Comment: How the four As are changing retail - Amazon

Today's consumers expect convenience, transparency and value for money. The best-performing retailers are those who have a rigorous focus on understanding their customer and apply that understanding through differentiation on price, product and/or convenience.

So, let's take the three driving principles of Amazon's value proposition – convenience, choice and price. A general observation is that, as simple as any model seems from the outside, the more complex it often is on the inside. Amazon is no exception. To achieve its simple, very appealing customer proposition, there is a huge and complex organisation responsible behind.

With a market capitalisation of $143 billion (May 2014) and continuing losses due to investment (projected at $810 million for the third quarter), from the outside it seems that Amazon does not operate profitably, but it is definitely worth exploring this in a little more detail.

If we look at convenience to begin with, it's clear that this is delivered principally through innovation and fulfilment. All innovations are religiously targeted at solving problems for customers. Amazon is hard-wired to innovate with a scale and rapidity that others can only dream of.

In order to be first to market, it is important to get the right people together, then to test and launch very quickly. Amazon have retained this ability by keeping platform development largely in Seattle, close to the leadership, where very bright people are able to produce mainly technology-based solutions which can be rolled out globally. It is the classic centre of excellence that holds the principal organisational power due to its proximity to CEO Jeff Bezos.

Customer obsession permeates into fulfilment. The operations teams work from huge purpose-built, semi-automated facilities, managing processes which are constantly redesigned to support the rapidly changing and expanding convenience proposition.

When exceptions occur, they are dealt with at an individual transaction level. This is where theory and practical reality collide. When things go wrong, dealing with them results in a mountain of additional work: firstly to deal with the exception, and secondly to redesign and simplify the process to reduce the future incidence with the goal of reducing cost. It is clear from customer review forums that Amazon struggles to handle these exceptions both effectively for the customer and efficiently in terms of minimal cost for the business.

When it comes to choice, Amazon's customer obsession drives a 'just do it' mentality. Local product managers are incentivised to expand their selection either through increasing the choice offered directly by Amazon or by increasing the number of SKUs offered through the Amazon marketplace (vendors who sell their products through Amazon's platform). The first priority is to get the products and services in, the second priority is to worry about the consequences.

Since 1994 Amazon has expanded its assortment continuously. More and more categories have been added and in mature categories such as books, Amazon has collected a wealth of operational experience towards perfecting its operation, often destroying the competition and delivering healthy and sustainable profit margins. But the rapid expansion introduces multiple categories in early stages of maturity which makes it extremely difficult to maintain profit margins.

The resulting question is whether the relentless pursuit of broadening customer choice is sustainable in the long-term? A good example where the answer was clearly 'no' was when Amazon launched a white goods offer in the UK, only to withdraw the category due to the complexity involved in reverse logistics with its onerous legal requirements.

If sensibly applied, expanding choice represents a powerful mechanism of growth. Success in the market has brought a war chest of capital that has enabled the senior team to enhance customer choice by acquiring start-ups and intellectual property, bringing new propositions to the market – focusing on delivery platforms, services and content. LoveFilm and Kindle are examples.

These new businesses have been bolted on to the existing operations with varying degrees of synergy and once again the fulfilment operation is left to deal with this additional complexity. Delivering customer choice while trying to prevent operational costs spiralling out of control.

The danger is Amazon's huge breadth of products and services makes it confusing for the customer unless they have a clear idea of what they want to purchase. The customer shopping experience can feel more like a visit to a car boot sale rather than the structured aisles of a physical store.

Deploying category management processes for the online environment are an imperative for the future – not only for Amazon but for all retailers that offer choice. Partnering with data aggregators who can provide additional data points, offering a holistic view of the customer, represents a winning formula. A key question though will be how to incorporate this into the operating model.

Finally, how does Amazon deliver either market-leading price or a price matched with the lowest in the market? Instead of linking price to the cost of production and fulfilment, price is matched to the price out in the market. The local product manager retains accountability for volumes and margin, and uses a sophisticated tool which automatically alters prices to match the lowest in the wild. This keeps ticket price (and consequently margins) low.

The tool is self-teaching with the ultimate goal that it will not need human intervention. The strategic risk for Amazon is that a sustainable margin cannot be achieved given that Amazon itself is driving the market to offer cut-throat prices across many categories.

But in the end, will growth lead to a lower cost structure? Without it Amazon fails ultimately to make a profit. The growth aspect of the model is not in question: we agree that the strong focus on the customer proposition combined with the structure and mindset of the business will continue to deliver an enhanced customer experience through reduced prices, greater choice and greater convenience. This in turn attracts more vendors and more customers.

However, in the meantime, the business is baking in complexity in pursuit of growth, raising the prospect that the costs associated with this complexity may outweigh the benefits of economies of scale in the future.

Paul Martin is managing director of Boxwood Insights at management consulting firm Boxwood. Find out about Aldi and the other two As which are significantly impacting the retail industry, in his regular Essential Retail column over the coming months.

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