Over the holiday break, I was finally able to spend some time cranking through some updates to the E-Commerce Financial Model for Startups for all of you startup nerds! There are loads of updates to tell you about. The updates fall into three sections: 1. Model Updates 2. User Guide Updates 3. Additional Goodies for the package.
I went through the model pretty much from top to bottom to refine it, flush out some areas that I didn't pay enough attention to before (like the Paid Search Build), and just make it prettier all around. To explain the updates, I am going to explain each sheet moving left to right on the workbook.
The majority of the changes on this sheet were cosmetic - there were a bunch of formatting issues that were not resolved when the model was converted back from the gDocs version. All of the Operating Expense headings have been properly italicized, the line items are all now uniformly indented, and the segment totals have been properly bolded.
There is an entirely new Shipping & Fulfillment costing build that was updated based on this Quora Answer that I updated in Dec - What's the average Profit Margin earned by apparel distributors? Brick & Mortar Retailers? E-Commerce / Online Retailers? Here are the lines that we added, what they mean, and how they work:
The startup modeled here is a vertically-integrated brand selling online who purchases inventory directly from the factory on an FOB basis or fully manufactured basis. A large purchase order is placed with the factory, the product is purchased, and shipped to the brand in bulk - meaning that all of the product will arrive at the warehouse at one time.
This is a calculated row pulled from the Sales Build sheet - it's the total number of conversions from each customer segment.
Certain orders contain multiple units, like a customer who buys a Shoulder Duffel & a Travel Kit, and certain orders will contain only one unit - but they all will be for at least one unit. This is an average metric that is calculated from the Sales Build Sheet and pulled into the Income Statement to make the calculation easy.
Units in Inventory
Inventory is shipped from the factory to the warehouse and every sale deducts from this metric. Every unit incurs a charge for being on the warehouse's shelf (assuming that you are using a 3PL from the beginning of operations). At the end of the month, you are charged for the inventory remaining on the shelves - this metric keeps track of the units in inventory.
Inbound Warehouse Fee
The cost per unit for receiving the shipping container from the factory into the warehouse management system. To make this number easy to calculate, it's based on a per unit charge. In case of this model, it was a $1.10 per unit for the 3PL warehouse that we used for VÆL Project - so yes this is an actual number.
When you receive an order & submit the order to the warehouse for fulfilment - this incurs a cost. When talking about working with a 3PL warehouse, this Order Fee includes the cost of boxes and packing materials and is reflected in this number charged by the warehouse.
In addition to the Order Fee, there is a per unit charge that is added for each item in the order. This makes logical sense as each unit requires a person to go to that units location and pick the product - costs incurred by the warehouse that you will have to pay for.
This is why we pre-calculated the Units in Inventory from above - you are charged for the storage of your inventory. The majority of the time, this fee is a daily rate based on the amount of time that the product is in inventory. However, to make this number easy, we are just going to assume that all of the sales are going to be evenly distributed throughout the month - half of your sales will leave at the beginning and the other half at the end so it averages out to $0.50 per unit.
Outbound Shipping Expense
This is the cost to ship the order via UPS from the warehouse to the customer. This number is an average of distribution of orders by geography and the cost of the shipping method that is calculated in the Sales Build sheet.
Total Fulfillment Costs
The total of all the fees by the number of applicable units for fulfilling orders.
Orders that the customer doesn't like or want will be returned - This build is done in the Sales Build sheet.
Since there are multiple units per order - we need to account for the actual number of units and not just the orders being returned. The monthly average units per order for returns are going to be the same as the average units per order shipped. Yes there will be a variance but this is not a statistically significant number for purposes of this analysis.
Back in the day, retailers could charge customers for the cost of returning product. This was until Zappos changed the world of e-commerce in about 2008 - when Zappos really started gathering steam - and Free Shipping became a way of life. Free returns are almost universal these days and it's retail suicide to even attempt charging customers for returns. We are going to assume that it costs the same amount to return the shipment as it did to send it, so the shipping cost continues on this line.
For the better part of the past 10 years, warehouses have been getting the shit kicked out of them on both sides of the Great Recession (pre-GR the access to cheap credit meant financing company-owned facilities was negotiating position & post-GR insolvency driving cost negotiation was a distinct possibility). When Zappos erupted onto the world stage with their free returns, most smart warehouses realized the strategic value of charging for e-commerce returns. In early '10, I saw several 3PL warehouses dramatically increase their return fees from $3.50 - $5.00 all the way up to $25.00. These days the number has regressed to the $12.50 - $15.00 range - which is still a lot of money to receive a simple package - but I'll generally give it to them if I am coming out ahead on fulfillment costs and work on reducing my returns later.
Return Restocking (per Unit)
In the same way that the warehouse will charge the Unit Fee per item in a given order, the warehouse will charge a restocking fee per unit to take each item from an order and return it to the shelves. The return fee covers the receiving & inspection while the Return Restocking Fee covers taking each unit and putting back on the warehouse's shelves and optimizing the location for future fulfillment.
Sales, Email, & Social Builds
Mainly cosmetic updates - nothing really structural was changed.
Pay per click (PPC) (also called cost per click or CPC) is an Internet advertising model used to direct traffic to websites, where advertisers pay the publisher (typically a website owner) when the ad is clicked. With search engines, advertisers typically bid on keyword phrases relevant to their target market. Websites that utilize PPC ads will display an advertisement when a keyword query matches an advertiser's keyword list, or when a content site displays relevant content. Such advertisements are called sponsored links or sponsored ads, and appear adjacent to, above, or beneath organic results on search engine results pages, or anywhere a web developer chooses on a content site
Google AdWords is hands down one of the biggest strategic advantages to online retailers because you have access to basically an unlimited market of new customers. This section will primarily be focused on using the tools in your Google AdWords account for analyzing how this will drive revenue for your startup.
To explain this section, we are going to use the VÆL Project Travel Duffel that we have used in several examples previously:
Google Keyword & Traffic Estimator
The essence of Google Paid Search is based on using keywords to provide context to the search algorithms for users. The first step is to log in to Google AdWords and go to their “Google Keyword Tool” that will give you traffic estimates for the volume of monthly searches for the keywords that you select for the product. For this product, here are the search terms that were input into the Google Keyword Tool:
|Canvas Travel Duffel
||Travel Duffel Bag
|Mens Shoulder Bag
||Mens Outdoor Luggage
Here were the results from these keywords:
Now these are not very large numbers, but the power of the Google Keywords tool is that it gives you tons of ideas on search terms. Here were all of the different categories that Google recommended to me based on those four search terms:
After looking at some of the suggested search terms, here were the additional keywords that quite aptly refer to this item – the yellow highlighted sections are the terms that I selected to include in the search:
After you generate a list of keyword ideas, you move on to the Google Traffic Estimator Tool – here were the results from the Google Traffic Estimator:
This process will give you a general idea for how much you will need to spend based on your budgetary restrictions and revenue goals. After you input your data for your keyword results, you will have your averages for your product.
Paid Search Comparable Analytics
In order to forecast how this channel will perform, we need to aggregate all the information from the Google Traffic Estimator tool
Here are the relevant definitions:
The total number of times your ad was seen by a user conducting a search. An impression is counted each time your ad is shown on a search results page.
Click Through Rate (CTR)
The ratio of the number of clicks that your ad receives divided by the number of times your ad is shown (impressions).
Click Through Rate
The traffic generated by Click-Through Rate generated on each ad group’s impressions. Clicks on a Paid Search ad become a visitor to your site.
Cost per Click (CPC)
The average cost that you will pay for each click generated by Google on one of your ads. This is calculated by taking your total budget ($150 in above graphic) divided by the number of clicks that money generated. Here is an example:
Cost per Click
Total Daily Budget
Number of Clicks
As the name Pay per Click (PPC) implies – you only pay for the clicks that are generated by Google. This is in contrast to Cost per Impression (CPM) advertising model that Facebook uses and charges you based on the number of times that your advert shows up on the screen regardless if any action is taken. Additionally, there is a third model called Cost per Action (CPA). CPA places the highest risk on the advertiser because they only pay when an action occurs, which is generally an order is placed.
Google AdWords provides you with daily figures that are helpful to understand simply how Google AdWords will function as a valuable tool for your startup. However, we have to project that daily figure into a monthly number to get a high level view of this channel. There are on average 20.92 working days per month, so we assume that we are only going to be aggressively using paid search when there is someone in the office (i.e. someone to watch the program).
Historically, e-commerce traffic plummeted on the weekends as people didn’t have the same quality of Internet connection at home as they did at work. However, since the iPad zoomed to mass popularity – this trend is reversing. Weekend traffic to retailers is progressively rising as the iPad is an incredible shopping tool for those lazy Saturday’s on the couch or, while watching the Food Network, you can pick up a tool from Amazon for the kitchen.
You can toggle this figure to anything you want, but 20 is a good round figure that you can control and learn from. The most important aspect of Paid Search is learning – once you know it, you can hire someone else to do it for you. Maybe those additional 10 days can be spent reviewing and analyzing your performance to create an even better strategy for next round.
Cost per Acquisition (CPA)
The most important number that you want to base your analysis on is your cost per acquisition or the average cost it takes to acquire an order. CPC represents the cost to get a user on your site, but it does not account for performance of this paid channel. The Cost per Acquisition takes the amount spent on clicks and divides it by the number of orders (i.e. the performance aspect of the metric). Here is what the CPA formula looks like:
Cost per Acquisition
Total CPC Cost
# of Orders
Weighted Average Metrics - CTR, CPC, CR, & CPA
When analyzing a group of metrics that do not all equally contribute to the metric, the weighted average method provides on of the best ways to simply analyze a metric. Think about this logically in the case of the Average CPC rate for the month – if you did a simple average, each value ($2.74, $2.79, $2.37, $2.27) would be totaled and divided by four. That means that the average is equally based on each of these 4 values.
This approach does not take into account the fact that these CPC rates performed very differently in terms of number of clicks (i.e. visitors). When thinking about a metric that depends on various weights of factors – we use the weighted average method to get a more informed view of the metric. The weighted average takes the amount each value contributes to the whole and then totals those contributions up. Here is how this looks visually:
Here is the overview for all the different aspects of the Paid Search:
Paid Search Budget Build
Now that we have the build metrics added to the model, we can now begin to flush out the budget to this model.
In order to forecast the Paid Search Model, we need to break down this section into four main components:
· Budget: The monthly amount of money allocated to be spent on Paid Search Monthly
· CTR Build: The improvements in click throughs on impressions that will be made overtime
· Conversion Build: The progressive improvements to the site, checkout process, and customer experience that will increase conversions from Paid Search
· CPC Build: Your weighted average CPC cost will get progressively higher over time based on the constant improvement & targeting new segments – we call it optimization because the metric refers to getting better.
Budget & Budget Growth
This represents the increase in budget that you will allocate based on your success with the channel. The Budget Growth variable is a fixed value that you can adjust monthly based on the story that you are telling in your startups vision narrative. For example, leading up to the holiday season, you will be increasing your spend to generate new sales for the end of the year. Additionally, as you have a new shipment approaching, you can increase your budget to drive sales to drive down inventory levels in preparation for the new stock coming into the warehouse.
This is a blue section because you can change each of these numbers based on your budget. It might be worth having a negative month to drive through some extra inventory in preparation for a major shipment. This situation can be risky – but you have the ability to toggle this as you see fit.
It’s incredibly important that this activity be managed form inside the company and preferably by each person on your team play a role in driving revenue through paid search. After each campaign, review the analytics, content, and demographics to build a “drivers list” – what were the magic components of this particular text copy with demographics of the audience that make this successful or not. Every month, you will be making tweaks to the terms, headline, copy, and pricing based on what’s working for your products.
The model increments the conversion rate monthly based on a percentage because of these tweaks that you will be making. To understand what you should increment this number by monthly – let’s go back to out Google Traffic Estimator tool and plugin two sets of numbers that demonstrate the possible range for the quality improvement.
After you have a good idea of what the market looks like at various levels, we need to bring it home to our model:
Now although our Click-Through Rate (CTR) increases way more than the rate on the Google Traffic Estimator tool, we see that the ending CTR metric of 4.43% is more inline with the CTRs Google estimates that we should be seeing. Well done Paid Search should yield between 2.50% - 5.00% CTR – so this range would be fairly average for a startup.
One of the most difficult aspects for most new founders to understand is that the rules are completely different for a new startup than they are for “everyone else”. Most founders think that their experience running marketing for a previous employers means that their old conversion rate benchmarks should connect – the answer is “No!” The fight to convert the customer is completely different for a brand/startup that no one has ever heard of than it is simply for a company that has been around for a couple of years.
As such your conversion rates will start relatively low for a new e-commerce startup and rise fairly quickly over the first couple of years. In this analysis, we estimated that we would generate a 50% improvement from the month when we start. These numbers are on the conservative side, but give you a “good” look at how the range performs over time.
Cost per Click Optimization (CPC)
As your budget expands, gain more experience with Google, and build your brand presence – you will progressively be able to move up the CPC budget world and fight bigger fights in more expensive keyword groups. In this forecast we stay fairly conservative for the sake of building a highly engaged customer-base.
Background & Overview:
This section will give you a quick background how Distributors, Retailers, and Brand Direct E-Commerce work as businesses and their corresponding relationship to the brand who makes the products available for retail.
A distributor is an entity that engages into a formal business relationship with a brand for the rights to serve as local representation and (most of the time) to be the exclusive purveyor for the brand’s products. In fashion, distributors are generally the international partners lending their relationships, understanding of the intricacies of the local market, and financial resources to effectively capitalize on a brand’s market opportunity. Therefore, distributors are primarily involved in B2B relationships - they purchase a large quantity of goods (a min. # set by the brand in order to grant distributor status pricing discounts) and primarily sell to retailers in the local market. However, distributors are increasingly capitalizing on the e-commerce by managing the local e-commerce presence for the brand in that territory.
An example of one of best international distributors in the world for fashion startups is Jack of all Trades (JOAT) Co for Japan. I have worked with JOAT over the years with several companies and one clear value propositions for their organization is Lloyd Seino. Lloyd is a Biz Dev / Brand Manager (as we would call it in the US) and truly has one of the best eye’s for a fledgling brand’s market potential in the crowded Japanese fashion industry. JOAT is also regarded as one of the leading companies for identifying and building a brand into a Japanese powerhouse (as Lloyd has done with dozens of brands).
[ Note: You can generally find any brand’s distributor by going to brandxyz.com
-> Contact & look for International. This section will have the names of the international companies that distribute the brand’s products. ]
In other industries there are domestic local distributors that have regional territories - a two good examples are food and alcohol. Due to the large geography of the US, food was most commonly broken down into regional distribution because of the large number of customers per region and difficulty in coordinating the logistics of food delivery. Let’s take the example of a buddy’s health bar company that he purchase 2009:
- In 2009, Ryan, my buddy, purchased the rights for Southern California to distribute energy bars to local and national chains in that region.
- By purchasing the rights to Southern California, Ryan could purchase the energy bars at a special distributor price
- Ryan could focus on building deep market insight into Southern California, developing great relationships with retailers, and maximizing the effectiveness of his advertising spend in based on what’s going on there (i.e. He could setup a booth at a local music festival to sell his energy bars while the kids are dancing in the perpetual summer sun of Los Angeles - where this festival would fall under the radar of the national marketing goals of this company)
[ Note: I have written an extremely in-depth analysis of the relationship between Retailers & Brands and how this dichotomy drives retail prices that you see online and in-store - How do designers set prices for dresses and why do dresses often cost more on a designer's website than on purchase through an online retailer?
This is a vendor, generally within the home market for the brand, who purchases goods at wholesale (about 52 - 55% below what you see at retail for). The retailer issues a purchase order (a legally binding document to purchase X # of goods at Y price to be delivered at a specified time frame) to a brand. The brand takes all of the POs and goes to production for deliveries roughly about 4 - 6 months after the PO was issued. Upon completion the brand ships the goods from their warehouse or factory (depending on the size of the retailer).
This is what the stages look like from the Brand’s perspective:
The Retailer’s job is to focus:
- Building brand equity with the customer to be a shopping resource.
- Create a customer experience that derives long term value from investments in customer mindshare (i.e. ‘I think that I am going to stop by Bloomingdale's after work,’ said the proverbial customer)
- Develop extensive local customer insights that enables the retailer to optimize their merchandising assortment to reflect the local trends, fashion, and personality of a store’s retail presence
- Understand local advertising mediums & methods to maximize the effectiveness of advertising dollars based on how local trends (i.e. San Francisco may work extremely well with clever Facebook Posts while West Texas can do well sponsoring a High School Football team)
Let’s take a look at how this process looks for a single retail store or a simple model:
When we are talking about a major retailer like Nordstrom, this model gets a little more complex. Since the retailer has to manage inventory between multiple stores, the retailer will often have a brand’s shipments delivered to their Warehouse. At the warehouse, the shipment will be broken down and allocated to each store based on forecasted demand. Additionally, you will see that a certain allotment will be held back in the warehouse to cost effectively manage fill-in orders.*
This is what the retail logistics process looks like:
* The San Jose store runs out of a medium green t-shirt, it’s more cost effective for Nordstrom’s to combine that medium green t-shirt in addition to all the other orders routing through the regional distribution center. This is in contrast to the San Francisco store pulling the out of stock size & shipping the one unit to the San Jose store.
There is little difference fundamental difference between a Retailer & an E-commerce relationship. Both are responsible for creating an engaging retail experience, building defensible customer relationships, gathering customer insights to guide merchandising decisions, and manage demand generation & advertising investments. However they differ in three main ways:
- Digital Medium: Obviously the biggest difference is the fact that retailers sell products via a website while retailers deal with physical stores.
- Zero Transportation Costs: Purchasing online is a much easier experience due to the fact that you don’t need to get in a car, drive to the store, fight for parking, deal with sales staff that hates their jobs, wait in a checkout line, and then get home.
- Deeper Customer Insights: Shopping online enables retailers with much deeper customer insights on purchasing patterns & products at the individual customer level - where brick & mortar retailers must make a concerted effort at checkout to gather billing zip code at checkout.
E-Commerce retailers leverage two huge advantages:
- Massive Population: Obviously the biggest difference is the fact that retailers sell products via internet to the entire country (technically the world, but that’s another whole can of worms) while brick & mortar retailers are limited by the customers geographically in a given store’s territory. As of 2012 there is an estimated 154.6 million people that will purchase something online in 2012.
- Targeted Demand Generation: If an online retailer have slow moving inventory that you need to sell (commonly referred to as turn), then they can send a target email to your customer base of highly targeted people that have purchased a complimentary product (i.e. a jacket that would go great with that shirt). Alternatively, an online retailer can level the power of Google to increase their keyword spend to drive up their paid position on the brand’s keywords to generate sales.
Understanding the Cost Basis
Brands traditionally employ a “Cost X” model that takes the loaded costs for producing, landing, and fulfilling their goods & services by a multiple - commonly referred to as a Keystone markup. One of the biggest mistakes you can make in pricing is not having an educated idea of what your cost basis will be. If you don’t have an idea - then it’s easy to misprice an item and kill your business because you’re not making enough money on each unit to finance your operating expenses.
is a pricing methodology that multiples the cost basis by a factor of two (sometimes can be up to 5x in the case of jewelry) to dictate the price for next rung in the value chain. Keystone markup arose as the simplest way to universally markup goods across the retailer to a profitable level. Generally speaking, it is logistically impossible to uniquely price each product (from 100s or even 1,000s in a given retail location) to reflect market conditions and retail demographics. The theory being that retailer profitability was more of a function of units sold versus maximizing each product’s price. Subsequently, this approach normalized prices across the marketplace (i.e. everyone is pricing a shirt at $100).
What does the costing build look like for a typical brand:
: The represents the total cost of paying for the item, shipping to the US, tax & duty, receiving in the warehouse, and getting on the shelves ready to sell.
: This is the cost basis that I generally like to always keep in my head because it represents the fully-loaded cost basis of selling an item & gives me a better idea of how much cash I will have at the end of the day.
: The Wholesale Price of a product is the revenue in one channel for the brand, but it’s the cost basis for the retailer who purchased it from the brand. For retailers like Urban Outfitters, Finish Line, Journeys, or Amazon the wholesale price is the baseline inventory cost for them.
This is quick graphic to show you how this relationship works:
To put this all together into a graphic of a real product with real world pricing, let’s take a look at the pricing of one of the old boots from one of my old brand’s, VÆL Project:
Distributor Margin Analysis
This explanation (obviously) gets more complicated as the company grows - but let’s keep it simple. There are two models than create the pricing landscape (once we know what the distributor is charged product, we can more acutely understand how they charge for it). There are two predominate pricing models:
“Cost +” Model
Distributor Price = FOB + x%
“Wholesale -” Model
Distributor Price = Wholesale - x%
Cost + Model
FOB is the cost to the Brand to produce the good or service. This represents the baseline cost to the brand to produce good and is the starting point for analyzing the revenue model to the brand and thus do a margin analysis. When you are growing a fashion brand, the typical range for the markup % or the “+” in the model is anywhere from 25% - 40%. After working a lot of brands and speaking with loads distributors, you end up starting at FOB + 35% and progressively this % gets smaller as the brand does more business. The logic is as follows:
- Volume of units to the distributor will be small in the beginning and the brand needs to 35% to boost contribution margin to OpEx as the burn rate is particularly high for startup brands (you just need a lot of people to do all of the stuff required to build a brand properly).
- As the brand grows the cost/unit (FOB) is driven down. Therefore, the margin $ value of the contribution margin is driven down also.
- The realization of scale is good for the brand and good for the distributor so this model incentives the distributor to help grow the brand in the particular country in a responsible manner.
- The logic is that you demonstrate transparency by showing your Cost Basis in efforts to build a partnership where the distributor & the brand benefit by realizing scale economies. However - BE CAREFUL - if you don’t choose the right partner they can screw you over by virtue of your honesty.
Important qualifications about this perspective:
1. FOB means that the distributor is responsible for coordinating logistics from FOB Destination (most likely Hong Kong) to their host country. FOB is an old legal term for “Free On Board” meaning that ownership of the product changes once the product is delivered to the shipping carrier - make sure that you get paid T/T Advance (a fancy way of say a “wire”) prior to shipping. If you don’t get paid first, they legally own the goods and have fun trying to collect from a company in Japan or UK.
2. Tax, Duty, and Quota is a very tricky art that should be the responsibility of the distributor. Japan has horrendously high tariffs and their Quota system requires intimate understanding of the inner workings of the system along with the experience to account for the screw ups.
This is why you want to work closely with your Distributor to figure out the right pricing for the brand for that particular market. This will require the brand to spend time over there and figure out the market (what products are priced where & what’s the market feeling). However, this doesn’t mean that you don’t need a distributor to enter a country - there are an insane amount of factors that require you have someone with relationships to the retailers and their pulse on the culture to nail down properly.
Wholesale - Model
The Wholesale - Model is more common with larger brands like K2 or Patagonia (I reference these two brands specifically because I have worked with them in the past). Elements of the Wholesale - Model:
- Pricing for the product is indexed to US Wholesale (which is the largest revenue source for most brands) thereby obfuscating the true cost basis (think Apple & COGS).
- You generally see a range of Wholesale - 30% to start with. As the distributor achieves the performance hurdles of the “distribution agreement” they will realize greater discounts (duh!).
- If you have the clout to be able to employ this model - you should do it. But most likely you will get beaten up so badly in the beginning that this model is prohibitively challenging for most new brands (anything younger than 3 years).
This a real world example of a pair of shoes & the margin from one of my old distributor relationships from VÆL Project.
Distributor Revenue & Margin Analysis
Margin from the distributor’s perspective is rather complicated. For small brands, you want to allow the distributor to set pricing - however, you need to make sure that their distribution timeline is both aggressive, yet prudent. You won’t build any “staying power” in a foreign country’s fashion scene if you don’t have clean & controlled distribution. Many of you can relate to Ed Hardy from the early-00s when it was moderately cool - now it is literally trash.
Distributors’ negotiate exclusive rights to sell a brand in a country because it creates an exclusive value proposition that ensures the highest possible price that they can charge for this cool “American” Brand. When you have exclusivity you reduce the ability to price check for comparable goods and thereby stronger positioned to be a price setter rather than a price taker (ie empower consumers).
In the beginning, you will see that prices are fairly inelastic for cool brands (however, these barriers are falling rather quickly in the globalization of fashion) - pricing models trend on 2.7x to 3.5x Landed Cost.
Distributor Pricing Model for Men’s Shoes in Japan under Wholesale - Model
Check - If a standard 2x markup on Wholesale in a foreign country is employed a $100 Shoe US can be as high as $300 in Japan. Remember a 63% duty rate for imported goods from China.
This pricing can vary immensely by the deal & by the country - what are the tariffs that the distributor is responsible for? What does the market command? There are brands here that are “meh!” but are gold overseas - this can often float a brand in between fashion cycles.
Retail Margin Analysis
Retail Price: This is the price that the ultimate consumer of the product pays when you purchase a product from Urban Outfitters, Bloomingdales, Finish Line, etc. This price is also generally “keystone” or Wholesale Price times 2. For Example:
[NOTE: Keystone is the general rule, but certainly Wholesale Price can be 2.1x Landed or Retail could be 2.2x Wholesale. This all depends on the retailers pricing power, brand positioning, and market position to be able to make these tweaks.]
For purposes of moving forward, I am going to assume that you understand what Gross Margin is (Gross Profit / Revenue) or the % of each $ of Revenue that drops down to fund OpEx. Let’s run through a quick example, from the Retailer’s Perspective:
This is an oversimplified margin analysis. Let’s take it one step further to account for the realities of life. Two items that can be used to better exemplify try margins are the Credit Card Fees (you can push CC fees into OpEx under Bank Fees, but we won’t go there) & Shipping & Fulfillment costing.
: Credit Card Fees are pretty straight forward as they are a % of Gross Sales that the CC processor charges to the Retailer for use of a CC or Debit Card. They range from roughly 1.65% - 5.4% (for a small retailer processing an AMEX or Discover card - now you know why a lot of bars / convenience stores in SF & NYC don’t accept cards?)
*** This may not seem like a big deal, but a 2% reduction in Gross Sales is a BIG Deal. Assume that a retailer sells 1,000 units/week & there are 52 weeks/year.
One of the more interesting aspects that you should take into account is the shipping & fulfillment analysis for this margin analysis.
Brand Warehouse -> Retailer Warehouse -> Individual Store
We live in an age characterized by the economic realities of lean inventories. If you read Nordstrom’s quarterly or annual SEC filings, one important aspect to note is that management highlights increasing profitability because of more effective inventory allocations & stock optimizations. As a brand when, regional chains function in a fairly decentralized manner - meaning that brand shipments go directly to each store.
**** Assumption: The shipment will be sent FedEx Ground from Zone 1 to Zone 5 (CA to NYC) @ a rate of $24/carton or $2/unit (footwear is the unit - shoes take up a lot of space).
(Remember this shipment is going directly from the brand’s warehouse to the individual Retail Location)
Shipping truly is an industry of scale economies and this new world of lean inventories requires major retailers (like Nordstrom) to leverage these cost efficiencies by having brand shipments routed to their hub & then ship individual stores (driving costs down by having one bulk shipment to each individual store, of demand forecasted product compositions).
Active Margin Management:
One of the more interesting things that I began to do was implement a proactive management strategy for retail distribution in the US. Generally, a brand let’s it’s sales reps control most of the communication with the people that the brand is selling to. This really didn’t make a whole lot of sense because if I am running the bloody company - I need to actively know how the product is performing at retail for small boutiques. Boutiques are your leading indicator for pricing & sizing (two hugely important aspects).
- Every two weeks, I would call every independent boutique that I worked with - that was about 117 doors in the US. I focused primarily on the top 30% that I found were the most interesting.
- After chatting with all of them, I would build maps of what I was seeing. I would hear that a certain product was not performing well in Baton Rouge, LA at $210 retail but was absolutely killing it at $240 retail in Colombus, OH. In addition, retailers would actively express their frustrations with heavy product positions on say Nike Dunks in that same Baton Rouge, LA shop - but the shop in Orlando, FL was drying to get some but Nike.net (nike’s wholesale management system wouldn’t hook them up with an allocation).
- Based on this feedback, I would build full pricing analyses for each of the biggest bell-weather retailers - generally 10 - 12 every 2 weeks (Generally, I did this at night from 12 - 2:30am which is my last conference call of the day 2:30am PST is 5:30pm in China end of work day).
- In the above example, I would have the Baton Rouge, LA retailer reduce price of $195 from $210 but structure increases in other products to compensate for Margin Reductions. Basically testing price sensitivity to create an optimal margin structure for the retailer.
- In addition, I would use the credit that I extended Baton Rouge, LA store & the different Orlando, FL (My relationship with them is the only common factor between these two guys and they both owed me $$) and shift Baton Rouge store’s Nike Dunks (that he was long on) and get them to the Orlando guy.
What did I gain:
- Boosted Cash Conversion (If I spent that much time caring about their business, who the hell do you think that they are going to pay first?)
- Increased Rev/Account (I have multiple touch points with my customer and I gave them something that no one else really could give them - they are of course going to give me a larger merchandise location at their store)
- Deep market insight ( simply just knew more than anyone else about market dynamics and could apply that knowledge throughout all aspects of the organization - thereby building the human capital endemic to the organization).
E-Commerce Margin Analysis
Now let’s get to the fun part - online retail is near & dear to my heart and this is the part that I really wanted to answer. E-Commerce is an incredible channel because you have the ability to:
- Create the Retail Environment: Being online means that retailers have the power to design the retail narrative that visually communicates the retailer’s story. Think about it - a brick and mortar retailer will maybe remodel the story once every five to seven years. With an online store - you can dynamically change the homepage, create a new theme for the season, add “sub-shops” for designs/styles, or with a little html & CSS you can tell a totally different story.
For a more in-depth version of this story, check out: How Retailers Can Replicate the 'Magic' of the Apple Store... Online
(I am really proud of that piece)
- Tell the Story: Being online provides the retailer with the ability to tell the product’s story to bring the customer in the world of the retailer. Online retailers can add “looks” to augment the retail experience - the story enables online retailers to tell a story that would be challenging for a brick & mortar. Did the sales associate get busy and forget the brands background? Were they too busy and didn’t get a chance to connect with the customer? Online gives the retailer to tell the story that gives the customer a reason to buy stuff.
- Deeper Customer Insight: The luxury of e-commerce is that we have an incredible number of tools to track & analyze user behavior in ways that brick & mortar would only dream of. Although it’s challenging to nail down your e-commerce analytics - it’s extremely powerful to have a detailed customer profile to tweak your merchandising & promotion strategies.
- Regular Engagement: The era of using Facebook & Twitter to simply promote your products is dead. Modern e-commerce social strategies involve crafting a narrative that makes your fans want to engage by NOT talking about yourself. For example, a music blog will use a new mix to engage fans & readers & then subsequently sell tickets to the show after they are on the page.
This all leads up to the point of analyzing the costs of the costs of e-commerce and gather some insight on the associated margins of online retailers.
We are going to look at this first from the perspective of a ‘typical’ online retailer like Nordstrom or Urban Outfitters.
You might be wondering why the costs of shipping & fulfillment must be included in the Cost of Goods Sold - well that’s a good question. Most retailers have to offer free shipping as a normal course of competing online today. The IRS says that when a promotional expense is a standard practice (i.e. free shipping on all orders) it must be calculated as a COGS expense. Here is a little graph that shows you the prevalence of free shipping as a norm in online retail: