Chicago is a good town for seminars, conferences and conventions. Several times a year I attend those of interest. Recently, I attended a conference for B2B e-commerce. Sponsored by a litany of software firms in the space, the attendee roster was a who’s who of Billion Dollar wholesalers and manufacturers. The presentations and panel discussions were slick and high level touting the expertise and experience of the sponsors and their clients.
I calmly sat in the presentations, done by new age techie types replete with skinny designer jeans, designer eyeglasses and neon footwear. I soon realized any meaningful, detailed, empirically-validated discussion of most of the subjects was not going to happen and looked forward to the breaks where I could network and salvage at least part of the registration fee. Far too many of the presenters relied on their expertise in B2C markets and did not offer a good defense of why B2B markets are vastly different and customer demands are much more extreme.
It was all too obvious that their expertise was in B2C and their understanding of the fundamentals of B2B supply chain economics was questionable. I felt that the panel discussions, involving wholesalers and manufacturers who had actually done the work, would be more enlightening, but I was wrong. Time and time again, the moderator asked participants how they measured profitability with their e-commerce efforts. And, time and time again, the answer(s) forthcoming lacked clarity and believability. The fact that these companies invested millions in their e-commerce efforts and had no clear and satisfying answer if said investments yielded an acceptable profit was more than disappointing. Well-paid and highly educated executives blew the question and it was obvious that they lacked good measures for their efforts.
Net profit of the transaction
During the second day of the conference, attendees went to breakout sessions. The session I attended was presented by a veteran of e-commerce who had been in B2B markets for the better part of two decades. When asked by a large wholesaler how one should measure the profitability of e-commerce efforts, he calmly responded, “by the net contribution of the transactions.”
After the break-out session, I sought out the presenter and talked to him a bit about my disappointment at the answers given by IT execs regarding the profitability and financial measures of their efforts. He was not surprised that the answers were poor. His experience was that most B2B firms don’t know how to accurately measure the profitability of their e-commerce efforts.
Too often they relied on standard financial accounting allocations and assumptions of profitability without specific and suitable measures regarding the profitability of individual transactions. Without these measures, most companies had only the vaguest idea if their significant investments in e-commerce were profitable. Furthermore, some companies had allocations based on standard accounting measures but there was tacit admission that these measures were not accurate.
E-commerce and e-business efforts, including EDI, can have a significant impact on the profitability of the firm. In a buy/sell supply chain business such as wholesale distribution, the significant cost of investment in software and people to develop an e-business platform demands an acceptable ROI. Getting to an ROI, however, is not as easy as it looks and standard accounting and allocations don’t cut the mustard.
Measuring e-commerce ROI
E-commerce is financially attractive because it allows solicitation and customer service at a low cost. Customers don’t necessarily need a full outside and inside sales effort to process the order. Taking these costs out of the order can both lower the channel cost-to-serve and increase the net profit.
Crucial to understanding how e-commerce impacts profitability is the use of an acceptable allocation method of service costs to the transaction. In the B2B supply chain, there are numerous transaction types including stock orders, non-stock orders, drop shipments and customer pick-up.
Along with these orders are varying levels of sales, accounting and warranty service. We typically have 14 to 20 different transactions that we model for wholesalers and each one has differing costs. Without this detailed modeling, it is impossible to know if a transaction, of any type, makes money to the operating profit line.
Unlike manufacturing cost accounting, distributor transaction costs do not have direct labor and direct overhead cost components in the gross margin calculation. These costs are located below the gross margin line in operating expenses and to understand if e-commerce investments and transactions are profitable, service labor and direct overhead costs have to be allocated to understand the e-commerce ROI.
Our work in cost allocations finds that e-commerce transactions are significantly less costly than full sales supported orders. Variances of $50 to $75+ less than full sales supported transactions are common in e-commerce orders. However, there are also problems with e-commerce strategies when it comes to profitability of overall e-commerce efforts.
For example, suppose that Big Wholesaler has full sales supported transaction costs of $100 for a stock order and the e-commerce (non-sales supported) stock order has a transaction cost of $40. If Big Wholesaler operates on a 20% gross margin, the stock order would have to be $500 to break-even versus $200 for the e-commerce order.
However, after a year of e-commerce solicitation, Big Wholesaler finds that e-commerce had caused small stock orders of $100 to explode from 5,000 to 15,000 in number. In essence the “reach” of the e-commerce site and web marketing efforts gathered a significant increase in small, non-specific customers who purchase small orders. The net effect of these orders is that they lose $200,000 ($20 loss per order X 10,000 orders).
Furthermore, the more profitable, often larger customers have to pick up this loss as they pay for the capacity drain of the smaller customers. Without accurate transaction-based allocations, it is literally impossible to know if e-commerce efforts are profitable.
Financial prerequisites for e-commerce investment
The Chicago Conference was awash with presenters touting that e-commerce improved average order value or (AOV). Unfortunately, in the distribution supply chain, there is no real, actionable entity such as AOV. Averaging 14-22 transaction types to compute their sales and margins may be arithmetically convenient, but the exercise is a misleading construct.
Transactions have different cost profiles and, to measure them correctly, individual profiles should be used for accuracy and believability. Some wholesalers have made entirely new low-cost models by concentrating on a handful of low-cost transactions.
Our recommendations for wholesalers who engage in e-commerce efforts are to have a well-documented logic for costing transactions and determining the cost differences between them. We’ve listed the financial prerequisites for evaluating e-commerce efforts below:
- Understand the discrete costs of differing transactions including e-commerce.
- Use the transaction costs and mix of transactions in a time period to model the profitability of the e-commerce effort. Consider a NPV analysis placing e-commerce development costs in the early years and measuring their yield over the course of 3-5 years.
- Consider the effects of labor capacity and Robert Kaplan’s rules on accurate cost allocations (see our White Paper: “Follow the Value Streams”.)
- Move small orders and small customers to e-commerce transactions early and keep up the pressure to convert them to a non-sales supported relationship.
- Monitor non-specific new buyers who use your site as a specialty supplier. Make sure their transaction size is covering fulfillment cost(s).
These steps should help. There is no excuse for undergoing major investments in e-commerce software, specialists and content development without a good understanding of the ROI of the project. In the distribution space, standard financial accounting and allocations based on sales or gross margins are poor tools to measure the ROI of an e-business platform. They are no more predictive than the bare-assed ape throwing darts at the Journal’s stock page to assess future picks.
Because of the variance in different transactions and their cost(s) in the B2B supply chain, transaction costs that cover variables of order type, sales support, shipping method and post sales support are a logic that works well for assessing if an e-commerce effort is contributing to the operating profit of the firm. Firms that undergo this level of investment and detail will find their understanding and future ability to drive a profitable e-commerce platform to be far superior over existing efforts based on traditional accounting allocations.