Almost everything you buy online has a 4–5x mark-up embedded in the price. That blue shirt you just bought for $100 and looks fabulous on you costs less than $15 to make.
You’re not paying that high of a mark-up because ecommerce businesses are greedy. Most of them actually struggle to make money and the ones that do typically don’t make a lot. The gap between price and COGS is the result of three structural hurdles that ecommerce companies face, which have historically eroded profitability:
1. Inability to accurately predict demand: It’s very difficult to forecast demand before launching a product. Brands with high SKUs are almost always forced to liquidate/ discount a portion of their products, leading to profit erosion.
2. Difficulty to acquire customers: Finding a customer and convincing them to buy your product is very expensive, especially given everyone is fighting for our attention online. Every year, Brands find themselves allocating an increasing share of their budget to attract customers and convert them.
3. Complications of last-mile delivery: Delivering the product to a customer is very expensive. That’s because last-mile delivery, which typically accounts for 50–60% of the cost, is very complicated and costly.
Since its inception 20+ years ago, ecommerce went through three stages of evolution, starting with the emergence of marketplaces in the early 2000s to the direct-to-consumer model in the early 2010s and the consumer-to-manufacturer model today. In each stage, a few companies figured out how to overcome the ecommerce hurdles and build strong businesses in the process. Today’s piece is about these companies and the strategies they employed.
Let’s dive in.
Amazon started just like any other retailers, just online. It bought products (mostly books, CDs, and DVDs) from suppliers and sold them online. Of course, this model was very (very!) unprofitable and was obviously not the end goal.
A few years after launch, Amazon opened its website to third-party retailers, allowing them to sell their products on Amazon.com, and, in 2006, introduced the fulfillment-by-Amazon service allowing retailers to use its warehouses and fulfillment network to deliver products to their customers.
Today, third-party sellers account for 61 percent of GMV on Amazon. This expansion from a pure retailer into a marketplace and fulfillment provider was at the core of Amazon’s success in eCommerce as it helped the company tackle all the hurdles above beautifully:
Amazon’s marketplace helped the company minimize demand risk in two distinct ways:
1) By selling an increasingly large volume of third-party products, Amazon removed its inventory risk and transferred it to these retailers.
2) By becoming the go-to retailer for most products, the company collected large amounts of data and developed a good understanding of what customers looked for and what they bought, helping Amazon’s retail arm offer products they knew would sell.
Amazon reduced customer acquisition costs by becoming the main destination for buying products online. To do so, the retail giant sold its products at almost no margin for a very long time, with profitability coming from third-party merchant fees, ad services, and Prime subscriptions.
The promise of product diversity (anything you need), low prices, and superior convenience (through 2-day shipping) helped Amazon become the place most shoppers start their buying journey in.
Fulfillment costs in eCommerce are very high, especially last-mile delivery. However, they benefit heavily from economies of scale.
As more merchants join the Amazon marketplace, the number of orders fulfilled by the company’s fulfillment centers and drivers increases, thus increasing utilization and reducing average delivery cost.
It takes a driver almost the same amount of time to deliver 10 parcels to a neighborhood vs. 5 parcels.
Direct-to-consumer companies emerged in the late 2000s and promised to help consumers save money by cutting out the middleman (distributors and retailers). These digitally-born startups used an innovative playbook to disrupt traditional retailers and resolve the ecommerce core hurdles.
I’ve talked a lot about this model so I won’t bore you with details. For more information, make sure to check this, this, and this piece.
In summary, the playbook looked something like this:
Direct to consumer startups leveraged crowd-funding platforms (Kickstarter and Indigogo) and social media experimentation tools (which I’ve discussed in great detail in the article below) to validate demand for their products before launch. These tactics helped founders minimize demand risk by confirming consumer interest and raising money to fund their initial orders, all while creating a buzz (earned media) around their products.
Being digitally native, Direct-to-Consumer founders understood the power of social media before others did. They used Facebook, Google, and other platforms as the main channels for customer acquisition, back when costs (CPMs) were still low. D2C brands knew how to build and nurture a direct relationship with their target customers and push them to convert at a low cost.
Direct-to-consumer brands leveraged the emergence of third-party logistics providers, which provided delivery solutions at cheap rates achieved through 1) bundling orders from various retailers, 2) working with independent warehouses/fulfillment centers across the country, and 3) using technology to optimize delivery routes and order flow.
Unfortunately, D2C’s success only lasted for a few years. D2C players’ solutions to solve the triple eCommerce problem were not sustainable, and these players were unable to build competitive moats. The ease of building an eCommerce business attracted a lot of entrepreneurs to this space. Consequently, CPMs skyrocketed, and the cost of acquiring customers became prohibitively high, making it hard to win. I spoke in detail about this here.
In the past few years, we have seen the proliferation of players, mostly in China, that have adopted innovative ecommerce models that link consumers directly to manufacturers, such as community group buying, live stream commerce, and ultra-fast fashion.
It would be unfair not to dedicate a full post to this model, and I plan to do so in the coming weeks. To avoid making this a 3,000-word post, I’ll focus on how Pinduoduo’s community buying program helped the 6-year-old company become the largest ecommerce platform in China with more active users than Alibaba and a market cap of $152 Billion.
Pinduoduo (PDD), which translates to “Together, More Savings, More Fun,” offers users up to 80 percent discounts when they buy in groups (community buying) by connecting them directly to manufacturers. They can offer such savings because they built a very robust flywheel that solves the ecommerce hurdles above:
PDD’s group purchasing dynamics is centered around a self-designated community leader who creates and maintains a WeChat group (up to 500 members) where interested individuals from the local community sign up to participate.
The community leader would post a range of product selections (mostly groceries and life essentials) to the group, and group members place orders on the items they want. When the collective demand exceeds a certain threshold, an order is made to the manufacturer/ farmer, and the delivery date is set.
By aggregating demand before placing orders, PDD allows manufacturers to “build to order,” thus eliminating the need to guess and waste inventory. Direct buying ensures products (specifically agricultural produce) are fresh when delivered to customers, leading to a positive experience and higher repeat purchase rates and customer LTVs.
The community leader receives a 10 percent commission when an order is successfully made, and therefore is incentivized to acquire members to the group and for the order threshold to be met. As a result, PDD doesn’t need to do any activation work to acquire customers and instead relies on community leaders for this task.
As a result, PDD can acquire new customers for as low as $2, a 20x cheaper rate than other eCommerce platforms in China.
Once an order is ready, it usually is delivered in bulk to the community leader, who unpacks the order and organizes it for community members to pick it up. This entirely removes the cost of last-mile delivery from manufacturers.
Whereas traditional grocery delivery costs about 7–10 RMB per order, the group buying model reduces this to 1.5 RMB per order.
It’s not only PDD that has adopted the C2M model. Companies like Meituan, Didi, and Alibaba (Freshippo) are also heavily investing in space. I’ll discuss this topic in a more detailed post sometime soon.
First published on Termsheet, a newsletter with commentary on startups and venture capital in emerging…
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