Under Pressure

Profit is being squeezed out of our multichannel businesses, especially in the online and catalog channels.

This is an example of what a reasonably healthy online/catalog profit and loss statement might look like today.

Demand	$50,000,000
Merchandise Fulfilled	$45,000,000
Returns	$11,250,000
Net Sales	$33,750,000
Gross Margin	$16,875,000
Less Catalog Marketing	$4,000,000
Less Online Marketing	$2,000,000
Less Pick/Pack/Ship	$4,050,000
Variable Operating Profit	$6,825,000
Less Fixed Costs	$4,050,000
Earnings Before Taxes	$2,775,000
EBT As A % Of Net Sales	8.2%

This business generates $2.8 million profit on $33.4 million net sales, yielding a healthy EBT of 8.2%.

Then, the USPS elects to make mailing catalogs more expensive. If you simply absorb the cost of this increase, your profit and loss statement might look like this:

Demand	$50,000,000
Merchandise Fulfilled	$45,000,000
Returns	$11,250,000
Net Sales	$33,750,000
Gross Margin	$16,875,000
Less Catalog Marketing	$4,360,000
Less Online Marketing	$2,000,000
Less Pick/Pack/Ship	$4,050,000
Variable Operating Profit	$6,465,000
Less Fixed Costs	$4,050,000
Earnings Before Taxes	$2,415,000
EBT As A % Of Net Sales	7.2%

The USPS increase takes a full percent of your Earnings Before Taxes.

Even more interesting, however, is the looming trend toward free shipping and free returns. Long-term, I don't think we can escape this trend. The customer will demand we provide this service for free. A customer will gladly pay $3.00 for a $0.60 cup of coffee at Starbucks, but she won't pay to have a dress shipped from Columbus, OH to her home in Portland, OR.

Free shipping and free returns will put a lot of pressure on the profit and loss statement. If free shipping and free returns drove enough top-line sales to offset the expense, every multichannel retailer would already be offering free shipping and free returns. Let's take a look at the future p&l, after absorbing the expense of free shipping and free returns.

Demand	$55,000,000
Merchandise Fulfilled	$49,500,000
Returns	$14,850,000
Net Sales	$34,650,000
Gross Margin	$17,325,000
Less Catalog Marketing	$4,360,000
Less Online Marketing	$2,000,000
Less Pick/Pack/Ship	$5,890,500
Variable Operating Profit	$5,074,500
Less Fixed Costs	$4,050,000
Earnings Before Taxes	$1,024,500
EBT As A % Of Net Sales	3.0%

Ooops.

Free shipping and free returns are likely to increase the overall return rate, and reduce shipping and handling income, costing our business another $1.4 million of Earnings Before Taxes.

Remember, our business was generating $2.8 million in profit before the USPS increases, $2.4 million after, and maybe $1.0 million after having to move to free shipping and free returns.

Business leaders will be put in a difficult situation. Expenses will have to be cut, in order to maintain a healthy level of profit. I see two areas where this is likely to happen.

First, catalog circulation will be dramatically cut, mostly in low-productivity areas like prospecting. This is why you see our vendor community so up in arms.

The second area will impact the customer. Items with high return rates will not be featured in advertising, and may not even be offered at all, in an effort to lower the overall return rate. Free shipping and free returns will encourage customers to take more risks, but it will encourage businesses to take fewer risks to make the p&l work. Ultimately, the customer is going to lose the breadth of merchandise assortment she has grown used to.

Multichannel CEOs and CMOs: Start planning today for the pending pressure our profit and loss statements will face in the future. This is a good time to test free shipping and free returns (for an extended period of time, not just a few weeks in December), and project the financial impact this will have.

Running A Business Without Discipline

We frequently read about the importance of "managing the brand", about providing a great brand experience for the customer.

In the catalog/online world, it is just as important to properly manage the fundamentals of the business, the 'back of the office' execution that can make all the difference in the world.

There are several elements that all must be executed in harmony, executed efficiently, for the business to produce profit.

Fulfillment Rate: It should be no surprise that having the right merchandise available is an important part of meeting customer expectations. Too much merchandise yields markdowns. Too little merchandise yields lost sales. I spent my formative years at Lands' End. They were really good at striking that all-important balance.

Return Rate: Businesses don't have a lot of control over what is returned. For instance, the return rate on a pair of shoes is very high. The return rate of an iPod is probably a lot lower. However, businesses can take steps to reduce the return rate. Quality control is important. Using text to describe merchandise is important. Color-matching is important, so that the customer knows she is getting a 'lilac' dress.

Gross Margin: Closely related to fulfillment rate, gross margin is one of the most important profit drivers in a business. Gross margin is the difference between what the item sells for ($100) and what the item cost the business ($50). Markdowns are gross margin killers. Merchants who know 'what sells', and inventory managers who know 'how much to purchase' drive a lot of profit.

Pick, Pack 'n Ship Expense: Businesses should invest considerable effort in running an efficient call center and distribution center. Overstaffing either center results in too much expense. Inefficient ways to store merchandise result in added expense. This is an area that really good businesses focus a disproportionate amount of effort on improving.


When a business manages these areas efficiently, profit falls to the bottom line. When a business fails to manage these areas effectively, the business must significantly increase sales, in order to pay for its own inefficiencies.

In the table at the end of this article, one quickly notices that inefficiencies cause the business to have to sell nearly twenty percent more merchandise to achieve the same level of profitability. Think about that. When a business is run in a sloppy manner (the example below is not all that sloppy, by the way), customers need to spend twenty percent more just to help the business achieve the same amount of profit.

Leaders need to balance the importance of 'brand building' activities with the everyday tasks of running a business efficiently.

Profit And Loss Statement: Well Run Verses Sloppy Business
		Base Case		Sloppy
Demand		$5,000,000		$5,854,500
Fulfillment Rate	90.0%	$4,500,000	88.0%	$5,151,960
Return Rate	25.0%	$1,125,000	27.0%	$1,391,029
Net Sales		$3,375,000		$3,760,931
Gross Margin	50.0%	$1,687,500	48.0%	$1,805,247
Less Marketing Expense		$800,000		$800,000
Less Pick, Pack & Ship Expense	11.0%	$371,250	13.0%	$488,921
Variable Operating Profit		$516,250		$516,326
Percent of Net Sales		15.3%		13.7%
Required Increase In Volume To Achieve The Same Profit:				17.1%

Is An Item Profitable?

So many of us in multichannel retailing are asked to quantify how individual marketing activities perform.

We measure the effectiveness of an e-mail campaign. We prove that catalogs and direct mail drive business to the online channel.

Congratulations, we demonstrated that advertising works! Maybe.

Now it is time for us to measure how advertising influences the sales of individual items. I don't sense that our industry is doing the best job of measuring the profitability of an individual item, after factoring in the effect of advertising.

At the end of this post, I include a template for measuring the overall profitability of a specific item. In this case, we advertise the item through catalogs, through e-mail campaigns, and through online advertising (search, portals). During the course of an eight week period of time, we total the sales of the item, both online and over the phone. We also sum all advertising of that item.

What follows is a multichannel profit and loss statement for an item. This exercise should be replicated for every item sold by your business. Yeah, that's a lot of work. But how else are you going to know what sells, what sells because it is advertised, and what doesn't drive profit?

Quite honestly, the advent of the online channel has reduced our industry's zeal to understand the profitability of items. In catalog, it is easy to measure profitability. We need to have a passion for understanding which items truly work, across all channels.

Here, then, is a mocked-up template for the multichannel profitability of a single item. If you work for a business that also has a retail channel, simply add an additional section to the template for the retail channel.

Multichannel Merchandise Profit And Loss
Catalog Metrics
Catalogs Mailed		1,000,000
Total Pages in Catalog		124
Total Book Cost	$1.00	$1,000,000
Percent of Page Allocated		33.0%
Cost To Advertise This Item		$2,661
Total Responses		225
Response Rate		0.02%
Response per 000 Pages		0.07%
Units per Order		1.15
Total Units Sold		259
Price per Unit		$65.00
Total Demand		$16,819
Fulfillment Rate	88.0%	$14,801
Return Rate	25.0%	$3,700
Net Sales	66.0%	$11,100
Online Metrics
Total Visits To The Website		1,483,005
Total Visits, This Item		4,593
Total Website Cost, Non Adv.		$800,000
Cost Allocated To This Item		$2,478
Placed In Shopping Cart	25.0%	1,148
Total Responses	55.0%	632
Units per Order		1.08
Total Units Sold		682
Price per Unit		$65.00
Total Demand		$44,334
Fulfillment Rate	94.0%	$41,674
Return Rate	25.0%	$10,418
Net Sales	70.5%	$31,255
Multichannel Profit And Loss Statement
Multichannel Net Sales		$42,356
Gross Profit	48.0%	$20,331
Less: Book Cost		$2,661
Less: Website Cost		$2,478
Less: E-Mail Cost		$1,500
Less: Online Marketing Cost		$3,550
Less: Pick, Pack, Ship	11.5%	$4,871
Variable Operating Profit		$5,271
Profit as a % of Net Sales		12.4%

Endless: A Shoe And Handbag Business Courtesy Of Amazon.com

Amazon recently unvieled a new e-commerce business called Endless. Featuring fashionable handbags and shoes, Endless uses a new hook to compete against multichannel retailers like Macy's and online pureplays like Zappos. The hook: Free Next Day Shipping!! Order an item at 1:00pm on a Tuesday afternoon, and you'll have it on Wednesday.

In case you haven't walked into your local UPS store, attempting to ship a product cross-country via next day air, the proposition is not inexpensive. How can this business compete? The following numbers are for illustrative purposes only --- the numbers are not intended to reflect absolute reality at any of the retailers in the example. However, the numbers should be adequate for a directional argument.

Let's assume you are an aspiring woman hoping to purchase the Jessica Simpson Dawson Satchel via an online business. You narrow your choices down to Endless, Zappos and Macy's.

Assuming you live in a state that has a six percent sales tax, the total price for the same item, including tax and shipping, is $248 at Endless, $251.95 at Zappos, and a whopping $281.91 at Macy's. The item will arrive tomorrow from Endless, in three to five days from Zappos, and in five to eleven days from Macy's.

Given these choices, the logical choice is for the customer to purchase the item at Endless.

Can Endless make money doing this? It is possible. At the end of this post, I include a sample profit and loss statement for each company.

The punchline is this: In order for each company to generate the same level of profit from this item, Endless needs to sell 1,000 units, Zappos needs to sell 741 units, and Macy's needs to sell 491 units. If Amazon has efficiencies that make their expense structure cheaper than Zappos or Macy's, the number of units decrease.

Amazon is betting that the Endless business model will cause customers to be 30% more productive than Zappos, and 100% more productive than Macy's, using these assumptions. This gets Endless to a break-even scenario, most likely, on a fixed-cost basis, and generates the same number of dollars of variable profit as Zappos and Macy's.

What do you think? Do you think customers will flock to Endless to take advantage of free next day shipping? Who will be hurt more by this strategy, Zappos, who is directly competing on total price, or Macy's, who has a retail channel that essentially provide "free shipping same day"??


Sample Profit And Loss Statement

Jessica Simpson Dawson Satchel Price Elasticity And Profitability
	Endless.com	Zappos.com	Macys.com
Item Price	$248.00	$251.95	$248.00
Shipping/Handling	$0.00	$0.00	$17.95
Salex Tax (6%)	$0.00	$0.00	$15.96
Total Cost	$248.00	$251.95	$281.91
Delivery Time	1 Day	3 - 5 Days	5 - 11 Days
Estimated Units	1,000	741	491
Demand	$248,000	$186,695	$121,768
Net Fulfilled (90% of Demand)	$223,200	$168,025	$109,591
Less Returns (30% of Demand)	($66,960)	($50,408)	($32,877)
Net Sales	$156,240	$117,618	$76,714
Gross Margin (50% of NS)	$78,120	$58,809	$38,357
Less Marketing	($18,000)	($18,000)	($18,000)
Less Picking & Packing (20% of NS)	($31,248)	($23,524)	($15,343)
Shipping Expense/Item	$17.50	$8.00	$5.00
Less Shipping Expense	($17,500)	($5,928)	($2,455)
Plus Shipping Income	$0	$0	$8,813
Variable Operating Profit	$11,372	$11,357	$11,373
Profit as a % of Net Sales	7.3%	9.7%	14.8%
Profit per Item Sold	$11.37	$15.33	$23.16
Ad to Sales Ratio	11.5%	15.3%	23.5%

Setting Your Online Marketing Budget

Undoubtedly, many of you are putting the finishing touches on your online marketing, e-mail marketing, or catalog marketing budget for 2007. Oh, the excitement!

Is there anything more enjoyable than sitting across from your Chief Financial Officer, having to defend why it is important to advertise with a certain affiliate at a time when expenses need to be trimmed by ten percent?

CFO's demand rapid, financially-based answers to questions. The humble Chief Marketing Officer or Online Marketing Executive needs to be able to respond in a credible, but timely manner.

Most of the time, when asked a random question, you don't have the appropriate data with you to answer the question quickly. This is where the "square root" function comes into play.

Frequently, sales generated by advertising follow a "square root" function. In other words, if you had the opportunity to increase your marketing budget by twenty percent, your net sales would increase by the square root of 1.2. This number is (1.2 ^ 0.5) = 1.095. In other words, a twenty percent increase in marketing spend yields a 9.5% increase in net sales.

This becomes important when the CFO makes a random statement like,"Please reduce your marketing budget by ten percent, you have no choice in this, everybody must share in the pain."

Look at this example, where the online marketing budget is reduced by ten percent:

High-Level Online Marketing Scenario
		Reduce Ex-	Incremental
	Base Case	pense by 10%	Sales Lost
Orders	90,909	86,244	4,665
Average Order Size	$110.00	$110.00	$110.00
Cost per Order (CPA)	$22.00	$20.87	$42.87
Net Sales	$10,000,000	$9,486,833	$513,167
Gross Margin @ 40%	$4,000,000	$3,794,733	$205,267
Marketing Cost	$2,000,000	$1,800,000	$200,000
Pick/Pack/Ship Expense @ 13%	$1,300,000	$1,233,288	$66,712
Variable Operating Profit	$700,000	$761,445	($61,445)
Profit as a % of Net Sales	7.0%	8.0%	-12.0%
Ad to Sales Ratio	20.0%	19.0%	39.0%

Notice how the profit and loss statement changes. In this case, the CFO may have a good suggestion, as the incremental advertising dollars are not yielding a sufficient return on investment. Conversely, the numbers might work out in your favor, giving you the ammunition to actually ask the CFO for more money!

Not every business follows the "square root" rule. Your analyst can help you figure out which relationship makes the most sense to build the scenarios around. But in a pinch, go with the square root function. And then ask your CFO to quickly cost-justify some of her investments!!

Running A Profitable Business

Given that today is the alleged day that retailers finally turn a profit, we should spend some time on profitability.

We frequently read about the importance of merchandising, branding, gross margin, marketing, and expense management in driving a profitable online/catalog business. We infrequently read about the importance of managing the mundane details of a business, things like filling orders, minimizing returns, and running and efficient fulfillment center.

In the example below, we have an online/catalog business that is barely profitable.

Profit and Loss Statement / Break-Even
	Key	Annual
	Metrics	Results
Total Demand		$40,000,000
Lost Sales Rate	15.0%	$6,000,000
Gross Sales		$34,000,000
Return Rate	30.0%	$10,200,000
Net Sales		$23,800,000
Gross Margin	45.0%	$10,710,000
Marketing Expense		$3,025,000
Fulfillment Expense	17.0%	$4,046,000
G & A Expense		$3,570,000
Earnings Before Taxes		$69,000
EBT / Percent of Net Sales		0.3%

Now, let's assume that management improves three key metrics. Assume that the lost sales rate improves from 15% to 10%. Assume that the return rate improves from 30% to 25%. Also assume that fulfillment expense (what it costs to pick, pack and ship and item) improves from 17% to 12%. The profit and loss statement below illustrates the impact of these improvements on profit.

Profit and Loss Statement / Improvement
	Key	Annual
	Metrics	Results
Total Demand		$40,000,000
Lost Sales Rate	10.0%	$4,000,000
Gross Sales		$36,000,000
Return Rate	25.0%	$9,000,000
Net Sales		$27,000,000
Gross Margin	45.0%	$12,150,000
Marketing Expense		$3,025,000
Fulfillment Expense	12.0%	$3,240,000
G & A Expense		$4,050,000
Earnings Before Taxes		$1,835,000
EBT / Percent of Net Sales		6.8%

In this example, profit dramatically improves, from about break-even, to more than $1.8 million in annual profit.

This is one of the big secrets about profitability. Many management experts look to driving top-line sale, improving gross-margin, driving sales via marketing, or managing general and administrative expenses as the route to business success. However, a relentless focus on filling each order, reducing returns, and improving distribution and contact center efficiency have a significant impact on overall profitability.

Business Review: Overstock.com

Earlier this week, Overstock.com announced third quarter results, sharing with the public a year-to-date loss of $56,000,000 on net sales of $499,000,000.

There were many interesting tidbits in their 10-Q statement. Let's explore some of the comments.

In the third quarter, and early fourth quarter, sales decreased verses prior year. This will be very interesting to follow, going forward. We all follow the online sales forecasts from folks at Forrester Research and other outlets, forecasts that suggest continued and unimpeded double-digit online growth. Overstock.com is bucking this trend. Management states that sales decreased due to a decline in conversion rate. In other words, traffic supported growth, but fewer visitors decided to purchase something.

It is interesting that management elected to throw the marketing department under the bus. Management is quoted as saying "The areas of our business that most directly affect conversion rate, including personalization of the website, customer retention, e-mail marketing, site design and layout are the responsibility of the marketing department". Ouch! Apparently the quality, assortment and price of the merchandise do not play as large a role in determining whether customers want to purchase anything from Overstock.com. As a customer, do you buy from Overstock.com because of the merchandise, the price, or the design and layout of the site? Obviously, any marketing department can do better. Merchandisers can also do better.

Management stated that marketing expenditures were less efficient because marketing agreements with MSN, Yahoo! and AOL expired or were too expensive to cost justify. Management elected to increase spend on television and radio. This caused brand recognition to increase, but did not result in an increase in sales. Management says marketing dollars will be re-directed only to activities that increase conversion.

Technology costs increased dramatically, hurting profitability. Management states that the technology platform now supports a billion-dollar a year business.

There are several takeaways from what Overstock.com was kind enough to share with us about their business.

• Overstock.com will probably need a 20% to 40% increase in net sales, assuming marketing expense increases at half that rate, and technology expense decreases significantly, in order to achieve break-even status.
• Management did not publicly criticize the merchandise assortment as a reason for decreases in conversion rate. Wow. Is it possible that customers did not want to purchase what Overstock.com had to offer, or did not find the price of the merchandise amenable?
• Overstock.com publicly announced a problem that many other online retailers are going to run up against in the future. Overstock.com depended upon portals for reasonably priced advertising opportunities. Conversely, Portals charge what the market can bear for the real estate they offer. As you continue to yield control of your business to MSN, Yahoo!, AOL and Google, be willing to accept loss of control over your sales and profit trajectory.