Comment: Uncontrolled sales growth destroys online profitability

So the secret is out, a recent survey revealed that only 16% of multichannel retailers believe they can fulfil online orders profitably. This rather shocking statistic poses some serious questions for retailers about why many find it so hard to make money online. You could be forgiven for thinking it would actually be easier than traditional retail, but dig a little deeper and the cracks in the online model begin to be revealed.

Fulfilment costs are often cited as the number one reason for poor profitability performance but at A&M we believe the real reasons behind this performance are much more complex.

It is perhaps ironic that most retail CFOs have an almost forensic approach to understanding traditional retail profitability but are struggling to understand the basic components and drivers of their eCommerce operation. If you ask a retailer about their online performance they will normally quote sales growth, traffic, conversion rate and possibly average order value. Indicative of the problem is that profitability rarely features in their top 10 KPIs.

To fully understand today's problems with online retailing, it is worth remembering that just over ten years ago YouTube, Twitter, iPads and iPhones did not exist. Facebook only launched in 2004 and paid search ads on Google only have only featured since 2000 when Amazon was just an online book store. It may not feel like it at times, but eCommerce is still a very young industry that has gone through an unprecedented period of constant change and innovation.

Retailers have done their best to get to grips with new technology, changing customer expectations and behaviours, digital marketing, the rise of social media, the mobile revolution and increased competition from pure-plays and overseas brands, all whilst dealing with the worst financial crisis in living memory.

Inflated sales targets

During this period online revenues for most retailers have grown steadily but some businesses are still reporting online turnover is less than 10% of their business while more successful high street retailers are moving towards 40%.  Traditional mail order businesses are now reporting 60% to 90% of sales are online. All this has fuelled unrealistic ambitions in many boardrooms that subsequently set unrealistic sales targets.

This results in a furious charge for uncontrolled growth and this is when the real problems begin…

Setting unrealistic sales targets often sets off a series of events and behaviours which can initially seem to be delivering the required growth, but ultimately lead to poor profitability.

In many cases bonus schemes are created that reward top-line sales performance but do not take profitability into account. It is not surprising then that management is becoming obsessed with sales growth with little or no understanding of true bottom-line performance.

Many retailers explain that their eCommerce strategy is to "reach £xxx million in online sales" or to "reach xx% of overall sales online" but these are ambitions, not strategies. In the race to drive sales the need for an overall cohesive execution strategy is often overlooked, which can cause severe problems further down the line.

Marketing effectiveness

One of the easiest ways to increase revenue quickly is to drive more traffic to your website. The easiest and quickest way to drive more traffic is to spend more money on digital marketing, particularly on paid search, display advertising, affiliate marketing and re-targeting campaigns. The key point here is that there is a tipping point when additional spend in these areas has a diminishing and often negative return on the investment. This is however often obscured by the addiction to top-line sales and the fact that marketing spend is frequently managed on an average basis, i.e. "on average we spend x% of our sales on digital marketing". This can be misleading because within that x% there is often a significant amount spent which generates little or no return at all.

Increasing sales by spending more money on marketing and financially incentivising people to focus on sales causes a significant increase in the cost base but this is just the beginning.

Many retailers are also guilty of over promoting, literally throwing away money by offering more discounts on promotions than they will ever get back from some customers whilst at the same time conditioning the entire customer base to expect heavy discounting.

Inefficient internal processes

Inefficient internal processes that coped with initially modest online volumes start to become exposed and as sales increase so do queries to the call centre and returns begin to pile up in stores and in the distribution centre. All of this is happening at speed and without an overarching strategy; therefore the natural reaction is often to invest in more people to deal with the additional volume rather than tackling the issues directly. After all, sales are going up as planned, aren’t they?

Becoming multichannel

Next in the equation are additional sales channels and integration with stores as the retailer attempts to evolve into a multichannel business. A mobile site and mobile app(s) are often developed, trading is extended to include new marketplaces and social media channels are brought into play. Overseas shipping often completes the picture of ever increasing complexity and associated costs. Most retailers cannot decipher how many of these activities actually make a positive profit contribution. Sure, some are simply the cost of doing business but we can’t allow that to become the standard response to poor performance.

Stock is also often used inefficiently; click & collect orders are shipped from a central distribution centre to the store but the store already had the item in stock. This increases the transportation costs and adds delays, while stock levels could be reduced by utilising the store stock rather than duplicating it in the DC.

IT systems

Eventually existing IT systems begin to struggle with the increasing volume and complexity, and the answer is thought to be a new online platform which promises a rich array of features and functionality that will improve conversion. On the back of this, sales budgets are increased further. All too often implementation of the new systems gets delayed, goes over budget or the anticipated benefits fail to fully materialise. Often we find this is due to expectations that were overly optimistic from the start.

We all witnessed the serious problems some retailers had online on Black Friday and it is easy to blame "the website". In many cases the problems resided in back office and order management systems that could not cope and allowed stock to be sold that the retailer did not have.

Stock increases

As sales increase, more stock is bought (often with very long lead times) and therefore additional warehousing space and distribution capacity is required. This adds further costs and can create operational inefficiencies as warehouses start to reach their bursting points.

Buyers tend to buy what sells in stores and assume it will therefore sell online but this is often not the case. Buyers need to buy for what sells and is searched for online and product content must be rich enough to give customers the confidence to buy online.

End result

The final nail in the coffin for profitability occurs when sales begin to plateau below the overly aggressive sales targets despite additional marketing spend. Stock builds up and has to be marked down to clear space for the new stock that has already been ordered. In the short term this boosts sales but destroys the margin and thus profitability. It also starts to influence customer behaviour as they begin to expect heavy discounts and avoid buying full price items.

Counterintuitive it may be, but uncontrolled sales growth will eventually kill profitability. As the old saying goes, turnover is vanity, profit is sanity...

Former Carpetright IT director Ian Woosey is a senior director at professional services firm Alvarez & Marsal. He will be writing a monthly column on the challenges of modern retail, exclusively for Essential Retail.

In his article next month, Ian will explore the problems online retailers face due to masses of data with little actionable insight and how this contributes to poor investment and operational decisions.

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Alvarez & Marsal