Online Food Retailing (2000)

Home > About Us > Online Food Retailing article

Goals and Motivation

This article on Online Food Retailing is written with three distinctive goals in mind:
1. To prevent new companies from going bankrupt in an early stage.
2. To demonstrate Internet opportunities for existing "brick and mortar" companies.
3. To show how cost/profit modeling is used to develop an effective e-business plan.

My motivation for writing this article is based on the analysis of five commercially successful and five commercially failing online retailers in different business sectors. I also have personal experience as interim wholesale director and supplier to a very well run but failing online food business.

Management Summary

Success of Online Food Retailing (Online Grocery Shopping) depends on two key issues: market potential and distribution costs. These key issues are interdependent. If market potential is high, distribution costs are moderately high. If market potential is low, distribution costs are extremely high. Because market potential appears to be low, online food retailers try to gain market share by lowering consumer prices (and margins). Result is a low margin operation with extremely high operating costs; the ultimate nightmare of every entrepreneur.
It is challenging to develop the exception to this rule and a solution to this dilemma.

The first solution is niche marketing: a focus on a small, affluent and service oriented consumer group. The second solution is a focus on margin rich products, that sell well on the internet. The third solution is a focus on information distribution.

These solutions can be combined into a powerful Internet strategy, that increases competitive advantage of any existing business. This strategy should be executed in an excellent way. There are many pitfalls and a number of critical success factors. These success factors cover the entire marketing mix, the logistic system, information technology and internal organization.

The Strong Market Position of Traditional Food Retailing

Some major e-commerce consultants were very optimistic about the market potential of Online Food Retailing. Andersen Consulting used to predict a market share of Online Food Retailing of 20 % in the year 2003. These figures are used by Peapod.com to explain its potential, and by Webvan.com as the foundation of a nationwide investment program of nearly one billion US$.
Cap Gemini was even prepared to predict a percentage between 30 and 40 %, but the influential Verdict Research tuned the market potential of online retailing down to 3 % in 2004 for the total retail sector and only 2.33 % for the grocery sector.

Fact is that beginning of the year 2000 the online food market in the USA and in Europe is less than 0.2 % of total food sales. Potential for the next five years is not more than 3 - 5 % in the USA and not more than 2.5 - 4 % in most countries of Europe.

There are four good reasons why Online Food Retailing will never become popular by real consumers. Home-shopping of food is no fun, it adds complexity to your lifestyle and it is more expensive than buying at the supermarket. On top of those disadvantages: traditional supermarkets are fighting for consumer loyalty by improving their marketing mix and increasing their efficiency.

Reason 1. In my view online shopping for dry groceries and perishables is boring. It does not even come close to the fun of buying books at Amazon.com or the joy of  assembling your own PC at Dell.com. There is absolutely no advantage here over the weekly trip to the supermarket. I dare you to try it yourself a couple of times, and then convince your partner who is not in the food business or consultancy business. Only when the online business focuses on special products and on rich information content, the consumer will become interested and stay interested.

Reason 2. Online shopping is less time consuming than traditional shopping, but it adds complexity to your lifestyle. Let us assume in an optimistic mood that every "household manager" will master the skill of shopping online. After ordering online you first have to make sure that the goods are properly received at home. Second you often have to go to the store anyway for miscellaneous articles. Third you have to check proper billing and payment. Fourth you have to follow up on order-picking mistakes and delivery errors.

Reason 3. The distribution costs of home-shopping are twice as high as the costs of traditional food retailing, and most consumers are not willing to pay the extra 15 %. Internet startups will first try to gain market share with low prices and low service fees, but when the shareholders cash is consumed they will have to ask higher than "normal" prices to cover the costs and survive. Of course their is a small niche market for expensive home-shopping services: affluent PC-minded and service oriented consumers and consumers with no easy access to a nearby store.

Reason 4. In recent years Efficient Consumer Response and Category Management had a significant and positive impact on quality and efficiency of traditional supermarkets. Food retailing has always been a very competitive business, and in recent years super-marketing has become a professional science that is constantly improving the value to the consumer. Both in the USA and in Europe very competitive stores with Every Day Low Prices and high service levels are gaining market share and are making the food business a war zone for new entrants.

Conclusion: the average consumer does not have a good reason to go food shopping online.

High Distribution Costs of Online Food Retailing

Distribution costs of Online Food Retailing are twice the distribution costs of traditional supermarkets. Traditional channels are extremely efficient, because consumers do most of labor intensive work for the retailer: order-picking in the store and transportation of goods to the home. Costs of  these activities are approximately 10 % of consumer price. Online retailers have to pay well trained and very professional employees to do this work without errors. An additional 5 % of costs are spend on information technology, order management and after sales service. The additional costs are much higher in case of low market penetration or sub standard execution.

There are roughly three scenarios for online food distribution:
1. Distribution from an existing store
2. Direct home delivery from a dedicated central warehouse
3. Home delivery from a central warehouse via satellite stations

Each scenario has its own specific benefits and value chain characteristics. Distribution from an existing store is appropriate for a small online business. Direct home delivery from a dedicated warehouse is appropriate for an online business with a high market share in a medium size densely populated area. Home delivery from a central warehouse via satellite stations is appropriate when the area is larger and the market share is lower.

The next table is an overview of supply chain activities and cost structure of each scenario, including traditional retailing. The figures are costs per activity as a percentage of consumer value. 

Cost/profit analysis by RetailEconomics.
[This cost structure is an indication only. In each country and in every situation the costs per activity will differ. Outsourcing the delivery process to logistics service providers may add efficiency but also increase complexity costs].

Peapod.com is the oldest and best known online food retailer in the USA. Peapod once delivered from local stores, but in 1999 the company switched to direct delivery from central warehouses. In this case the delivery fee changed from US$ 16. (very high) to US$ 8.

In the first 9 months of 1999 turnover was US$ 57.305, excluding additional income of
US$ 14.453. Gross margin was extremely low: 5.9 % of turnover. Distribution cost were exactly 30 % of turnover, in line with the cost/profit analysis table.
Other costs were: marketing and sales (13.2 %), information technology (5.9 %) and other overhead (19.7 %). The result was a loss of 37.6 % of turnover. Note that this is not a recent startup, but that this company has been in business since 1989.

The "about us" section of the website of Peapod.com made a remarkable referral to "industry experts" who predict a 20 % share of online groceries in the year 2003.

This example shows two things very clearly. It proves the fact that distribution costs of Online Food Retailing are very high. But it also shows that in order to gain market share over traditional supermarkets the company has to invest heavily in price reduction and sales promotion. On top of that: overhead costs of Peapod.com exceeded the total distribution-  and store costs of any well managed traditional supermarket chain.

Webvan.com is a new player in the American market. The company planned to develop 26 automated warehouses in populated areas all over the USA. These warehouses would deliver groceries to consumers via satellite stations. The Webvan case is interesting because it is a combination of high investments in buildings and equipment, and high customer service like a 30 minute delivery window.

The very professional "help section" of the Webvan website explained the pricing policy ("prices up to 5 % less than in local grocery stores"), and the product policy of a large and high quality assortment of groceries, perishables and drugstore items. Webvan offered free delivery for orders US$ 50 and over and a delivery fee of US$ 4.95 for orders under US% 50. The handling costs were "50 % less than the grocery industry average".

In my view this combination of high capital investments, extreme customer service, low prices and low delivery fees only stands a chance, if Webvan gains a large share of a substantial online grocery market. The problem is that Webvan has based its business plan on the same optimistic online grocery market estimations as Peapod. If the market share of online grocery retailing will not reach the 20 % level in the year 2003, Webvan will have a serious problem to solve.

Webvan will probably be caught in the same trap of every dedicated online food retailer: reducing the extremely high order fulfillment costs means high turnover; high turnover means low prices and high service; low prices and high service means a very negative bottom line.

The president of Federal Express has declared that the Webvan format is not feasible. This little speech started a downfall of the market capitalization of Webvan from a high level of US$ 8.5 billion in November 1999 to a level of US$ 4.5 billion in January 2000.
However the beauty of this case is that Webvan is able to realize its complete investment plan of nearly 1 billion US$ in a period of four years, using only the interest of its initial market capitalization. This leaves of lot of cash to survive for a very long time.

First Solution: Niche Marketing

"Niche marketing" is focusing the marketing mix on a special target group. This strategy is particularly effective for traditional retailers with a high market share and an affluent customer base. These retailers can develop an online channel as service offering, as market development strategy and as barrier against new entrants. In the USA this would be the recommended approach for successful local chains, in the UK for Tesco and in The Netherlands for Albert Heijn.

A niche online retailer uses its quality image to reach for example 8 to 15 % of their own customers and 6 to 12 % of the rest of the market. They will spend on average 35 % of their grocery shopping online. In this way a company like Albert Heijn has the potential to reach about 10 % of total customers and win 3.5 % of total market share online. In this example the online sales are only cannibalizing 4 % market share (= 15 % of total sales) on the traditional business, but the company gains more than half of the total potential online grocery market.

The niche target group will mainly consist of affluent service oriented double income families, who are willing to pay the extra service fee. The other niche group are consumers who do not have easy access to a supermarket of choice. Every target group must have affinity to shopping on the Internet.

Second Solution: Focus on Margin Rich Products

A focus on margin rich products is the most debated solution for online food retailers.
Many e-commerce analysts assume, that consumers will prefer to order their heavy bulk products online, and visit the store for the rest of their grocery needs.
This assumption about consumer behavior is not supported by practical findings. In practice consumers will try to order enough products to avoid the delivery fee, in most cases set at an order amount of above 50 US$ or the equivalent in Europe. For online retailers the sale of mainly bulk products is the quickest road to bankruptcy, since these products are the loss leaders of the grocery business.

There are already many examples of a clear product focus in Online Food Retailing. The best example is wine. This product group is often the only food group of general merchandise online retailers. Another important online food group is vitamins and supplements. In the USA there were some very attractive examples: Wholefoods.com and Vitamins.com.

Online food retailers are also differentiating their business to financial services like banking, insurance and mortgages. Other service areas are video/DVD rental and dry cleaning, but the most attractive product development is non-food. This category is related to food and is therefore an expected extension to the online food business.
Walmart USA will probably concentrate its new Internet venture on its large non-food assortment, and stay away from Online Food Retailing.
The Belgian food retailer Colruyt used non-food not only as an important margin rich extension of the food assortment, but also as a traffic builder for the supermarkets. Consumers could order the non-food articles online, but have to collect the merchandise from the store.

The Third Solution: Focus on Information and Communication

"Information distribution and communication" is the name of the Internet game. Internet is the perfect channel for targeting different consumers and other stakeholders of the company.

In traditional advertising every commercial message is targeting a specific consumer profile with a specific message. Alternatively an Internet site has a menu structure, which makes it possible to communicate a whole range of messages to a wide range of interested target groups.
The other major advantage of Internet is the ability to really communicate in two directions. This important feature of Internet will have a great impact on the internal and external organization of any company. David Siegel, the author of "Creating Killer Web Sites" explains the impact of web communication on the organization in "Futurize your Interprise".

Communication with different customers may focus on special products, like the low fat or sugar free assortment. Allergy information gives the opportunity to add rich content to specific consumers. Other products that benefit from information are wines, private label products, vitamins and food supplements.
Retail organizations also use their website to inform their customers about their internal processes. Randalls.com is an excellent example of a description of the distribution process, and it enhances the professional image of the company.
In the USA the Internet is frequently used to distribute coupons. A good example is Pathmark.com. However the disadvantage of Internet distribution of coupons is fraud: the possibility to change rebate figures by the PC.
The most promising communication feature is the possibility for customers to respond to the retailers information and marketing mix elements. A retailer may solicit assortment suggestions and complaints. The Internet infrastructure makes it possible to use customer complaints as powerful drivers for quality improvement in the company.

Communication with other stakeholders of the company requires much attention but opens many opportunities. Most professional websites already have a special section for shareholders (annual and quarterly reports), potential employees (vacancies and working climate), suppliers (category management approach) and the media (latest news). Every target group gets maximum attention without annoying the others.
In case of communication with other stakeholders every target group must have a professional contact in the company, who is responsible for content and direct response. If this is organized in a professional way, the Internet communication will strengthen external relationships and internal responsiveness to the market.

Running the "Longest Mile"

The physical distribution of goods ordered online has been called the "Achilles heel" of e-commerce as it is considered to be the week spot of a powerful development.
In the USA the physical distribution is now referred to as "the longest mile". It is an old trade, that must be mastered by an ex Wallstreet investor like Jeff Bezos of Amazon.com and an ex consultant like George Shaheen of Webvan.com.
Jeff Bezos and George Shaheen were at the extreme ends of logistic complexity. Jeff Bezos of Amazon.com solved the sore knees of employees (and himself!), who were packaging books sitting on the floor, by issuing knee protectors. His partner suggested the idea of purchasing some packing tables, so he tells with laughter on TV.
George Shaheen of Webvan.com developed the concept of a sophisticated semi-automated warehouse for storing, picking, packaging and shipping groceries. This is Webvans solution to prevent sky high handling costs, and a revolution in grocery distribution.

In my opinion the Webvan.com solution would work very well for the high turnover business of medium priced commodity products of Amazon.com, and the low tech solution of Amazon.com would work best for the medium turnover business of low priced commodity products of Webvan.com. My recommendation is that these companies should exchange CEO's, or at least exchange each others logistics concepts.

When the home shopping market increases, professional service providers will develop distribution networks for general use by different online retailers. This will reduce the transportation costs by approximately 30 % and the total additional food home shopping costs by approximately 1.5 % points. Amazon.com is already using this concept by sending books by mail, but a 1.5 % point reduction of food distribution costs is to small a gain to change the less then positive outlook of food home shopping for the best.

Cost/Profit Modeling

The costs of order management and distribution alternatives can be evaluated from a distance using "cost/profit modeling". It is even better to use this tool in the business plan preparation state. Cost/profit modeling was already used to develop the value chain presented in the table of this article.

A good example is the home delivery process. This is a major element of order fulfillment. Online retailers have to optimize the following cost elements of distribution:
1. The average distance from the warehouse to the customers
2. The average distance between customers
3. The stop time at customers
4. The loading- and unloading time
5. Handling efficiency
6. Cost per hour
7. Vehicle fill rate and utilization
8. Capital investment

The optimization process of distribution elements will be covered in a different article. The point is that every distribution decision has an impact on all eight elements. It is interesting to show the most important effects of some home delivery alternatives on these distribution cost elements.

The decision of Peapod in 1999 to change delivery from stores to delivery from central warehouses increases handling efficiency but also increases capital investment and the average distance to the customer.
The semi automated warehouses of Webvan require huge capital investments, but were intended to increase handling efficiency. The use of local satellite stations increases capital investments but also has a positive effect on vehicle fill-rate and vehicle utilization.
The very narrow 30 minutes delivery time window of Webvan greatly increases average distance between customers. In my opinion this service element will prove impossible to maintain, because it has a tripling effect on transportation costs.
Two other online food retailers Streamline.com and ShopLink.com have introduced containers that are placed at the homes of customers. These containers make it possible to deliver the goods at unattended homes, avoiding the extremely expensive narrow time windows. Of course this solution also has a price: 30 US$ per month. This solution is typically suited for so called "Busy Suburban Families" (BSF's) with incomes over US$ 75.000 per year.

Critical Success Factors of Online Food Retailing

Any successful online retailer has to work hard and intelligently on a large number of critical success factors. These factors are critical because failure to excel in one of them may damage the company considerably.

We already covered the critical success factors customer targeting, focus on margin rich products and focus on "information distribution" and communication. Other critical success factors are:

• Trust. The online customer must have absolute trust in the retailer, because the retailer takes control of most of the shopping process. It is a good start if the retailer has an excellent reputation to start with, but when new channels are used the retailers must be certain that this trust is not violated

• Tailoring: The site should be tailored to the individual customer. An excellent example is Amazon.com, that greets you personally when you open the site, and gives you a choice of products that match your personal preferences

• Choice. Every target customer group must have excellent choice within every product category. The online retailer must exceed the product offering of traditional competitors in order to create loyalty to the business. The best strategy is to add high end products to the assortment, and promote these products heavily on the site

• Quality. Every service element of the online retailer must have excellent and predictable quality. Mistakes in online retailing have a much bigger impact than in traditional retailing

• Price. Internet makes pricing very transparent and this is a great concern for online retailers. Most American online retailers charge prices 3 to 5 % lower than traditional retailers, with the effect that gross margins do not cover the costs by far. European online retailers tend to charge 5 to 8 % higher prices than normal, but they will be exposed by price comparing websites. The solution is to charge market conform prices and an additional service fee

• Promotion. Every marketing mix element must be promoted on the site, and the site must be promoted in the traditional promotion channels. This emphasis on site promotion is a substitute for the physical store and the physical signals in the store

• Information Technology. Web technology features many commercially attractive possibilities like feedback on input, preference lists, cross-selling, inventory checks, differentiating service and cost structures, and professional order management

• Payment. This is a major subject in itself. Basic is error free and easy payment. Optional is the service of payment alternatives

• Economies of scale. High investments in information technology and marketing must at least in the long term be covered by high turnover. Even more important is the necessity of a high market penetration and a dense customer network, in order to optimize the delivery costs.

Take the Challenge Seriously

Earlier publications on which this article was based have already evoked much discussion. The author invites readers to supply feedback, constructive criticism and new scenario's to make online food (and non-food) retailing profitable.

Real Life Developments (February 2001)

Webvan has lost almost 99% of its maximum market capitalization. The price of shares dropped from US$ 25 in January 2000 to US$ 0.34 in February 2001.

Ahold has a 51 % controlling stake in Peapod. The Financial Times reports a gross profit margin of 32 %, and an average order value of US$ 125. Average net profit is US$ 8 per order - before marketing costs! At the same time Peapod reported that its fourth quarter 2000 net loss widened to US$ 25.3 million compared with US$ 9.1 a year before.

Peapod and Peapod.com are trademarks of Peapod, Inc.  Webvan and Webvan.com are trademarks of Webvan Group, Inc. Streamline and Streamline.com are trademarks of Streamline.com, Inc. ShopLink and ShopLink.com are trademarks of ShopLink.com, Inc)