Why Getting into Ecommerce is so Hard - and How to Get to the Holy Grail

Posted by Ivan Mazour 19 Aug 13

shutterstock_158329670Ecommerce is not easy. It's a huge industry, and it may seem that there are many opportunities to start a new online retail business - but as many people have found out, although it may be exciting and fun at the start, the tough reality is always just around the corner. In the early days of ecommerce, niche businesses could be profitable right from the beginning. You could make a decent living selling long-tail items like swimming pool liners. But most niches are now filled, which means that companies just getting started are almost always entering a competitive market, not a wide open one, and they have to be prepared to fight their way through in order to succeed.

Let's consider an ecommerce CEO or founder going through the top-level calculation for their online retail business.

They start with the goods they have sold - their Gross Revenue. But a lot of these goods get returned, so these are subtracted to get Net Revenue. Then the wholesale cost of the remaining goods is subtracted to get the Product Margin. This would have been the Gross Margin in the early days of ecommerce, but now the industry standard is to offer free shipping, and most often free returns as well, so the cost of this needs to be subtracted first.

So now the CEO is at Gross Margin. Time to subtract the main operating costs - customer service, merchant fees, photography, fulfillment costs, and ecommerce operational costs (including Ometria analytics, of course!) They subtract all of these to get the Gross Contribution Margin. And then the big one - subtract marketing and promotion costs to get the true Contribution Margin.

So finally this is the figure that they can spend on staff. If staff costs are lower than the True Contribution Margin, then they take the team out to celebrate. And the investors have their own party, too. If not, then it's time to invest some more, and hope that the numbers keep moving in the right direction.

There are a couple of very significant scale factors that early-stage ecommerce founders don't expect to come up against. The biggest is the impact of brand strength on customer acquisition cost. There is a direct relationship between the marketing and promotions spend, and Gross Revenue, and this relationship is completely different for a company with strong brand awareness compared to a company which is brand new. A marketing campaign which gets a known company in front of a potential customer is much more likely to convert than one which gets an unknown one in front of the same person - so the incumbents benefit from a much lower proportional spend on this. The same applies to the ecommerce operational costs - running a website when you're small is just as complex as when you're big, although of course many new challenges do arise as you scale in size.

So a new company will have proportionally larger costs, and since they cannot expect to charge more than their competitors, they will struggle to become profitable. If all they can do is keep selling the same goods at the same price as their larger competitors, it seems that they have no choice but to shut up shop. But that can't be right. What's the solution?

Well the answer comes from the world of technology startups. In the early stages of a technology company, the team are looking for just one thing - product-market fit. The software needs to be good (product) and there need to be people willing to buy it (market) and most importantly they need to buy it for enough to make the company a profitable proposition (fit). So the three pieces of the puzzle are products, customers and prices. A startup quickly and constantly adjusts all of these until the product-market fit is found. If the product isn't right, it's changed. If the price is too low, they find a different market that will accept a higher one. Nothing is set in stone.

Ecommerce founders, on the other hand, tend to have a very specific vision of what selection of products they want to stock, and what kind of people they want to sell to. Often this stems from a personal requirement that they have found unfulfilled. Even when this doesn't work, and they find themselves with a different customer segment, they aren't willing to pivot the company in the direction that would clearly work better. For a large company, that is even more true. Adjusting the positioning and brand presence of a huge well-known retailer is extremely hard. But trends, as we can see from the prevalence of "disposable fashion", change extremely quickly, and being able to keep up with them is the great hidden advantage that a smaller retailer has over a larger one.

By carefully monitoring their customer groups, seeing which ones are the most profitable, how they can be acquired, and what products they are buying, a retailer can see what direction to take their brand to get the best audience. By then analysing their product mix, they can determine how it should be curated to present a proprietary selection to this audience. It may be the same items that are available elsewhere on the internet, but the key is that this selection is perfectly tailored to the audience of that moment, making it much easier for those people to shop with this retailer rather than with any other. Add in some individual margin analysis and price / volume analysis to maximise the profitability of that selection, and the plucky underdog is suddenly operating much more profitably than the large-scale competition - just because they have taken an objective and data-driven approach towards their customers, products and prices.

This isn't something that can be done once - every week the equation changes, and the same process gets repeated all over again. But with every week of this kind of advantage, the company gets one step closer to a secure, and very profitable position - the Holy Grail of ecommerce. 

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