By changing their primary role from seller to marketplace-operator, Amazon and other online retailers have discovered a new paradigm for increased profitability: driving sales for other retailers.
Yet the majority of physical retailers still follow an antiquated sales model that is unsustainable. If physical retailers are to remain relevant, we believe they must move away from their problematic direct-sales revenue model towards a more profitable locally optimized marketplace model.
The physical store as a platform
A physical store can be transformed into a platform by providing third-party vendors with a means to sell products directly to its visitors, a model that Amazon has perfected.
Since launching its Marketplace service, Amazon discovered that making referrals often proves more lucrative than making sales. Today, over two million independent vendors sell items on Amazon, often in direct competition with the website’s own offerings.
Despite reported early doubts among Amazon’s management, the service grew exponentially and has become an unmitigated success. According to Amazon, Marketplace’s share of its revenues has doubled in 2014, accounting for 40% share of overall sales.
But, why does Amazon so casually hand so many of its visitors over to competitors? In many product categories, stiff price competition has shrunk margins almost to nil, making referrals a far steadier and more lucrative business than direct sales. Amazon charges referral commissions that range from 6 to 20 percent of the retail price, depending on product category. In addition, Marketplace allows the website to offer complementary products and highly profitable auxiliary services such as “Fulfillment by Amazon (FBA)”.
A physical store can similarly facilitate the sale of products by multiple vendors by using a combination of shopping apps, in-store electronic displays, and self-service kiosks. All of these technologies are at a mature stage, and are widely available at a reasonable cost.
Interactive kiosks with a self-checkout provide store visitors today with a convenient way to finalize online transactions. Whereas retailers such as Marks & Spencer naturally limit the choice on their kiosks to what is offered on their own web-shop, the list can be easily extended to feature also competitors’ offers.
In this new world of commerce, each store visitor can be presented with a personalized list of options: both in-store and online. Whenever the customer opts for a competitor’s deal promoted by the store, a referral fee from the competitor is due.
Customer acceptance of novel, in-store technologies is impressive. In a recent study conducted by InReality, 69% of shoppers stated they would be more likely to buy in-store if given digital self-help tools like kiosks or interactive displays.
Interestingly, shoppers regard digital solutions as complementing, rather than substituting, human sales staff. In the same study, 63% of respondents said they would be more likely to buy in-store if sales associates equipped with tablets were available for product information, availability, or ordering. Of course, we would expect customers’ willingness to use kiosks and interactive terminals in stores to become even higher when these tools finally allow hassle-free selection among the offerings of multiple, competing sellers.
Towards smarter customer-segmentation
Physical stores carry huge overheads, including rent and staff salaries, and can hardly survive on referral fees alone. Can new capital investments in such stores really be justified? With a smarter online-offline segmentation of store visitors, we believe they can.
Amazon enjoys relatively low overheads and high asset-turnover ratio. It requires much less capital of its own in order to make each sale. In contrast, a physical store needs to earn enough revenues to justify its substantially higher fixed costs, which include the costs of capital originally invested in the store, and of new capital needed to maintain and grow it. It is indeed unlikely that referral fees alone would cover these substantial costs.
However, unlike Amazon, a physical-store can deliver products on the spot and enjoys other advantages such as personal service and hassle-free returns. By collecting referral fees on sales lost to online competitors, it can therefore charge higher prices for in-store transactions.
This is just basic economics. When you get zero commissions on referrals you are fighting too hard for each and every customer. However, if the store is paid for servicing price-sensitive customers’ online transactions, it can then focus on selling only to those who are willing to pay for its added-value services.
Indeed, what we really need is a smarter method of online-offline customer segmentation. The current goal of serving all customers at the store at all costs is impractical, unwise and destructive.
Consider a store with a turnover of ten million dollars a year. Suppose that store’s operating profit is initially $400,000 per year (4% of revenues). In addition to its own sales, this store generates five million dollars in annual revenues for third-party online retailers. If like Amazon, the store is able to charge a referral fee of 15% on most of these lost transactions, it can immediately generate an additional revenue of up to $750,000 a year while incurring little or no extra costs.
By practicing more efficient and informed customer segmentation, and providing auxiliary services to online retailers (e.g., servicing product returns for a fee) and to online buyers (e.g., offering service packages for a fee), the store can further increase its profit.
Let us estimate these added profits at $500,000 a year. In this hypothetical case, therefore, operating a marketplace resulted in a significant profit increase of about 300%.
In conclusion, physical retailers will need to adopt a hybrid model: marketplace and sales. The surviving stores will be the ones to strike the right balance between serving as a marketplace and an immediate-delivery, premium service point-of-sale. The traditional retail model that relies on making sales alone is gone forever.
Segmentis is a pricing and revenue management consultancy based in the Netherlands.