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Christmas Gift Guide
Tech Industry

The e-tailer's secret weapon?

E-tailers are struggling to deliver deep inventories of products, and profits remain elusive. McKinsey Quarterly says "category managers" may be what's needed to save the day.

Most general retailers have made huge investments in their online businesses but are still struggling to make money out of the Web. Yet their perseverance is more than justified.

While offline retailing is a mature, slow-growing business, the online market--albeit still fairly small--is expanding at double-digit rates. Moreover, customers increasingly demand an online presence from retailers.

The search for ways to make the Web profitable is therefore on. It is a considerable challenge, calling for skills that go well beyond those required to run an offline business successfully. General retailers have always succeeded by striking a carefully calibrated balance between offering a wide choice of goods and the opportunity cost of offering each additional category. But customers in the savvy new generation who shop both on- and offline have different expectations of Web-based retailing: They want greater depth of inventory as well as rich and relevant online product information.

For many pure e-tailers--and even for some retailers with substantial offline expertise--the cost of trying to provide that depth and content has proved insupportable. But help is at hand from an established offline strategy: category management.

How category management works
General retailers tend to be masters at managing only three to five core categories. When a general retailer has established a loyal base of customers for those core products, it must determine which additional categories will make the most of its valuable shelf space--a decision that calls for sophisticated brand analysis and focus-group research.

Customers in the savvy new generation who shop both on- and offline have different expectations of Web-based retailing: They want greater depth of inventory as well as rich and relevant online product information.
J. C. Penney's mainly middle-class customers, for instance, are not at all likely to shop for expensive Raymond Weil watches, unlike customers of Saks Fifth Avenue, at the luxury end of the retail market. The equally high-end customers of Neiman Marcus wouldn't expect to find CDs there, but the value-driven customers of Wal-Mart love the idea of buying them in its stores. Too often, retailers offer a wide product range to increase their share of overall customer spending without knowing enough about the non-core categories they stock.

This is the opening for category managers: wholesalers that develop specific expertise in managing stocks of a given type of product--snack foods, sneakers, CDs or the like--for the stores they serve. A category manager decides what mix of brands a retailer should carry in a particular category, and in what quantity, and helps to promote the products. A general retailer can use this expertise to add another string or strings to its bow, thereby increasing its chances of capturing a higher proportion of its customers' total spending. It can benefit from the added value the category manager offers through the economies of scale achieved by serving many retailers.

Category managers are most useful when a category is relatively complex and customers demand deep selection from an array of many competing brands. Currently, category managers exist in 10 to 15 leading product categories, including financial services, music, sporting goods and travel.

CDs are a good example: Handleman Entertainment Resources has built a billion-dollar business by managing the music aisles of chains such as Wal-Mart and Kmart. It decides which CDs to stock in individual outlets, arranges the shelves and displays, prices the CDs, and even designs newspaper advertisements for the stores. Since these stores carry as many as 3,000 different CDs on their shelves, it is easier for a category manager with special knowledge to get the selection right than it is for them. Handleman employs 20 or more music experts to track the music scene, for example, compared with the average retailer's one or two. This detailed knowledge means that even the most localized preferences can be picked up and reflected in a store's stock.

The deal suits both partners. While the category manager gets access to an extensive base of customers and a cut of the margin on each sale, the retailer gets the category manager's knowledge of and access to significantly larger inventories. If everything works as planned, the retailer makes more money than it could by managing the category itself: It increases its "share of wallet" by matching products to customers more effectively, without having to invest the time needed to build expertise in non-core products. Moreover, for stores, the risk of managing a complex non-core category in-house is usually quite high.

Going online
Partnerships of this type are already well-established offline but have even greater potential online, not least because customers are known to be more demanding on the Web than they are in stores.

In the case of online CD sales, for example, retailers are expected to have just about everything, however obscure. This means that more than 200,000 titles have to be organized and cross-referenced, and all of them must be stored somewhere and distributed to customers quickly and efficiently. Nor is that all. Online music buyers are acutely aware of what technology can offer; they tend, for instance, to favor sites that make it possible for them to hear samples of songs, to preorder hot releases, and to see related entertainment content, such as interviews with artists, concert schedules and reviews. Online category managers--also known as virtual category managers and virtual private-label channels--take care of all this. They build and maintain the Web pages and provide inventory, shipping and customer service. All the retailer provides is the customer. No floor space and no staff to answer questions are needed.

Because the Web environment is so demanding, retailers should consider availing themselves of the services of online category managers even for product lines that they happily handle themselves in their stores.
By teaming up with an online category manager, the retailer can look forward to increasing its revenue, with no corresponding increase in stock or fulfillment costs. Suddenly, products that weren't worth floor space offline make commercial sense online. J. C. Penney, for example, sells CD players off- and online, but until recently it hadn't sold the CDs themselves, though the synergy was obvious. By hooking up with Handleman's "mFinity" online category-management service, Penney can profitably sell CDs over the Web. It stands to increase its earnings by as much as $2 million a year.

Because the Web environment is so demanding, retailers should consider availing themselves of the services of online category managers even for product lines that they happily handle themselves in their stores. Some single-category retailers are likely to find--as did The Sports Authority, a specialized sporting-goods retailer--that the cost of establishing an e-commerce platform exceeds the potential online profits and that it might therefore be worth striking up a partnership with an online category manager to run the entire operation.

The beauty of such an arrangement is that the brand of the retailer can remain pure: Customers don't know that it is using another company's skills. The host site's brand and appearance are maintained throughout; contact information, billing and all other customer interfaces--as customized for different hosts as they wish--are completely integrated with the rest of the site.

Global Sports, an online category manager in sporting goods, offers 600 brands and more than 60,000 products. It boasts partnerships with, among others, MC Sports, Modell's Sporting Goods, The Sports Authority, and even the Web sites of television channels, such as FoxSports.com. Its managed sites amply show how category managers tailor them to the needs of different retail clients.

The SportsAuthority.com site, for example, is organized just like The Sports Authority's physical stores, with a similar but deeper range of general sports equipment. The retailer's logo and tagline, "Go out and play," are stamped atop each page. FoxSports.com's home page offers a series of buttons, including "Shop," "Games" and "Shows." A click on the former button sends customers to a section of the FoxSports site that is absolutely identical, in both look and feel, to the rest of it and quite distinct from the style of the SportsAuthority.com site.

Potential pitfalls for the retailer
The possible benefits for a retailer of striking up a partnership with a category manager for online business are clear, but there can also be pitfalls. As in any commercial alliance, a retailer must be sure to protect its interests by choosing the appropriate manager and products to be managed. And because so many aspects of an online business are left to the online category manager, the retailer is in some danger of compromising the integrity of its brand if it makes the wrong choice. Once lost, a reputation for customer service and quality is difficult to retrieve.

As in any commercial alliance, a retailer must be sure to protect its interests by choosing the appropriate manager and products to be managed.
With this in mind, affiliate programs of the kind pioneered by Amazon.com, among others, might seem a less risky alternative. In such arrangements, a general retailer, in return for a commission, features links to a category manager's specialized site. There is, however, a serious drawback here: Once customers are carried off to another site, the retailer is in danger of losing them to it. Lost as well is the possibility of the long-term revenue that can be generated by a full partnership with a category manager.

A better alternative might be for the retailer and the category manager to forge a strict agreement covering the site's performance, customer service and order fulfillment. Such agreements, already quite common, protect the retailer's brand by requiring category managers to match or exceed the retailer's own standards.

The bottom line
Whether or not a retailer finds the right online category manager, the economic challenges of setting up e-tailing ventures are formidable. In the past they have been notorious black holes for cash. But aspiring online category managers can look forward to a more positive future than can e-tailers, from which they differ in several ways.

To begin with, most category managers, like Handleman, are engaged in moving successful existing businesses online and can draw on years of expertise and experience. Second, many category managers already pay commissions to general retailers, so going online doesn't change the category managers' revenue structure in any fundamental way. Online commissions vary according to the category of the goods but tend to range from 5 percent to 10 percent of sales. To compensate category managers for taking on the inventory risks and costs borne by retailers in the physical world, these rates are slightly below the level of offline commissions. They are also lower than the commissions charged by standard affiliate programs because category managers offer ongoing revenue instead of what is, in effect, a one-time payment for the acquisition of customers.

Third, unlike a typical e-tailer, the online category manager doesn't have to do the hard work of attracting customers. In effect it buys a market for the price of a commission. To establish a brand and drive traffic to a site, an e-tailer, by contrast, must invest $50 to $60 a customer--a cost that has proved prohibitive for many e-commerce pioneers.

Although it is early to judge whether online category management will be a money-spinner, the signs are good.
The only significant expense that online category managers and e-tailers have in common is technology, which involves an outlay on the order of $10 million to $20 million, depending on the size and complexity of the business. For the lower amount, the category manager can buy a content server, a search engine and a basic e-commerce platform--all shared by every host--as well as the flexibility needed to create Web pages in different styles and to offer assortments of merchandise with tailored pricing.

Typically, a further $1 million to $2 million is required to train telephone operators or to set up a contract with a call center. In addition, customers in some categories may make technologically complex demands, such as audio streaming of music samples. An online category manager isn't likely to have this expertise in-house, but it can generally lease the necessary technology from third-party providers.

Offline category managers that go online must also upgrade their fulfillment capabilities. Stocks have to be more extensive, and fulfillment centers--which, offline, may ship only to stores--must now be capable of serving individual retail customers and of ensuring first-class service for each. These costs can range widely, depending on the category manager's operation in the physical world; one company, for example, spent $5 million to $7 million adapting its warehouse and adding inventory. Companies that have only minimal fulfillment operations offline will undoubtedly need to spend more at first; thereafter, additional spending should track revenue growth.

Once an online category manager is up and running, it has, in effect, two profit centers: one online and one off. The online business basically consists of all interactions with consumers that take place over the Web, from providing product information to conducting transactions for merchandise. It typically yields operating margins of 50 percent or more, since operating costs are low once the initial investment in technology has been paid for. The offline business--which consists of handling the physical operation, including call centers, distribution and customer service--offers margins of 8 percent to 15 percent, which is typical of well-run wholesale companies. The combination of this business and its online counterpart, with those higher margins, is an attractive one.

Although it is early to judge whether online category management will be a money-spinner, the signs are good. Handleman was well-established before it moved online. It manages about 10 percent of offline music distribution in the United States and plans to achieve a comparable share online within five or six years. If it does, that would enable the company to own 10 percent of a market that is predicted to exceed $3 billion by 2005.

While offline category managers have an obvious potential to become online category managers, the role could also be taken on by distributors, ordinary wholesalers and even erstwhile e-tailers. Global Sports, which was once an e-tailer, sold its branded business after a troubled year in 1999 and moved behind the scenes. Within 12 months, it had achieved sales of $40 million, rising to $102 million in 2001. It posted its first profit in the fourth quarter of 2001.

Another possibility is the use of partnerships between retailers and online category managers to create a platform for shared revenue. One promising area for expansion is targeted advertising. Even now, it is clear that a teenager who is interested in buying, say, a Britney Spears CD might also be a customer for J. C. Penney's Arizona jeans, which are aimed at teenagers. Over time, a knowledge of spending patterns across huge geographic areas and a range of demographics will be the invaluable basis of targeted e-mail campaigns that could add significantly to the retailer's sales and the category manager's commissions. In short, everyone wins.

For more insight, go to the McKinsey Quarterly Web site.

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