To build a successful ecommerce business, it’s critical to make sure customer lifetime value is higher than customer acquisition cost. Jeremy Liew‘s article “Why Do Ecommerce Startups Come in Waves?” provided insightful analysis of this point. Not mentioned, however, are two variables that play a major role in determining the viability of ecommerce startups – supply chain and logistics efficiency – which are often ignored by entrepreneurs and investors. This oversight can be extremely costly and therefore should be factored into their analyses.

To start, it is instructive to look at the evolution of retailing in the past century. In the early 1900’s most goods were purchased at local general stores which had limited selection and stock. Sears revolutionized retailing by introducing a mail-order catalog that provided significantly greater variety and convenience. By the 1930’s it was known as the “Consumer’s Bible.”

Over the next 50 years, Sears opened large format stores which eventually eclipsed and shuttered the catalog business. What caused this change? First, the large format store provided much greater variety than a catalog and the cost of bringing all the merchandise to a central retail location made it more cost-effective than home delivery. Second, the proliferation of cars made that business model possible.

Therefore, when we look at online retailing, it is actually not a new phenomenon but the re-emergence of a previous catalog model with new and more powerful capabilities. The digital format offers unlimited product selection, and more importantly, the scale and coverage of logistics companies like UPS and Fedex have significantly driven down the cost of home delivery. Today, most online merchants deliver products for free, and this makes online shopping much more compelling.

The cost of transportation is amplified when taking into account the cost of restocking stores. Women’s shoes are a prime example. Not only are there a huge variety of styles, but each style has different colors and sizes. Shoes also require a lot of shelf and storage space which is very expensive, especially if the store is in a prime retail location. Therefore most shoe retailers keep only one unit per size per style, which requires daily delivery to the store to replenish inventory. Even at that service level the stores are often out of stock, which incurs a very high cost of lost sale and customer dissatisfaction.

These economic factors provided a prime opportunity for online retailers like Zappos. By centralizing all inventory in one warehouse, Zappos could send multiple sizes per style to the consumer and afford to have the wrong sizes returned for free because it has no retail store lease or lost-sale costs. With scale they also negotiated very favorable shipping rates which enabled them to offer consumers a highly compelling service that retail stores could not match. Most people attribute Zappos’ success to their superior customer service, but it was the logistics economics that made it work.

At the other end of the spectrum are products such as precious jewelry, where one size fits all, and the amount of store shelf and storage space is minimal. A brick-and-mortar store can stock a wide selection of items with little need for regular replenishment. Therefore precious jewelry etailers would not enjoy any significant logistics cost benefits over their physical retail competitors. There is almost no stock-out cost as compared to shoes and the service provided in store is much more compelling than online. These factors also apply to products like cosmetics, perfumes and fashion accessories.

The logistics equation continues to evolve as retailers weigh the tradeoffs of keeping inventory in store, in warehouse, or at the point of production. Imagine that Zappos, instead of shipping merchandise from a central warehouse in Las Vegas, delivers shoes from factories directly to consumers, thanks to a much more efficient supply chain. It would further eliminate stock-out cost and improve service levels. Therefore back-end capabilities such as supply chain and logistics are critically important in determining the success of online and offline retailers. They should be front and center when examining the various options in an omni-channel retail world.

[Image courtesy Tetrapak]