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 / Spring 2006 / Issue 42(originally published by Booz & Company)


The Hidden Costs of Clicks

Internet retailers are finally learning why books and luggage make money online — while shoes and toys don’t.

Illustration by Lars Leetaru ranks as one of the more notable successes among Internet retailers. The leading online purveyor of luggage, eBags generates more than $38 million in revenue a year and has been consistently profitable since its founding in 1998, in the heyday of the Internet bubble. Operating with minimal inventory thanks to direct “drop shipments” from manufacturers to end customers, eBags could be the model for the future of commerce.

But that model is still developing. EBags continues to expand and adapt its business. In 2004, the online retailer, which is based in Greenwood Village, Colo., acquired, a seller of dress shoes for men and women, and renamed it Having expanded from its original focus on luggage into backpacks, handbags, and other accessories, eBags considered shoes the next logical category for marketing synergies. Yet, despite the clear marketing logic, selling shoes online turned out to be more complicated than selling the other product lines.

The issue, as eBags discovered and as many online vendors have yet to understand, highlights the fundamental operational challenges of Internet retailing. It centers on a concept common in the business-to-business realm but rarely employed in a business-to-consumer context: cost-to-serve. Defined as the total supply chain cost from origin to destination, cost-to-serve incorporates such factors as inventory stocking, packaging, shipping, and returns processing. This metric also helps to explain why some of the early high-flying “e-tailers,” such as eToys and Webvan, failed miserably.

In the eBags example, the cost of serving shoe customers is far higher than the cost of serving luggage customers. The Shoedini acquisition more than doubled the number of SKUs that eBags handled, and the complexity of managing the inventory exploded. Most bags come in two variations — usually different colors. But a shoe style comes in several colors and many sizes; there can be 30 or more variations of a single model.

Bags, furthermore, come in boxes that manufacturers use for shipping via small-package delivery to a fragmented base of mostly mom-and-pop retail customers. But shoes ship to retailers in bulk packaging rather than in individual boxes. When sells a pair of dress loafers direct to a consumer, the manufacturer thus has to incur extra shipping and handling costs to repackage and ship the shoes.

Most important, shoes have a short product life cycle — typically three to six months — and suffer from a high return rate. (Some customers order two pairs at a time, planning to return the pair that doesn’t fit.) Luggage life cycles can last six years, and return rates are minimal. For eBags, this means that although shoes and luggage command similar gross margins, shoes carry a much higher cost-to-serve, and selling them online thus requires a different business model.

Understanding the cost-to-serve dynamics is more important than ever as online retailing continues its growth spurt. More than a third of U.S. households now shop online, according to a September 2005 report from Forrester Research, and annual sales of physical goods are expected to hit $100 billion for the year.

Over the second decade of online retailing, the companies that truly grasp the drivers of cost-to-serve at the level of individual items and individual customers will unlock the full value-creating potential of online retailing as an alternative to — and complement of — traditional retailing.

Trial and Error
Back at the dawn of online retailing, highflyers like Value America (an online “department store”) and Webvan (an Internet-based delivery service that focused its offerings on grocery items) did not comprehend the operational cost implications of their business models. Value America started with a virtual inventory model supposedly applicable to any branded product. Although its initial offering, computer hardware, sold well, shipping and handling costs for lower-value goods proved prohibitive, and an unmanageable flood of returns ultimately sank the company in August 2000. Less than a year later, in July 2001, Webvan declared bankruptcy after concluding that it would never turn a profit, despite its state-of-the-art supply chain with a hub-and-spoke network of delivery cross-docks and highly automated distribution centers. (The flaws in its economic model were highlighted in a Booz Allen Hamilton study more than a year before its collapse. See “The Last Mile to Nowhere: Flaws & Fallacies in Internet Home-Delivery Schemes,” by Tim Laseter, Pat Houston, Anne Chung, Silas Byrne, Martha Turner, and Anand Devendran, s+b, Third Quarter 2000.)

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