2

34.8

Drivers of profitability: Share of gross margin2


Groceries

Unexpectedly, the best product mix for a pure-play e-tailer may come fromgroceries. With order sizes as high as $100 or more and customers tendingto place frequent repeat orders, groceries can become a great e-business forcompanies that reach the necessary scale (about $200 million to $250 millionper market) in their home markets. Moreover, within a local market, it canbe relatively easy to reach sufficient scale—sales of perhaps less than 3 per-cent of the total, the equivalent of about 13 supermarkets. With relativelylow scale requirements and high customer values, as well as minimal marginadvantages for the established retailers, pure plays like Webvan have a greatopportunity to succeed despite the huge investment needed for a distributioninfrastructure.

Even with these advantages, on-line groceries are still far from the finishline. Delivery logistics make the model much harder to execute in real life

than on paper. Webvanand rivals with other,less capital-intensivemodels have also strug-gled to manage theirgrocery inventory.Shrinkage rates arehorrible, and move-ment up the grocer’stough learning curve is slow.

Apparel

The Internet offersbetter economics—andthus the possibility ofstiffer competition—for selling apparel(Exhibit 4). Largeorders and gross mar-gins make per-ordereconomics much betterthan they are in anyother category weexamined, especiallyfor established apparelplayers with private-


E X H I B I T 4

On-line economics are good for apparel retailers

Percent

1Assumes e-tailer achieves best practice levels in order size, gross margin, and fulfillment costs, andreaches $1.7 billion in annual merchandise sales.

2Does not include shipping, which is charged to customer and netted out.Source: Media Metrix; Jupiter Communications; Forrester Research; interviews with industry experts;company reports; National Retail Federation; McKinsey analysis

Established specialty apparel retailer

On-line1

100.0

15.0

Pretax return oninvested capital

Gross sales2

Returns

Cost of goods sold,merchandising

Occupancy andstore costs

Marketing

Distribution, fulfillment,warehousing, depreciation,

and amortization

Product development

General andadministrative costs

Operatingmargin

43.6

0

3.6

8.3

5.7

0.8

23.0

Landed

100.0

15.0

43.6

10.0

5.0

6.3

0

5.9

14.2

161% 61%


label merchandise. These high per-order economics translate into excellentper-customer economics for branded apparel players that can leverage theirbrands to minimize acquisition costs. For specialty apparel, direct mail, andtop department stores, the e-tailing breakeven point is much lower—poten-tially at $100 million for the strongest landed players. As an added benefit,once the company reaches the breakeven point, on-line sales provide a moreefficient channel for vertically integrated clothiers than do off-line sales.

Given the low breakeven levels and the inherent fragmentation of thismarket, as many as 50 to 100 established retailers should be able to buildand sustain a profitable apparel e-tailing business. However, pure plays typi-cally lack private-label goods, strong brand names, good gross margins, andaccess to products. Multichannel retailers have huge advantages in grossmargins (as much as 2,000 to 3,000 basis points) and can attract customersat as little as one-fourth the cost. As a result, on-line apparel sales are not a scale game but rather a new channel to be integrated into a multichannelapproach. Pure-play e-tailers will struggle to sustain themselves unless theycompete in well-protected niches and add a catalog—and perhaps evenbricks-and-mortar stores.

Advantage, incumbents

Since successful e-tailing and successful off-line retailing share many hall-marks, the leading e-tailers will probably be retailers that have alreadydone well with their stores and, especially, with direct marketing. Thanksto merchandising expertise and good relationswith vendors, multichannel retailers enjoy highergross margins than do the pure plays, which are ata disadvantage because they rely on heavy dis-counting. In addition, multichannel retailers canleverage well-established brands and integratedmarketing vehicles—Web addresses on shoppingbags and complementary multichannel promo-tions, for instance—to minimize the cost ofacquiring customers. Fulfillment remains a chal-lenge for all e-tailers,1 but those that have already mastered thecore business may have the best position to make the necessaryimprovements.

The boost that established retailers get from their advantages is consider-able, but to realize their on-line potential they must still overcome financial,organizational, and mind-set hurdles. The huge investments required for


1See Himesh Bhise, Diana Farrell, Hans Miller, Andre Vanier, and Adil Zainulbhai, “The duel for the doorstep,”The McKinsey Quarterly, 2000 Number 2, pp. 32–41.


e-tailing, along with the potential earnings hits, make it hard for establishedretailers to enter this channel. On balance, however, they are very likely toovercome these problems before most pure plays can deal with their struc-tural disadvantages.

To succeed on the Web, all companies involved in e-tailing must move rapidlyin several directions:

1. Run the e-business like a bricks-and-mortar store by rigorously measuringperformance against classic retail and catalog metrics, such as grossmargin and ticket size. Giving customers free shipping, for example, canhave the effect of depressing the latter, and that in turn can destroy aretailer’s economics. Therefore, on-line retailers should give free shippingonly as an explicit vehicle for acquiring new customersor as a prize to loyal customers or heavy buyers.

2. Use experienced merchants, marketers, and opera-tions executives. The on-line enterprise could bringin experienced merchants from the landed companyand hire catalog experts to manage warehouse operations.

3. Closely watch all of the marketing investments related to e-tailing tomake sure that they are properly focused. Expensive mass-media adver-tising along the lines of Super Bowl or World Series advertisements, forinstance, might be a less effective way of acquiring customers thanstarting a catalog.

4. Begin to reduce the fixed costs of e-tailing to a level that matches realisticcurrent business projections. Monitor all of the company’s key vendorsand Web investments, and apply tough retailing standards of judgment toevaluate every proposed new feature and function on the Web site.

5. Manage e-tailing as a truly integrated channel. Retailers can apply thisintegrated marketing vision in a number of ways, such as puttingdetailed information about their products and services on-line for thebenefit of anyone who wants to browse and coordinating their on-linemerchandise offerings with their catalogs and their stores (for example,by selling big-ticket, hard-to-bring-home items such as refrigerators andwashing machines on the Web).

6. Refine the business model to seek revenue from high-margin referral andadvertising commissions. Like Amazon, e-tailers can focus on their mostsuccessful categories and add partners for others, in which they can take a



commission. But they will be forced either to fight or to ally with contentplayers that are trying to reach the same sweet spot.

Among the pure plays, unsustainable models will rapidly disappear, and themost viable enterprises will start to consolidate. In general, categories cansupport only a few players profitably, so a majority of the survivors willmerge with other pure plays, add a second channel, or explore alignmentswith landed players. Multichannel retailing is the new game in town, but theplayers remain largely the same.



Documents

How e-tailing can rise - Indiana University Bloomingtoninfo.ils.indiana.edu/~hrosenba/L561/pdf_05/mckinsey_etailing.pdf104 THE McKINSEY QUARTERLY 2000 NUMBER 3 About 20 million people