Why offline retailers fail at online marketplaces

Once upon a time, retailers invested in large swathes of land, arranged aisles with the choicest of products, and built a fortune serving suburbia.

Then Amazon happened!

Over the past two decades, as Amazon has increasingly eaten retail with transaction economics that don’t make sense, retailers have constantly looked for ways to beat Amazon at its game.

Or, at least, get a hang of playing that game in the first place.

During this time, a range of consultants, tool providers, and transformation experts emerged with one common advice:

“In the age of Amazon, offline retailers need to become online marketplaces. Benefit from infinite shelf space and scale with network effects.”

Sounds enticing!

And yet, most offline retailers fail at running online marketplaces.

The promise of network effects comes with seductive lies that sound true but aren’t quite.

This is the first of a series of posts unpacking the seductive lies of network effects.

Let’s dig into this one!

The lazy logic of distribution advantage

Here’s the network effect playbook that consultants and marketplace Saas providers repeatedly offer retailers:

1. You’ve got a huge customer base but you don’t carry everything they want
2. Move online, get infinite shelf space, and open out to third party merchants
3. You now play across many more categories with this open marketplace model and can increase share of customer wallet
4. But here’s the real kicker, you now scale through network effects: the more merchants you bring on board, the more value for consumers, the more consumers spend, the more merchants want to come in
5. Sit back and let the network effect grow your marketplace sales

Sounds easy!

But this almost never plays out as promised here.

This line of reasoning assumes that you can use your access to customers to kickstart a network effects flywheel, which will eventually scale your access to customers even further.

To understand the flaw with this reasoning, let’s step back and look at how this plays out for Amazon.

The half-truth of the Amazon flywheel

What is the real source of competitive edge in online commerce?

There is a common myth that the sole reason e-commerce marketplaces win is the network effect created through inventory aggregation.

The larger the scale and scope of inventory, the greater the choice for consumers, the higher the network effect.

The famous Amazon flywheel visual perpetuates this further.

 

This begs the question – Why can’t Walmart, Target, Macy’s and every other retailer run the same flywheel?

They’ve got the selection, they can operate a great cost structure, they can even bring third party merchants onboard.

What gives?

This flywheel tells only one half of the story.

Will the real Amazon flywheel please stand up?

The bigger reason offline retailers fail at online commerce is their inability to profitably manage fulfilment, returns, and dispute resolution. These are the three factors that determine transaction economics.

First, managing fulfilment to the home requires management of 70 different use cases (leave it with my neighbour, use my smart lock, don’t play with my dog, the works…) as compared to store-based fulfilment.

This involves a fundamentally different supply chain.

Offline retailers struggle because their distribution centres and supply chains are geared towards in-store fulfilment, which involves far fewer – and more static – use cases.

Serving

• 40 stores
• with predictable assortment needs
• through 2-3 distribution centers

is orders of magnitude less complex than serving

• millions of consumer homes
• with unpredictable and ever-changing buying behavior
• and expectations of same-day or two-day delivery

Second, fulfilment, returns, and dispute resolution cannot be delivered at scale without supply chain data gathered through vertical integration from the warehouse to the home.

None of the traditional retailers have supply chains geared towards this.

The real reason offline retailers can’t even get into the playing field – ironically – isn’t so much the network effect.

It is the fact that they have far less vertical integration across supply chain data.

In particular, they lack demand-side data integration.

Ironic – given that we’ve spent so much time crafting the narrative that offline retailers would win if only they could move from being a retailer to being a marketplace.

And that brings us to the real Amazon flywheel – the one that no one tells you about. Because the half-flywheel looks insightful enough to go viral.

 

Why demand-side data integration matters

Now that you’ve shared this article further, let’s get back to the flywheel for a bit.

The crucial component here is demand-side data.

 

Demand-side data informs the entire supply chain.

Why is demand-side data integration so important to a successful supply chain play?

To understand this, let’s look at another online commerce player that defeated an offline incumbent through the sheer brilliance of its supply chain: Netflix.

If 2012 feels like ancient history, it’s worth calling out at this point that long before Netflix became the online streaming giant that it is today, it was a DVD rental startup delivering DVDs to doorsteps across the US. Blockbuster – the appropriately named incumbent – was the 800 pound gorilla that no one could unseat.

And yet Netflix did, in record quick time.

I’ve written about this in an earlier post:

You could argue that there were many things that drove Netflix’s success in the DVD rental business. But the one thing that Blockbuster could never compete with was the integration of demand-side queuing data (users would add movies that they wanted to watch next into a queue) with a national-scale logistics system. All this queueing data aggregated at a national scale informed Netflix on upcoming demand for DVDs across the country.

Blockbuster could only serve users based on DVD inventory available at a local store. This resulted in:

1) low availability of some titles ( local demand > local supply), and

2) low utilization of other titles (local supply > local demand).

Netflix, on the other hand, could move DVDs to different parts of the US based on where users were queueing those titles. This resulted in higher availability while also having fewer titles idle at any point.

Queueing data improved stocking and resulted in higher utilization and higher availability. It allowed Netflix to serve local demand using national-scale inventory.

Traditional supply chains need to manage the trade-off between utilization and availability.

But the ability to predict demand solves this trade-off and informs stocking and logistics.

This is why offline retailers struggle despite access to a customer base.

The seductive flywheel of Netflix

In other words, this is the seductive flywheel that you would normally associate with Netflix’s DVD business:

But this doesn’t explain why the incumbent loses.

Blockbuster could do all this much better… and more…

That’s because the full flywheel looks something closer to this.

 

Notice the red arrows that I’ve thrown in there? Those are the two arrows that make all the difference.

One arrow ensures high availability of DVDs locally, the other arrow ensures high utilization of DVDs at national scale.

There was no way for Blockbuster to compete with Netflix within the framework of local inventory – local fulfilment. Netflix fundamentally changed that framework.

 

And yet, you could run an entire class on network effects or go viral on YouTube if you only shared the first flywheel.

Why are these incorrect flywheels so seductive?

Because people want simple answers. And a flywheel that brings together obvious components is easy to relate to. The role of demand-side data in informing supply chain flexibility is non-obvious and more difficult to fully appreciate.