Long, long ago, there lived a poor farmer whose sole desire in life was to own a cow. After scrimping for many years, he saved up enough money to purchase one. Then he discovered that the animal needed space for grazing, so he had to acquire some land. Then the land had to be tilled, so the farmer bought tools and hired laborers. All this took time and effort to manage, so help was needed, and the farmer took a wife. But his bride wanted a bigger house, so….

As this old Asian fable shows, things become larger than life. Like what was surely the world’s most uneconomical cow, fulfillment, a straightforward function, has taken on gargantuan proportions, involving thousands of hours, tens of millions of dollars, and hugely complex customer service acrobatics, all because people figured out that it was convenient to order things online. To pre-crash dot-commers accustomed to skillions and gazillions, money was no object, and they basically stuffed the vendor bills in a trash can and didn’t bother to document how much order processing and fulfillment cost.

We’re starting to find out. Although e-merchants rarely report fulfillment expenses separately, late last year a small news item announced that in the second quarter of 2000, lost $317 million but ran up an $88 million tab for fulfillment — 15% of sales for a single three-month period. That seemed to open the floodgates. All of a sudden tantalizing bits of financial information began cropping up all over the place. We chortled at the wild spending that led to eToys’ debacle: hundreds of millions of dollars thrown at snazzy Web technology, warehouses the size of airports, six-figure salaries. For what? A modest $150 million or so in sales. Not to be outdone,, which shut down early in January 2001, spent more than double its 2000 revenue (a paltry $13.5 million) on marketing.

Spending spree

Now, more than ever, it is crucial to rein in operational costs as logistics spending hits an all-time high (see cover story, pages 14-24). According to a recent study by Establish, Inc./Herbert W. Davis and Company, a logistics consulting firm, last year logistics costs increased the most since 1973, the year of the Arab oil embargo. From 1990 to 1999, logistics costs averaged 7% of sales; in 2000, they came in at 9.6% of sales. Furthermore, logistics spending dropped at only about 25% of companies — the lowest number in five years. It isn’t going to get any better. We cope daily with paradigm shifts in the business climate, labor market changes, new technologies, environmental concerns, and political uncertainty in many parts of the world. You should expect all of these factors to affect how you manage logistics and what you pay for those logistics.

Take a close look at your numbers. Although a lot depends on your products and volume, in general the costs of fulfillment are higher for a pure-play online business. For instance, a two-line mail order costs about 50 cents to key in, whereas an e-commerce order would cost around a dollar. As a percentage of net sales, fulfillment cost (not including outbound postage or shipping) averages 9% for catalog and other direct marketing merchants and about 10% for e-commerce firms, reports Winterberry Group, a New York City-based research firm.

More Winterberry statistics: Direct marketers now spend $91 billion on fulfillment, and will shell out $157 billion by 2004; e-commerce fulfillment, which accounts for 22% of the current amount, will jump to 47% by 2004. In the next four years, catalog spending on fulfillment is forecast to rise only 4%, but e-fulfillment expenses will surge by 34%. The third-party e-fulfillment market totaled $4 billion in 1999, 56% of the $7 billion 3PF market. E-fulfillment outsourcing grew an estimated 20% in 2000, to $4.8 billion. By 2004, the market for e-fulfillment outsourcing will reach $8.8 billion.

Math whiz

Writing out checks for fulfillment has been the undoing of many an Internet merchant. In 2000, analysts from McKinsey & Co. and Salomon Smith Barney conducted a study of online retailers for The Industry Standard magazine. Measures included average order size, gross margin, and fulfillment cost per order. Of the seven industries evaluated, only two, apparel and books, made money after fulfillment and shipping costs were deducted (see table at left). To analyze this, the researchers went back to the online business model. The logic of e-commerce posits that as you get more customers and a bigger average order size, your distribution systems will become more efficient and you start paying less to fulfill each order and enjoy a higher contribution margin (gross margin minus fulfillment expenses). At a certain point, you will achieve break-even and cover the costs of marketing and Web site development. The glitch here is the revenue you need to reach the break-even point. The McKinsey and Salomon study found that Internet booksellers and drugstores needed total revenue of $1.2 billion — an amount that usually only off-line businesses have been able to approach.

The golden mean

What does this mean to you? It means: Scale back. Think about proportion. In the recent past, because capital was so readily available, many e-tailers built distribution facilities that far exceeded demand. These colossal fulfillment centers would have been economical only if sales topped a billion dollars or more. One of eToys’ warehouses measured 764,000 sq. ft. — eight times the size of the Great Hall in New York’s Grand Central Terminal. What eToys spent on distribution infrastructure last year equaled 95% of its 1999 revenue, compared to only 20% for most land-based retailers and 12% to 13% for catalogs, according to Kevin Silverman, managing director at ABN AMRO in Chicago. Although it farmed out most of its packing and shipping to Fingerhut Companies, eToys didn’t deliver 4% of its orders in the 1999 holiday season.

Examples abound of the lack of scale economics in cyberspace. Online grocery Webvan has a respectable gross margin of 27% (the average in retail grocery is about 27% to 30%), but the cost of picking, packing, and delivering the orders has almost wiped out the company’s gross profit.

Although you can launch a Web site fairly cheaply, it can be pricey to set up one that has all the functions you need to generate a billion dollars in sales. According to a 1999 report by Forrester Research, a site with small volume, say $3 million to $5 million in sales, would pay about $1.8 million in start-up costs, including marketing and technology. To support that site, you would pay $1.9 million a year, more than 50% of it for marketing. If you project sales of $20 million or more, your average start-up cost would be $10.6 million. Support would cost you $14.3 million, with about $9 million of that going toward marketing. But note that these are just ballpark figures; in real life, some high-performance sites have spent upward of $40 million to get up and running.

Fulfillment costs mount rapidly when you throw in such things as returns processing, taxes, and charges for overseas shipments, which you must expect to incur in the online business. Not realizing that the Web makes them global, many U.S. companies have been caught unawares by orders from other countries. Returns are another bane of e-commerce. Some experts say the value of goods returned after an online purchase could reach $11 billion in 2002, costing e-merchants $1.8 billion to $2.5 billion. And don’t forget the costs of technical troubleshooting — for example, when your site goes down or is hacked. You may also have to contend with legal fees. In 1998, computer marketer Gateway paid the Federal Trade Commission $290,000 to settle a case after the agency said Gateway had misrepresented its refund policy and on-site warranty service. Last year, the FTC levied fines of up to $300,000 on several prominent e-merchants (including and for not delivering orders as promised.

High five

Some financial problems are the inevitable costs of doing business. But what are some functions that you can tweak with little or no damage to your operation? Here, distilled from the remarks of industry experts, are five actions you can implement painlessly:

  1. Know your customers. What kind of person or company buys your product or service? Do you really need to offer all the bells and whistles? We’ve all been led to believe that Internet shoppers want everything in real time. But the pressure to provide this level of customer service may drive up your fulfillment expenses enormously. In a study that Jupiter Media Metrix conducted in early 2001, a third of online retailers cited the cost of shipping as a serious problem. So ask yourself if you can pass on some of those costs to your customer: Does he or she want the product badly enough to pay an extra $20 for it? Examine your business model. If you’re selling to a premium customer, you’ll have to pay more for fulfillment. If you’re targeting a mass-market shopper, you may be able to get away with less.

  2. Partner like crazy. Outsourcing your fulfillment is one obvious solution. It typically works best if your sales are between $5 million and $100 million, or up to 10,000 shipments a day. Outsourcing can cut your costs by 20% to 30% — a fact that hasn’t been lost on online retailers, more than a third of whom will contract shipping to drop-shippers in the next year. Winterberry Group reports that third-party fulfillment outsourcing is expected to double from $8 billion currently to $15.3 billion in 2004. But there are many other kinds of alliances to consider. Hallmark, for instance, has hooked up with various gift merchants for its online business, buying a gift certificate company for its online arm; an equity stake in Cheryl & Co, a gourmet foods marketer; and a stake in, which sells upscale gifts. Another advantage of the online business is that so much if it is virtual. For instance, you can, at minimal cost, make use of Internet trading networks to deal with suppliers, a move that can help save up to 25% in labor costs.

  3. Build customer relationships. If you cut out the frills you provide to all, you will be able to focus better on the customers who matter most to your company. Do what it takes — customer focus groups, surveys, special promotions, targeted e-mails. Repeat purchases will justify the cost of your infrastructure investment. Good customer service does work. IndyMac Bancorp, an online mortgage company, offers a “no voice mail” hot line, live online chat, a Spanish-language version of its site, and even rates offered by other lenders; according to IndyMac, the volume of loans in its direct-to-consumer mortgage division leaped 184% between the fourth quarter of 1999 and the same period last year.

  4. Think Old Economy. In the early dot-com model, the goal was to generate huge amounts of revenue, even at a loss. Now even, the ultimate pure-play, is showing greater respect for traditional business practices. In 1999, Amazon lost $39 million in inventory write-offs, mostly in toys. In 2000, Amazon hooked up with Amazon benefits from partnering with the Toys “R” Us brand; benefits by letting Amazon handle its fulfillment. Last year better inventory management reportedly helped Amazon to make 26 cents on the dollar on every sale, up from 20 cents in 1999.

  5. Stay flexible. When venturing into e-commerce, perhaps the most important thing to keep in mind is flexibility. The business is all about change, and it’s essential to keep your distribution center lean and mean and invest only in the technology, equipment, and staff that you absolutely need. Think carefully before investing in highly specialized material handling equipment. If you’re in many partnerships, you may find yourself dealing with products totally different from anything you’ve ever handled before, so you’ll need equipment that you can modify, such as shelves that convert to hanging racks if necessary.

The logistics business is at a critical point in the evolution of e-commerce. In spite of the market downturn, analysts expect Web commerce to grow to about $7 trillion in the next four years. None of us can afford to be left out of the action, so it behooves us to examine our businesses carefully and streamline them so that we don’t repeat the mistakes of the past.

Rama Ramaswami is editorial director of Operations & Fulfillment.

The Empire of Clothes

Profitability Per Online Order: Apparel Rules
Books Prescrip.
Drugstore Apparel
Grocery Toys
Average per-order revenue $37.82 $63.27 $19.50 $85.00 $61.82 $81.30 $52.00
Shipping revenue $7.18 $0.80 $4.00 $9.70 $0.00 $0.00 $10.00
Total per-order revenue $45.00 $64.07 $23.50 $94.70 $81.82 $81.30 $62.00
Cost of product $27.92 $60.29 $20.75 $43.60 $47.01 $66.20 $40.04
Shipping costs $7.18 $0.80 $4.88 $7.80 $9.01 $0.00 $12.00
Gross margin* $9.90 $2.98 -$2.13 $43.30 $5.80 $15.10 $9.96
Gross margin % of revenue 22% 5% -9% 46% 9% 19% 16%
Fulfillment costs** $5.00 $14.29 $14.29 $10.70 $11.00 $28.00 $14.00
Contribution margin $4.90 -$11.30 -$16.42 $32.60 -$5.20 -$12.90 -$4.04
Figures for fourth-quarter 1999. * Gross margin equals total per-order revenue less cost of product less shipping costs.
** Includes customer-service and credit-card processing costs. Source: Mckinsey & Co., Salomon Smith Barney

E-Commerce Lite

How much you want to spend on e-commerce is largely a matter of how much people say you should spend. According to celebrity Internet analyst Henry Blodget, as quoted in The Wall Street Journal, “If you’re trying to service a mass market, you need to maintain an expensive Web site that costs around $50 million, whether you have $1 or $1 billion in revenue.”

Not so, asserts Donald A. Coggan, a Montreal-based engineer who designs no-frills e-commerce sites. “If you expect $10 million a year in sales and you’re selling products that cost $200 to $300, you could probably set up a site for $10,000 or less,” says Coggan, who has created Web sites for as low as $500 for small businesses.

If you start out by thinking that e-commerce is cheap, you’ll spend yourself into a hole, he warns. For example, customer service is a major budget-buster: “There are a lot of time wasters out there. People think they’re buying from a huge organization with hundreds of people working in the service department. They send a lot of e-mails back and forth, and in the end they don’t buy anything.”

Fraudulent payments also run up your bills. “Just the ability to accept credit cards is quite a bit of expense,” Coggan points out. “Then people cancel transactions on credit cards, and the company has no recourse if there’s no original document. There’s a cost associated with that.” Online check processing systems do not usually verify if the shopper has enough funds in the account to pay; bad checks can cost an e-merchant as much as $10 for a $25 check. “All of these little things add up.

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