It’s a common misconception that e-commerce is inherently more profitable than brick & mortar retail. The fact that very few online dominant brands’ profit margins exceed those of “traditional” retailers is one clue that this isn’t true. But a better way to understand the longer-term outlook is to look at the underlying economic drivers.
Above a basic level of scale, online retail is largely a variable cost business, whereas physical stores succeed by driving sufficient revenue to leverage their mostly fixed costs. At the risk of oversimplification, this means that to make money online gross profit/order needs to exceed the variable costs associated with that order. The reason that many eCommerce companies (or the e-commerce divisions of “omni-channel” retailers) don’t make money is that the marginal cost of acquiring a customer, plus the supply chain cost of fulfilling that order, exceeds the gross profit (essentially, revenue less the cost of goods).
The challenges of profitably acquiring customers online is an article for another day. But even where that hurdle can be overcome, e-commerce is often unprofitable due to high supply chain costs–and a huge driver is the high rate of returns. Consider this quote from Michael Kors’ CEO John Idol in a 2016 Bloomberg story: “Unfortunately today, e-commerce generates a lower operating profit for us than four-wall, brick-and-mortar. We think over time that will reverse itself but…when the consumer requires free delivery, free return, wonderful packaging, plus there’s a new trend that people are buying multiple sizes of things to try them at home and then return them, that all is a negative headwinds for us.” Bear in mind, this comes from a brand with significant consumer awareness, a sizable online operation and a high average transaction value.
While returns are not an issue for products that can be delivered digitally–or for many commodity items–in categories like apparel, accessories, footwear and home furnishings, where fit, coloration, fabrication and the like determine whether the consumer ultimately keeps the product, return rates between 25 and 40% are often the norm. When retailers pay for free shipping & exchanges handling costs can quickly erode any chance for a profitable transaction. We must also consider that returned or exchanged product often cannot be sold at the original gross margin, either because it is shop-worn (or otherwise “defective”) or because by the time it comes back the retailer has taken seasonal markdowns.
Some analysts have taken certain retail brands to task for their failure to aggressively invest in e-commerce. Yet many dragged their feet (or were rather deliberate about how they invested) quite intentionally because they understood that aggressive online growth was detrimental to their profitability. The fact is that unless returns rates can be mitigated significantly and/or the cost of handling returns can be lowered dramatically, some retailers will continue to suffer from what I call “omni-channel’s migration dilemma.”
While outside observers may gloss over this phenomenon, brands that face this growing profitability menace are taking action. One trend flies in the face of the retail apocalypse narrative. It turns out that physical stores can be incredibly helpful in lowering both the rate of returns and supply chain costs. While it is not the only reason that formerly digital-only retailers like Bonobos, UNTUCKit! and others are opening stores, it is a key driver. Large omni-channel brands have also tried to make it easier to return online orders in their brick & mortar locations. Not only are handling costs typically lower, but–surprise, surprise!–driving store traffic often leads to incremental sales.
Another avenue for taming the returns monster is using new technology and processes. TrueFit is a venture-funded company that uses artificial intelligence (among other tools) to help consumers choose the right product during the ordering process. Happy Returns is a more recent start-up that has also attracted solid VC funding. This expanding brand focuses on reducing consumer friction in the returns process and helping lower the cost of eCommerce returns for brands by operating “return bars” in major malls. The malls may also benefit by seeing incremental traffic.
Clearly e-commerce will continue to grow at much faster rates than physical retail. And with Amazon and newer disruptive brands helping drive the share of apparel, accessories and home furnishings that is sold online, the impact of high returns rates will become a bigger and bigger issue for many brands. Industry analysts would be wise to dig into this more deeply. Consumers can continue to enjoy the free ride until some rationality takes hold. Retailers would be well served to not gloss over this growing problem.
A version of this story recently appeared at Forbes, where I am a retail contributor. You can check out more of my posts and follow me here.