Follow Apple’s Lead?

Establish an Online Presence?

Product Differentiation

Offerings with Online Advantage

Offerings with neither Online nor Offline Advantage

Offerings with Offline Advantages

Conclusions

I wrote a previous blog entry on retailing competition between offline and online stores, Will Smartphone-Enabled on-the-Spot Price Comparisons “Upend” Stores’ Business Models? This blog entry takes the previous analysis a step further and considers more explicitly how offline stores might be able to compete with Internet providers. In particular, this examination considers the increasing tendency of consumers to use bricks-and-mortar stores to test out new products, but then buy the products at lower prices on the Internet. How can bricks-and-mortar stores prevent such free-riding or otherwise continue to sustain viable businesses despite the existence of lower prices on the Internet?

Follow Apple’s Lead? 

Several discussions about retail in the Internet Age have mentioned the Apple Stores as the epitome of a successful offline retailer. For example, Harvard Business Review published an interview with Ron Johnson, the guy who, “working alongside Steve Jobs, built the Apple Store from scratch”:

HBR: Brick-and-mortar retailers are struggling, in part because of the growth of e-commerce. Is the traditional retail model broken?

Johnson: I don’t think the model is broken at all. Many stores are executing it very well. Look at the Apple Stores, which have annual sales averaging $40 million per store in a category that in 2000 everyone said would move entirely to the internet. Today the Apple Stores are the highest performing stores in the history of retailing. Physical stores are still the primary way people acquire merchandise, and I think that will be true 50 years from now.

The problem is that the Apple Stores are not your typical retailer. More specifically, Apple has such control over all its product channels, that no matter where consumers buy Apple products (in Apple Stores, online from Apple.com, or from third-party offline or online retailers), they are always charged the same price. I cannot think of a single other brand for which this is true. Apple thus avoids the precise problem that the other retailers face – having another channel provider undercut bricks-and-mortar retailers on price.

Surely, if online retailers were not constrained to all charge the same price, Apple would face the same problem all other retailers do of having consumers use the Apple stores to try out products and extract knowledge from salespeople, but then buy from lower-priced on-line retailers (“the free-rider problem”).

Establish an Online Presence?

Other discussions about offline vs online retail competition and the free-rider problem suggest that offline retailers compete with Internet providers by themselves establishing an online presence. In other words, the suggestion is that the bricks-and-mortar firms evolve into “clicks-and-mortar”, or “hybrid”, retailers.

At first blush this sounds perfectly logical. However, it turns out that this is no easy solution to the problem.

The underlying issue offline stores face is the cost differential between offline and online stores of providing similar products to consumers.  The total costs to offline stores of providing a given product is the sum of a fixed cost component to cover rent, salaries, etc., a marginal cost component for the product at issue, and a sales tax component:

(1)  Total Cost of Product for Offline Retailers = FC + MC + Tax

Online retailers do have fixed and ongoing costs associated with establishing and maintaining websites. However, these costs are generally small relative to the overhead costs faced by bricks-and-mortar stores. Also, at this point in time, many etailers (online retailers) do not collect sales tax on sales made to consumers, though I expect this will end at some point. On the other hand, etailers do incur costs associated with packaging and shipping the product to consumers. While many retailers do not charge customers for the costs of shipping and handling, etailers must still somehow cover these costs (presumably by charging a price over marginal cost):

(2)  Total Cost of Product for Online Retailers = MC + S&H

If we assume that sales tax and shipping and handling are roughly equivalent, then the difference in costs between online and offline retailers is fixed (overhead costs):

(3)  => Offline Costs ≥ Online Costs

Since offline stores’ fixed costs are nontrivial, offline retailers will not be able to survive using a strategy of trying to undercut etailers on price. In other words, the minimum prices offline stores can charge are higher than the minimum prices online stores can charge for similar products:

(4)  => Offline Prices ≥ Online Prices

Now suppose the offline retailer establishes an online presence to compete with other etailers. Competition for online sales will force the hybrid to charge a price “close to” the price other etailers are charging, or risk losing sales:

(5)  Hybrid Online Prices ≥ Online Prices

Furthermore, the possibility of arbitrage generally forces hybrid retailers to charge the same price for sales made either offline or online:

(6)  Hybrid Offline Prices = Hybrid Online Prices = Hybrid Prices

This means the online competition forces hybrid retailers to charge lower prices for its offline sales:

(7)  Offline Prices ≥ Hybrid Prices

In other words, low prices on the Internet put downward pressure on prices even for offline retailers with no Internet presence.

So now we have

(8)  => Offline Prices ≥ Hybrid Prices ≥ Online Prices

To the extent that hybrid retailers price their products below the prices of similar products sold by other offline retailers, becoming a hybrid will enable retailers to steal sales away from other offline stores. At the same time, however, to the extent that hybrid retailers price their products above the prices of similar products sold by other online retailers, becoming a hybrid will still cause retailers to lose sales to other online stores.

What we have, then, is that due to both cost constraints (3) and price constraints (8), establishing an online presence will not solve the problem offline retailers face from having to compete with Internet providers.

Product Differentiation

Clearly, offline stores cannot compete with etailers on price. So what they need to do is to differentiate their provision of products by providing additional products or services that complement the product at issue. Such product differentiation - done effectively - will increase the value of consumers’ retail experiences, and thus the price they are willing to pay. However, the extra value the offline stores provide for the product at issue must be either

•  inseparable from the product at issue, so customers cannot freely benefit from the extra value provided by offline stores, but then go online to buy the primary product (i.e., customers cannot free-ride), or

•  separable from the product at issue and provided for an additional fee.

In other words, offline stores must not only create value for consumers, but they must be able to extract that value as well.

In economic terms, offline stores must decrease the substitutability between offline and online consumer experience for “similar” products.  By differentiating the shopping experience in value-enhancing ways, offline stores will decrease the cross-price elasticity of consumption, thereby enabling higher offline prices.

In my previous blog entry, Will Smartphone-Enabled on-the-Spot Price Comparisons “Upend” Stores’ Business Models? I concluded that

What characteristics would be conducive to higher prices in stores than on-line and/or to general price dispersion of products across retailers?

 •  Unique items sold exclusively by certain retailers;

 •  Immediate availability of items purchased in-store;

 •  No shipping charges for items purchased in-store (where shipping charges exceed sales tax);

 • The provision of in-store sales services valued by consumers (product information, demos, easy returns, availability of complementary products/services);

 •  Ability to touch and demo products;

 •  Items sold in stores that are not conducive to shipping (i.e., the cost of shipping would be greater than the value of the item), such as items that are large, heavy, bulky, perishable, etc.; 

I’m interested in taking these conclusions to the next level by being more specific. I’ve listed the issues to be considered in the table below and discuss each one in turn.  I start with the issues for which online providers either have more of an advantage over offline sellers or have no less advantage.  Then I discuss the issues that offline retailers might be able to use to create extra value for consumers, thereby supporting higher offline prices.

Offerings with Online Advantage

[1] Cost to Seller

The costs to online and offline retailers were discussed above. See equations (1) and (2)

[2] Price to Buyer

The price to the offline buyer includes fixed costs for the seller (FC), product costs for the seller (MC), plus any markup (profit) component (Pi), plus any time and resource costs the buyers incurs to travel to the store (Transportation). The price to the online buyer includes product costs for the seller (MC), plus any markup (Pi).  Assuming similar profit margins for online and offline retailers, offline sellers cannot create a viable business by competing with online retailers on price.  Rather, offline sellers must create enough added value relative to online sellers, so as to cover the fixed cost and transportation costs components in the price buyers pay, plus any added costs associated with the creation of the extra value. 

[3] Access

Since etailers are generally available to buyers around the clock, offline retailers will have trouble competing with online retails with respect to store access.

[4] Organization/Ease of Navigation

The proper web design can make finding an item in an online store very easy to do, especially when there’s a well-designed search function on the site.  On the other hand, even the most well-organized offline stores require consumers to physically walk to the place in the store in which the items they’re looking for are located. And for larger stores, this can be a bit burdensome.  Offline sellers might take a cue from online vendors by providing small kiosks in strategic locations throughout the store, where consumers can type in a product they’re looking for and be instantly directed to its physical location in the store. 

[5] Product Assortment, Brands, Complementary Products

Due to the lower costs of inventory associated with online sales, online sellers have generally been able to offer superior product assortments than offline retailers.  This is the idea behind the much discussed Long Tail of the Internet proposition.

Contributors to discussions regarding offline vs. online competition have suggested that offline retailers compete with online retailers in product offerings by providing specialty, niche, or complementary products and services.  See, for example, “Niche Experts In Your Neighborhood: 4 Keys to Brick-and-Mortar Success” by Susan Friedmann. However, I’m not convinced.  Most complementary offerings or niche offerings by offline businesses, such as products catering to local tastes, can be reproduced by online competitors, unless the offline business has special access to, or proprietary rights over, the complementary offering.

Also, regarding complementary items, the tremendous evolution of online algorithms developed by Amazon (“people who bought that also bought this”) and Netflix ("people who enjoyed that also enjoyed this”), for example, are superior to most recommendations that all but the most knowledgeable salespeople can make in offline stores.

Regarding proprietary rights, many stores have recently either introduced or emphasized store brands or proprietary products or services as a means of differentiating themselves from their competitors.  But in either of those cases, I wouldn’t attribute the seller’s advantage to product assortment, per se, but rather to the fact that they have proprietary rights. And in that case, sellers’ ability to differentiate their products or services doesn’t relate to the issue of online vs. offline competition.

[6] Pre-Purchase Support

See item [14] below for a discussion regarding personalization.

While offline stores can provide product brochures and knowledgeable salespeople, etailers can provide product brochures and descriptions, side-by-side comparisons, product reviews, and customer feedback.  As far as general product information is concerned, it’s difficult for offline stores to outdo online vendors. 

[7] Ease of Transaction

Again, with no waiting in line and 1-click or few-click ordering in online stores, it’s difficult for offline sellers to compete with online sellers. 

[8] Externalities

The growing influence of online communities serve to provide associated providers with tremendous advantages over offline providers in the form of network externalities.

From “Competing Across Technology-Differentiated Channels: The Impact of Network Externalities and Switching Costs” by Siva Viswanathan:

Technological capabilities such as interactivity and real-time communications enable the creation of virtual communities and networks. In particular, brand-based online communities including those in health-care and online gaming have witnessed a significant growth in recent years, while firms like Amazon.com have leveraged their customer base to add value through user ratings, reviews and feedback. These user communities generate significant direct as well as indirect network externalities. The offline channel, offers much less scope for such community building, and consequently, a much lower possibility for the creation of network externalities.

Offerings with neither Online nor Offline Advantage

[9] Post-Purchase Support

Quick and easy return policies are perhaps the most generally important aspect of post-purchase support. Both offline and online retailers have learned the importance of, and are now offering, easy return policies for consumers. From “Returns of Online Holiday Gifts to Hit Record” by Phil Wahba and Alistair Barr:

It's expensive for retailers to take back products they have already sold, check they are still in good condition, repackage them and integrate them back into inventory for resale…

But retailers have found that easier returns policies, online or off, can be good business.

Additionally, both offline and online retailers can offer product warranties and product training (offline, online, interactive, etc.) (see also items [13] regarding personalization below).

Offline stores do have the advantage of offering installation, which can provide considerable advantage in some cases, for example, for large consumer appliances. 

[10] Switching Costs

Both online and offline retailers have similar abilities to reduce competition with rivals by creating switching costs for their consumers. From “Competing Across Technology-Differentiated Channels: The Impact of Network Externalities and Switching Costs” by Siva Viswanathan:

Switching costs include transaction costs, learning costs, psychological costs including ‘brand-loyalty’ and ‘frequent-flyer’ programs. ‘Community effects’. ‘personalized’ offerings, as well as uncertainty in product quality also introduce substantial switching costs for online consumers. In addition, there may be costs of subscribing to a competitor’s offerings as well as forgoing the benefits that accrue from learning effects for firms providing personalized services. These switching costs make it unattractive for consumers to switch to a rival firm, thereby enabling firms to ‘lock-in’ consumers.

Offerings with Offline Advantages

[11] Ambiance/Sensory Experience

From Designing for Persuasion: Creating Dynamic, Multi – Sensory Experiences for Customer Delight by Krishnesh Mehta:

In today’s fast changing and fiercely competitive world, a product, an ad or an ambience has to offer a high quality, fascinating, and alluring experience to attract customers, as in case of showrooms, advertisements, road shows, restaurants, hotels, theme parks, brands, web sites, software interfaces, etc…

Any given business interacts with their customers through their products, spaces, services, its people, et al which has been termed above and here as interface. Each interface creates or develops a unique ambience. This ambience is defined by and made up of:

1. Permanent elements like the product structure, furniture, exhibits, ornamentation etc.

2. Sensorial stimulants like ambient light, sounds, smells, air circulation, (the clothes, the smile etc. in case of people)

While Mehta mentions providing special ambiance for online sites, most people would agree that there is greater potential for stimulating the senses in offline, as opposed to online, stores.

One particular advantage offline stores have is the ability to enable customers to touch, taste (food), try on (clothes), or play with (electronics, toys) the product. Offline retailers will have a greater advantage over etailers in selling any product for which touching, smelling, or tasting provides a significant amount of information to consumers about the nature or quality of the product.

Additionally, as Mehta mentions, the ability of offline stores to delight consumers with “Permanent elements like the product structure, furniture, exhibits, ornamentation etc. [or] sensorial stimulants like ambient light, sounds, smells, air circulation” may also provide consumers with added value in their shopping experience relative to that provided by etailers. 

[12] Delivery

The fact that consumers can take immediate possession of product purchased from offline retailers, while online buyers must wait for the product to be delivered, is one of the defining elements of offline vs. online competition.

Start-up companies have tried to offer same-day delivery, the latest being Postmates, but none of them have yet been successful.  From “Bid for Same-Day Delivery Taps the Smartphone Boom” by Amir Efrati:

Numerous start-ups have tried to go after the Holy Grail of e-commerce—delivering things to people's homes and offices on the same day they ordered them—and have failed.

Postmates Inc., a San Francisco Internet start-up that launched its same-day delivery service in December, is hoping to succeed by tying its business to the proliferation of smartphones.

"We want to do for intracity commerce what FedEx did for overnight shipping across the country," says Postmates Chief Executive Bastian Lehmann. "We're definitely not blind" to the history of failed delivery start-ups, he says, "but we're not afraid."

Offline retailers that can create value for consumers by catering to their desires for immediate gratification will have a significant advantage over etailers.

[13] Personalization

Online sellers can tailor the shopping experience to meet particular consumer needs, but only to a certain extent.  There’s still no substitute for face-to-face, personal, fully-tailored services.  In particular, when shopping online, consumers generally must either present well-defined queries, and/or they must choose from the options presented.  There’s no room for vagaries or open-ended questions, both of which are possible with human interaction in actual stores.

To the extent that people don’t know or have a good idea about what they want, and/or they don’t know what they don’t know (and thus can’t inquire well enough to satisfy the needs of a virtual website), offline stores will have an advantage over online sites.

To the extent that people are idiosyncratic and/or have special or unique needs, offline stores will have an advantage over online sites.

Offline personalization can apply to

• pre-purchase support (knowledge, recommendations, salesmen’s knacks for knowing which questions to ask or having special talents for matching products with particular body types or preferences),

• exchange transaction (tailored payment process), or

• post-purchase support (delivery, installation, training, support). 

[14] Risk / Security

The risks associated with buying a product online include:

• The possibility that the product ordered by the consumer is never received from the seller (fraud, miscommunication);

• The possibility that the product received by the consumer is not like the product described on the seller’s website or is otherwise not as that expected by the consumer (fraud, counterfeit, misrepresentation, misinterpretation); and/or

• The possibility that the consumers’ information (preferences, ID, credit card information) will be used by someone in the company or by a hacker who breaks into the company’s database to commit fraud.

As Erik Brynjolfsson and Michael D. Smith state in “Frictionless Commerce? A Comparison of Internet and Conventional Retailers”:

[W]hile the importance of factors such as search costs may be reduced on the Internet, factors such as trust may play an enhanced role because of the spatial and temporal separation between buyer, seller, and product on the Internet.

Various methods have evolved on the Internet to address the issue of trust, such as by establishing online reputations for honesty and quality (Amazon, Netflix), by transferring offline reputations to online stores (Wal-Mart, Macy’s), by providing buyer feedback and ratings (Amazon, eBay), and by indemnifying buyers from credit card theft (Visa, Mastercard).

However, as discussed in [11] Ambiance/Sensory Experience above, for many products, there is no substitute for experiencing them in person and taking immediate delivery. 

[15] Value / Bulk of Transaction

From Zhu Wang, “Technological Innovation and Market Turbulence: The Dot-com Experience”:

Exploring the synergy between online and offine channels reveals that a click-and- mortar bank typically delivers standardized, low-value-added transactions such as bill payments, balance inquiries, account transfers and credit card lending through the inexpensive internet channel, while delivering specialized, high-value-added transactions such as small business lending, personal trust services and investment banking through the more expensive branch channel. By providing more service options to its customers, a click-and-mortar bank is able to retain its most profitable customers and generate more revenue from cross-selling.

Wang’s statement refers to how “click-and-mortar” (online-offline hybrid) stores can effectively segment their offerings in-store and on-line to take advantage of each channel’s strengths.  However, the concept of creating a channel advantage by focusing on offerings particularly well-suited to that channel also applies to pure-play offline and online retailers.

In particular, offerings that

• Are custom-tailored to meet particular buyers’ needs,

• entail more risk or require more trust, i.e., high value transactions, or

• are heavy, bulky, fragile, or perishable, and would thus be expensive to transport

are particularly well-suited to offline channels. 

Conclusions

A recent article posted in DailyFinance received a lot of press. Rick Aristotle Munarriz listed “5 Big Retail Chains That Will Be Gone in 5 Years”:

1. Barnes & Noble
2. Sears Holdings (Sears and K-Mart)
3. Best Buy
4. Radio Shack
5. Game Stop

With the exception of Sears large appliances, all five of these retailers provide mass-produced, relatively homogeneous products that don’t require any customization to meet buyers’ needs.  Furthermore, none of these retailers is known for providing excellent customer service.  In short, none of these stores provide a unique value-proposition for buyers.

In conclusion, I think the defining characteristics of offline (or hybrid) retailers that continue to thrive in the Internet Age include

• Powerful sensory experiences;
• Products whose nature or quality can be easily misrepresented or otherwise must be experienced in person;
• Products consumers want to use or consume immediately;
• Products and services that are highly customized to meet individual and idiosyncratic needs of consumers; and/or
• Transactions involving high value, high risk, bulky, fragile, or perishable products or services

In contrast, offline retailers who provide the following types of products and services will find their businesses increasingly jeopardized by online competitors:

• Products that are mass produced, relatively homogeneous or standardized, and/or appeal to repeat buyers;
• Products that are cheap, small, durable, and/or lightweight; and/or
• Products for which user communities play a large role.