E-Commerce And Catalog Management Case Study: Optimal Profitability

So far, we've studied numerous aspects of a failing e-commerce/catalog business:

• Profit And Loss Statement of the Failing Business.
• Operational Management
• Managing P&L Details
• Comparable Segment Performance

In the final installment of this series, let's extend the analysis, and review the ways in which customer investment influences the profit and loss statement.

When a business is struggling, it is common for the executive team to reduce marketing investment. When a business is thriving, it is common for the executive team to increase marketing investment.

Changes in marketing investment (which, in reality, is a change in investing in customers) cause short-term and long-term ramifications.

Let's assume that the business we've been analyzing can return to good operational profit performance --- in other words, the business does a reasonably good job of fulfilling merchandise, minimizing returns, increasing gross margin, and reducing pick/pack/ship expenses.

We can simulate the short-term and long-term impact of different investment strategies (this is the essence of a Multichannel Forensics project).

In the table below, I outline this year's Earnings Before Taxes (EBT) as a function of how much we invest in each twelve-month buyer, and as a function of how much we invest in acquiring new customers and reactivating older customers.

Maximize Profit This Year
12 Month
Investment		Customer Acquisition Investment
per Buyer	$600,000	$1,050,000	$1,500,000	$1,950,000
$6.00	$1,091,000	$1,011,000	$857,000	$661,000
$9.00	$1,115,000	$1,035,000	$882,000	$686,000
$12.00	$1,098,000	$1,018,000	$864,000	$668,000
$15.00	$1,051,000	$971,000	$818,000	$622,000

Which combination yields the most profit? If our brand invests $9.00 of marketing in twelve-month buyers, and invests $1,050,000 in new/reactivated customers, EBT is maximized.

This is where those of us in e-commerce/catalog typically stop our analysis. We simply look to "optimize" current year profitability, smile, create an investment plan, and move on.

Let's take the analysis a step further. Why don't we look at the EBT of this business in five years, given each of the sixteen strategies we just reviewed?

Maximize Profit Five Years From Now
12 Month
Investment		Customer Acquisition Investment
per Buyer	$600,000	$1,050,000	$1,500,000	$1,950,000
$6.00	$261,000	$388,000	$400,000	$346,000
$9.00	$339,000	$479,000	$501,000	$457,000
$12.00	$382,000	$529,000	$556,000	$515,000
$15.00	$399,000	$546,000	$574,000	$534,000

Which strategy is best in five years? It appears that investing $15.00 in twelve-month buyers, coupled with an investment of $1,500,000 in new/reactivated customers yields the best EBT/profit.

I can count on one hand the number of catalog/e-commerce businesses that I've seen simulate the long-term impact of short-term investment decisions. Sure, some businesses calculate "Lifetime Value". Even among those businesses, the calculations are rarely plugged into a simulation that measures short-term and long-term EBT.

The CEO should be given a series of simulated results, results that help the CEO determine the best short-term and long-term profit paths based on existing and new/reactivated customer investment strategies. Owners and Boards should always have ample access to simulated business outcomes, and should actively shepherd growth of the brand on the basis of simulated results.

Here is what happens to the long-term trajectory of this brand, when maximizing short-term results.

• Year 5: Demand = $20,400,000, EBT = ($259,000).
• Year 6: Demand = $17,300,000, EBT = $1,073,000.
• Year 7: Demand = $16,100,000, EBT = $813,000.
• Year 8: Demand = $15,600,000, EBT = $659,000.
• Year 9: Demand = $15,400,000, EBT = $548,000.
• Year 10: Demand = $15,300,000, EBT = $450,000.

Conversely, here is what happens to the long-term trajectory of this brand, when maximizing long-term results.

• Year 5: Demand = $20,400,000, EBT = ($259,000).
• Year 6: Demand = $21,400,000, EBT = $818,000.
• Year 7: Demand = $21,600,000, EBT = $774,000.
• Year 8: Demand = $21,800,000, EBT = $718,000.
• Year 9: Demand = $21,900,000, EBT = $651,000.
• Year 10: Demand = $22,000,000, EBT = $574,000.

The CEO has interesting challenges ahead.

The most profitable route is to shrink the business by about fifteen percent. However, this strategy constrains long-term profitability.

Conversely, the CEO can operate under tepid to flat growth, resulting in a healthier business in the long-term.

Regardless, marketing is not going to drive sales increases. Merchandise productivity will have to significantly increase, in order to drive improvements in sales and profit.

Let's try an example. Say the leadership team is able to increase customer demand for merchandise by fifteen percent. Now look at what happens when we try to maximize long-term profit:

• Year 5: Demand = $20,400,000, EBT = ($259,000).
• Year 6: Demand = $24,700,000, EBT = $1,692,000.
• Year 7: Demand = $25,900,000, EBT = $1,801,000.
• Year 8: Demand = $26,700,000, EBT = $1,829,000.
• Year 9: Demand = $27,100,000, EBT = $1,810,000.
• Year 10: Demand = $27,400,000, EBT = $1,758,000.

Wow!

In other words, the leadership team can play with investment in customers/marketing, significantly improving the profitability of this brand. But if the merchandising folks can find product that customers like fifteen percent more than prior products, the profit and loss statement sings a beautiful tune!

Armed with this information, the new CEO is likely to require the following of this e-commerce/catalog brand.

• Objective: Improve final merchandise fulfillment to at least 93.0%.
• Objective: Reduce the return rate to 25.0%, or lower.
• Objective: Target a gross margin of at least 50.0% or better.
• Objective: Reduce the pick/pack/ship expense to 11.5% or less of net sales.
• Objective: Improve merchandise productivity by at least 15%.
• Objective: Invest $15.00 marketing expense per twelve-month buyer.
• Objective: Invest $1,500,000 marketing expense in new/reactivated buyers at the most efficient cost per new customer possible.
  
• Objective: Grow net sales to at least $24.5 million on an annual basis.
• Objective: Increase EBT to at least $1.7 million, about 10% of net sales.

Realistically, it will take two years for the brand to implement the steps necessary to achieve lofty objectives like these.

In theory, every executive, director, manager and analyst should be accountable for at least one of these objectives. The new CEO gives the entire team a two-year timeframe for making this happen, demanding significant progress during year one.

And that, ladies and gentlemen, concludes our case study! Your thoughts?

Praise To Infrequent Customers!!

We've been taught to love "best customers". We worship "customer loyalty" in print and in practice.

Loyal customers are always going to purchase in stores. When infrequent customers decide to make unplanned purchases, retail profit sizzles.

In catalog, the opposite situation is true. Customers could not purchase unless the marketer sent the customer a catalog. The cataloger determined who purchased, and how often the customer purchased.

The internet is a hybrid of retailing and cataloging. Traditional marketing, catalog marketing, paid search, natural search, e-mail, affiliate marketing, shopping comparison marketing, portal marketing and word of mouth all blend into a slurry of online purchase bliss.

Therefore, principals of retail "passers-by" pertain to the online channel.

This profit and loss statement demonstrates what happens if you didn't accept purchases from the 40% of your online purchase file that buys infrequently.

Profit And Loss Statement			40% Loss Of
			Infrequent
		Actual	Purchasers
Net Sales		$65,000,000	$52,000,000
Gross Margin	53.0%	$34,450,000	$27,560,000
Less Marketing Expense		$16,250,000	$14,625,000
Less Pick/Pack/Ship	11.0%	$7,150,000	$5,720,000
Variable Operating Profit		$11,050,000	$7,215,000
Less Fixed Costs		$7,800,000	$7,800,000
Earnings Before Taxes		$3,250,000	($585,000)
EBT % Of Net Sales		5.0%	-1.1%

This hypothetical example illustrates the power that infrequent customers, customers that don't require a ton of marketing, have on the profitability of the online channel.

All too often, we marketers and business leaders spend our time worshiping our best customers. There's no doubt these customers should be rewarded for their contribution to the profit and loss statement.

But in online retailing and in stores, the infrequent customer plays a key role in determining business success. We don't read anything about catering to the needs of the infrequent customer. Why?

Profit And Loss Responsibility

About two months into a new fiscal year, the occasional ups and downs in a business begin to average out. You begin to have a good idea whether your year is heading in a positive direction, or if it is starting to become difficult to achieve bonus levels this year.

If you have profit and loss responsibility, your year is at an interesting inflection point. Most of the folks working in our multichannel businesses don't get to see the interplay between executives, especially when sales levels are not meeting expectations.

The merchandise executive feels a lot of pressure. Her merchandise is not selling, and there could be many reasons for this. Maybe the database marketing executive didn't mail the right customers. Maybe the online marketing executive isn't attracting the right traffic to the site. Maybe the brand marketing/creative leader is depicting the merchandise in an unflattering manner. She needs help understanding what is happening in the relationship between her customers, and her merchandise. No focus group of nine individuals, no survey of 3,000 loyal purchasers will provide the insight she needs to make decisions today.

Working with merchants who take accountability for sub-par business results is an absolute blessing.

The inventory executive feels a lot of pressure. He is bonused on outstanding fulfillment, great gross margins, and rapid inventory turn. When the business goes south, he needs to liquidate merchandise quickly. He'll demand additional clearance catalog mailings, increased e-mail frequency, free shipping, 20% off your order, whatever it takes to sell out from under the pile of unwanted garbage the merchants bought. The customer experience becomes secondary to moving merchandise at any cost.

The database marketing executive feels a lot of pressure. She is often the first person to be blamed for sub-par business results. It is so easy to assume that the wrong customers were mailed catalogs, that the e-mail campaigns were not actually delivered to the customer, that the post office forgot to deliver 200,000 catalogs, that the techno-geeks who forecast sales made big mistakes. It is hard for executives to accept the fact that customers didn't want to purchase our merchandise. This is the time of year that the database marketing executive starts trying to craft a story about customer behavior --- a story that doesn't offend folks, but adequately gets her off the accountability hook.

The finance executive feels a lot of pressure. He knows that additional mailings, online advertising, price reductions, shipping promotions and any of a number of additional incentives will cause expenses to not leverage well against sales. He'll demand that the database marketing executive re-forecast the customer file, and re-forecast sales for the remainder of the year. The board/owner will need to know the expected profit impact of the sales implosion. The finance executive will take more heat from the board/owner than is deserved.

The brand marketing/creative executive feels a lot of pressure. She is trying so hard to provide an outstanding experience for the customer. She reads a dozen blogs that preach the critical importance of "managing the brand". She reads another dozen blogs that constantly harp on how brands fail to treat customers well, marketing blogs that take repeated potshots at companies for failing to meet customer expectations. Then she looks at her business peers, who are about to trample the customer experience to move merchandise at any cost.

How does she convince them that this is bad for the business?

Worse, how does she provide a viable alternative for clearing $10,000,000 of overstocked merchandise, one that doesn't trample the customer experience? Do any of the marketing bloggers have a credible, creative solution to this problem? How about the vendor community?

This is a key element of profit and loss responsibility that vendors, bloggers and pundits fail to appreciate. There is tremendous pressure to bail out the profit and loss statement, tremendous pressure to get out from under yesterday's poor merchandising decisions today, tremendous pressure to save one's job. Few of the options (discounts, promotions, price cuts, free shipping, additional mailings, additional e-mail contacts, you name it) are good for the long-term customer experience or are good for "the brand". Comments like 'the brand should have offered great merchandise that the customers wanted to buy in the first place' fail to solve the problems the executive has to navigate through today.

Without viable alternatives, the brand marketing/creative executive is in a no-win situation. You can see why the average Chief Marketing Officer lasts 23 months --- no viable short-term solutions to move overstocked product, no way to protect the customer from the impending onslaught of advertising of crappy merchandise, no way to truly succeed in her job.

The operations executive is nervous, because a continued downturn in business results in staffing cuts in the phone center and distribution center. Who wants to go through that experience?

The human resources executive deals with secondary issues created by stress. Employees begin snipping at each other. Some employees quit, heading instead for the lucrative surroundings of a successful business. HR is not a fun place to be during a downturn.

The information technology executive is nervous, because the executive team is demanding that website improvements be completed now, to improve business. The executive team also is demanding business intelligence solutions from information technology folks --- the executives want to know why customers aren't purchasing, and cannot articulate questions in a way that an information technology executive can effectively program into a report.

Profit and loss responsibility changes the way one thinks about a business.

When business exceeds expectations, it is easy to think about theoretical issues like return on customer, providing an exceptional customer experience, enhancing the "brand", developing new business opportunities, figuring out how to grow to three billion dollars in sales, giving customers a say in advertising, developing a CEO blog, you name it.

But when the business fails to meet expectations, all that fun stuff goes out the window. One bad year costs the executive her bonus. Two bad years costs the executive her job. Short-term decisions are made to save the profit and loss statement, to buy another six months of time to acquire new merchandise that the customer might want to purchase.

And when the company is publicly traded, all of these issues are magnified by shareholders demanding a return on investment today. Most of you reading this blog are indirect shareholders --- you have 401k accounts, and you're not patient when your 401k account loses value, are you? You indirectly contribute to the problems you openly grumble about.

One can see how special visionary leaders are --- the rare individual who can keep an eye on strategic, visionary issues, while navigating choppy waters every-other or every-third year.

Today's online marketing executives have not gone through a lot of these business cycles. The online channel has pointed straight up for a decade. It's only a matter of time before the pressures all executives feel are thrust upon our new generation of online marketing executives.