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140 E L E C T R O N I C C O M M E R C E

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From retailing to
e-tailing
John D. Calkins, Michael J. Farello, and Christiana Smith Shi

Internet pure plays may have won the first round of Internet
retailing, but there is every reason to believe that store-based
retailers will give them a run for their money.

S tore-based retailers, alerted by analysts’ predictions that on-line

retail sales could account for as much as 10 percent of total US retail
sales by 2003, are joining the rush to the Internet. As yet, these store-
connected World Wide Web sites generate only trivial revenue. Many have
suggested that the game has emphatically gone to pure Internet plays such
as Amazon.com and eToys.com.

In fact, however, store-based retailers have a number of advantages over their

Internet-only competitors, which can offer personalized search tools and
links to related products and services but not the ability to see, touch, and
try merchandise and to walk out with it. More generally, store-based retailers
can leverage their multichannel advantage to give customers what they want,
how and when they want it. So if store-based retailers make their sites as
innovative and adaptable as those of their pure-play Internet rivals and at the
same time realize synergies with their brick-and-mortar facilities, they may
yet come in first after all.

Choose a winning business model

Building a thriving retail site on the Internet is every bit as hard as creating
an exciting store environment. Like real-world retailers, on-line ones (pure
play or not) must understand customer segments and shopping “occasions.”
But on-line retailers also have to address the complications arising from

John Calkins is a consultant and Christiana Shi is a principal in McKinsey’s Los Angeles office;
Michael Farello is an alumnus of the Chicago office. Copyright © 2000 McKinsey & Company. All
rights reserved.
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PETER BENNETT
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142 T H E M c K I N S E Y Q U A R T E R LY 2 0 0 0 N U M B E R 1

uncertainty about the behavior of Internet customers and the evolution of

competitors’ sites in the future.

To deal with these problems, retailing incumbents moving into the

on-line world must combine the three fundamentals of on-line retailing
(or “e-tailing”) and apply them to the business model that best suits the
company and its category. The first fundamental is content—whatever appears
on the Web site itself and on hot-linked Web sites—for if chosen wisely,
that content can increase both the rate at which browsers are converted
into buyers and their transactions. The second fundamental is community.
Through site-to-user and user-to-user forms of interactivity (such as chat
rooms), Web sites can generate a
EXHIBIT 1
core of dedicated customers who
E-tailing business models become avid marketers of the site.
The third fundamental is commerce,
Channel supporter
whether it involves offering goods
Content • Product and company and services directly or marketing
information—for instance,
AE-Zine on-line magazine those of another company for a fee,
Community • User responses and forums thus helping to cover the fixed costs
• Demographic user groups
American Eagle of site operations and to offset cus-
Outfitters
Commerce • Store referrals tomer acquisition costs.
• Referral to Web site from store

Category killer
These fundamentals can be applied
Content • Book reviews, abstracts to four main emerging e-tailing
• Links to related sites
business models: channel supporter,
Community • Site personalization
• User reviews category killer, auctioneer, and ver-
Commerce • Product sales tical portal (Exhibit 1).
• Out-of-print-book searches
• Outbound e-mail notification
of order status
Channel supporter
Auctioneer

Content • Wide, eclectic selection

• Deep “fad” offering (for
example, Pokémon)
Community • Participant word of mouth
Commerce • Commission on sales
• Advertising
Vertical portal
Content • Analyst opinion, company
information
• Customer account support
Community • Personalization
• User trading groups
Commerce • Schwab and third-party
product sales, referrals,
and content
• Outbound e-mail notification
of trades
Some store retailers use the Internet
more to support their existing chan-
nels than to generate additional
sales. This approach is appropriate
for categories, such as fast food, that
have been slow to move on-line and
for retailers, such as Tiffany, whose
on-line channels may be at a compet-
itive disadvantage to their traditional
ones. American Eagle Outfitters, a
retailer of apparel for teens, uses the
Web to deliver product information
and to share fashion updates through
an on-line magazine (content),
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F R O M R E TA I L I N G T O E - TA I L I N G 143

to offer user forums (community), and to sell an expanded range of prod-

ucts—for instance, bicycles and snowboards—and to refer customers to
stores (commerce).

Beyond cross-channel promotions, many brick-and-mortar companies use

the Web to increase their customers’ understanding of their products and
services. Others harness the Web’s interactivity to improve their product
development and product mixes by inviting customer responses on their Web
sites and feeding those responses back into buying decisions at the store.

Category killer
Amazon, which began life as a bookseller, is the quintessential on-line
example of the category killer approach, in which the retailer dominates
a particular category of merchandise. By now, Amazon has evolved into a
multicategory killer, and in every category the company has entered—music,
videos, toys, and consumer electronics—it has blended content, community,
and commerce by offering an extensive assortment of products supported
by user reviews and information tailored to individuals.

The purchasing power and brand recognition of incumbent retailers make

the category killer model in many ways the ideal choice for them: it leverages
their strengths more than the other options do, and these are strengths the
on-line competition must still acquire.

Auctioneer
Led by eBay, a number of companies are achieving success as on-line auction-
eers. Sellers of goods and services provide the content; community comes
from matching sellers with buyers and setting bidder against bidder; and
commissions on sales and advertising revenue generate the commerce. eBay’s
sheer level of presence has made consumer-to-consumer auctions the norm,
but business-to-business possibilities abound as well. In reverse auctions, for
example, a retailer puts out bids for tender on its Web site, thus expanding
its universe of lower-cost suppliers. And the Internet’s unparalleled access
to motivated buyers allows businesses to dispose of discontinued or excess
inventory from their shops or warehouses at the best possible prices.

Vertical portal
The business model that may take greatest advantage of the Internet is the
so-called vertical portal, which specializes in a particular industry or product
category but, like Yahoo!, also offers personalized information and advice as
well as access to a community with common interests. The Charles Schwab
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144 T H E M c K I N S E Y Q U A R T E R LY 2 0 0 0 N U M B E R 1

site is one example; another is boo.com, which seeks to become the one-stop
fashion portal for hip 20- to 30-year-olds. Store-based retailers that use cus-
tomer data adroitly and have brands the public trusts are in a good position
to build demand for well-targeted new businesses and to attract to their por-
tals customers who use more than one channel.

A new economics of e-business

To be successful on the Internet, incumbent retailers will have to do more
than reproduce their off-line business models on-line, because these business
models work only at considerable scale. Scale is certainly one route to prof-
itability. Our own analysis suggests that an on-line computer retailer, for
example, whose sales expand to $1 billion a year, from $100 million, moves
from a loss of 3 percent return on
EXHIBIT 2
sales to a profit of 9 percent. These
Impact of scale: Clothing figures hold true for product cate-
Targeting $100 million in Targeting $1 billion in gories with smaller average transac-
on-line sales by Year 5 on-line sales by Year 5
tion sizes, such as toys, sporting
Net present value, Cumulative earnings Ongoing operating
$ million before breakeven margin, percent goods, and do-it-yourself equipment,
point,1 $ million 8
250 6 as well as, to a lesser degree, for
–400 –65 –170 groceries and clothing (Exhibit 2).1

1 But the margin for error is small.

Breakeven point is defined as positive free cash flow.
Source: McKinsey softlines Internet retailing economic model
A 10 percent decline in the size of
average transactions or an increase
of 8 percentage points in annual customer churn would eliminate the profit
margin of typical traditional apparel store retailers. Internet sales projections
suggest that few retailers will sell $1 billion of merchandise on-line each year.

Even so, it is possible for an on-line operation to be profitable at far lower

sales volumes if it exploits seven levers. Some merely bring on-line efficien-
cies to traditional retailing; others exploit synergies between on-line and
store operations; while still others give an incumbent retailer with an on-
line presence an enormous advantage over pure-play Internet retailers. It
isn’t necessary to pull all seven levers perfectly; small improvements in key
measures can make a great deal of difference (Exhibit 3).

Exploiting two channels to close one transaction

First, the Web offers customers two channels for closing transactions.
Early winners on the Web belong to an exclusive club of Internet start-up
1
Clothing retailers gain only a two-point operating-profit advantage from scale if they expand to $1 billion in
sales, from $100 million, but that is enough to make the difference between a positive and a negative
return on investment.
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F R O M R E TA I L I N G T O E - TA I L I N G 145

companies, but established retailers could catch up and even overtake

them by offering a choice of channels. Gap has tested a scheme giving
customers an opportunity to preview and order goods on-line and then
to pick them up at its stores. Barnes & Noble permits customers to search
on-line for books that are not available in its shops, including titles no
longer in print, which it can then often provide from its own or its affili-
ates’ inventory.

Maximizing the value of the whole transaction

The power of the double-channel model is apparent from the discovery by
one store-based UK retailer that customers who buy both on- and off-line
have increased their total purchases by 10 percent. The incumbent retailers
that have done the best job of propelling themselves into the world of elec-
tronic commerce can boast on-line purchases that exceed the average off-line
purchase by as much as 20 percent. Similarly—and intriguingly—the trans-
actions of customers who use the Internet to purchase products in response
to print and catalog advertising by store-based retailers are 30 percent larger
than those of customers responding to on-line ads. Premium products, the
bundling of products and services, and cross-selling all contribute to these
higher average-transaction sizes.

Leveraging low customer acquisition costs

Traditional store-based retailers can use the Internet to exploit the fact
that they have to spend somewhat less than $5 a head to bring their
existing customers on-
EXHIBIT 3
line, whereas Internet
start-up companies Levers shape economics
must lay out an average
Impact of beneficial 10% lever change
of $45 a head to attract Levers1 on net present value,2 $ million
customers wholly from Exploiting two channels
0 5 10 15 20 25 30
to close one transaction
scratch. Furthermore,
Maximizing the value of Revenue per
the print and catalog the whole transaction transaction, $
advertising, mentioned Leveraging low customer Transactions
acquisition costs per customer
above, that appears to Fulfillment cost
Exploiting alternative
generate 30 percent revenue streams per transaction, $
Customer
higher on-line purchase Purchasing scale acquisition cost, $
at low volumes
activity costs the Cost of goods
Minimizing customer sold, $
store-based retailers churn
Customer churn,
virtually no increment Maximizing pricing percent
potential
at all over the money
1
For store-based retailers.
they are already 2
Base case net present value = 0.
Source: McKinsey softlines Internet retailing economic model
spending.
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146 T H E M c K I N S E Y Q U A R T E R LY 2 0 0 0 N U M B E R 1

Exploiting alternative revenue streams

An on-line presence offers retailers a wider
variety of sales opportunities. Many Web sites
also sell advertising space on their sites. Peapod,
a Web-based grocery service, generates more
than $1 million a year from sharing customer
purchase data with interested vendors. For Web-based
retailers, acting as an agent on behalf of customers could become a
revenue source in the future.

Purchasing scale at low volumes

Some retailers have been able to cut their purchasing costs by up to 20 per-
cent and to shorten their procurement cycles by as much as 50 percent.
They have done so by replacing electronic-data-interchange (EDI) tools with
Internet-based ones that facilitate product comparisons, streamline logistics,
and help business-to-business vendors, such as FreeMarkets and TPN
Register, aggregate these retailers’ back-office purchases.

Keeping down customer churn

Given the high cost of replacing established customers, losing them is expen-
sive. A Web presence supplies the personalized attention that could keep
consumers loyal—though even some of the most successful e-tailers have
acknowledged that working out operational kinks has, for the time being,
taken precedence. E-tailers should transcend the usual imperatives of direct
marketing (frequent high-sales, low-content marketing pieces) and build
trust by providing information on the product and customer experience, as
well as easy links to advisers, complementary vendors, and other customers.

Maximizing the pricing potential

Too many retailers believe that they must sacrifice the possibility of pricing
up when they go on the Internet, a supposedly price-transparent medium.
In fact, prices vary widely on-line. A 3Com Palm Pilot recently retailed for
$399 at Insight.com, for $299 at circuitcity.com, and for $269 at BUY.COM.
BizRate.com, an Internet consumer research company, found that buyers
shop on-line more for convenience than for cost and that only 20 percent
of on-line shoppers use “bots” (automatic-shopping agents) or other search
engines to secure the lowest price. Another 20 percent simply buy at the first
site that has what they want. In view of this relative indifference to price,
e-tailers should work aggressively to capture some margin premium, at least
in the early days of their sites.
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Consider a carve-out
While the correct use of the seven levers should be enough to catapult
any on-line retail operation into the realm of higher profits, traditional
retailers taking their first steps on the Internet may yet suffer from
cultural stress. Their struggle to keep up with fashion trends has not
equipped them to move at anything like Internet speed, nor do they have
experience building alliances. And while the top executives of a pure
Internet company can focus solely on e-commerce, their counterparts at
a traditional retailer too often want to pay only fitful, grudging attention
to it —at least until the distant time when increased volume starts to
deliver higher returns.

To promote speed and innovation unconstrained by such factors, retailers

should consider carving out their e-tailing organizations into independent
entities in which they retain equity stakes.2 The new companies should have
the full attention of the former parent’s CEO, who must show leadership,
support, and patience in the face of often substantial losses that might well
last for at least the first two years.

Moreover, such new companies should be judged by performance metrics

other than earnings. During the lengthy period before profitability, incre-
mental funding decisions must be based on indicators of the e-tailing busi-
ness’s health. These include customer conversion rates (from “lookers” to
“bookers”), customer acquisition costs, repeat purchase rates, and external
site recommendations.

Finally, a successful new e-tailing venture must have an entrepreneurial

culture. The excitement of building something new can itself energize
employees to take risks. But all employees have heard stories about how
struggling start-ups made fortunes for the people who contributed to
their successes. In e-tailing businesses, the currency of the Web is equity.

Few store-based retailers can afford to ignore the Internet’s growth poten-
tial— or to spend the next five years losing money chasing on-line oppor-
tunities that might or might not realize their potential. An on-line business
strategy that depends on synergistic skill rather than scale will permit
such retailers to pull ahead of both their land-based and their on-line
competitors.

2
See Patricia L. Anslinger, Steven J. Klepper, and Somu Subramaniam, “Breaking up is good to do,”
The McKinsey Quarterly, 1999 Number 1, pp. 16–27.