Snapshot : The direct to consumer business model can be a complex business case to work though with your accountant or finance team. Low conversion rates, high ‘net’ selling prices which impact your margin percentage calculations and how you fit delivery charges and costs in to the mix can lead to some challenging conversations and some freaked out accountants.
Read our experiences from our first direct to consumer business model, and the three key messages we’d use if we were to go through all that again.
Direct to consumer business model
As business owners who also run our own Direct to consumer (D2C) online store, we know that one of the most important tasks is how to plan and track your profit and loss account.
If you are a small business, then you are probably also the ‘finance team’ for your business, so it’s easier.
But if you are in a larger business, chances are you have a finance team or an accountant who will operate and control the accounting for the D2C channel.
And who will want to validate your direct to consumer business model.
From the D2C channels we’ve set up in the past, we know D2C requires a different way of thinking about the business model.
And ‘different way of thinking’ is not normally a phrase you tend to think of when it comes to accountants.
Let’s face it, accountants LOVE stability. They LOVE predictability. How many meetings have you sat in where someone from finance asks you why you didn’t hit THAT number? Or they ask you to justify why THAT forecast is at the level it is.
Direct to consumer – always start with the consumer
We know money makes the world go round. Accountants are important in any business. But as business leaders, be very clear the way businesses make money is from their consumers.
And if the D2C channel benefits consumers, then, it follows, D2C will benefit your business by bringing in more consumers.
And consumers aren’t stable.
Consumers aren’t predictable.
Just ask the toilet paper manufacturers how their forecast accuracy is going just now. (Sorry, trying to socially distance ourselves from all the Coronavirus bandwagon jumping going on right now. But it is so pervasive, it’s hard to not refer to it at all.)
Heck, even, sales and marketing people who are normally more pre-disposed to disruption and change can really struggle with the D2C P&L.
In our full guide to the D2C Business Model, we go line by line through how a D2C Profit and Loss works. But here, we want to share a few extra learnings from the very first D2C business case we ever put together.
Our first direct to consumer business model – some context
We had put together an overall e-Commerce strategy and plan for this business that broadly followed the e-Commerce planning process.
We started with a focus on existing online retailers. We already had online sales from those customers, so the quickest win was how to accelerate those sales.
The product range we sold had a relatively fixed, niche audience. But it was in high demand and there were continuing peaks and troughs of supply and demand.
And this unpredictability actually caused a lot of problems.
This struggle to keep a consistent sales and supply line going (damn, those accountants again) meant that building relationships with online retailers was a constant challenge.
They, quite rightly, were focussed on the day to day operation of hitting their sales numbers. They would not give us the time to have a conversation about anything that might be different or build a better customer experience.
And Pure Player wise, there were only a couple of niche players around at the time.
It was before the days when Amazon set up its physical operations in Australia. So, there wasn’t a lot of other sales channel options. So, that’s when we started to consider adding D2C in to the mix. And that meant creating a Direct to Consumer business model.
Freak warning #1 – D2C conversion rate
So, our choice to set up a D2C online store website was part of our overall strategy to connect, commercialise and control. Connect with online shoppers. Commercialise the offer to drive sales and profits. And, bring some control to the challenges of supply and demand.
But this category had never had a D2C offer before which meant no precedent or existing data to pull on to inform the business case. In that type of situation, where do you start?
So let’s tackle challenge number one.
Your P&L topline is really driven by the number of customers you attract and the price they pay.
We obviously had control over the price. It was our store after all. This was the same RRP as our retail customers charged as we were set up to add better service and range than be a price competitor. But how do you work out how many actual customers you think you will get?
Here’s the thing. There is no perfect way to answer that question.
Go back to what we said in our opening section.
This is about predicting customer behaviour, and customers are unpredictable. Now, before all the statisticians start coughing loudly and talking about using regression models and econometric modelling to statistically predict future trends, remember, this was a brand new channel.
No data. None. Zero. Zilch.
How do you predict the future then?
Forecasting sales with no historic sales data
Our way was to gather what data we could, that we could relate to the potential number of actual customers.
So, we obviously had website traffic data from our branded websites, that gave us a view of how many people could be our universe with potential to visit our online store.
And with a bit of Google research, we could find industry benchmarks for conversion rates of visits to sales.
Our conversion forecast at the time was 2%, as we could find all sorts of forecasts ranging from <1% to 10% but most experts seemed to settle round about that 2% as a reasonable conversion rate target.
So, here’s the first thing that freaks out an accountant.
A 2% conversion rate.
So 98% of people visiting your store won’t buy? That is really hard to grasp if you are not in the e-commerce business. It sounds so wasteful and inefficient.
You have to explain that people visit websites for all sorts of reasons and don’t do what you want them to do.
They are unpredictable.
Maybe they are just checking out your prices? Check out the concept of showrooming that is widely reported elsewhere.
Maybe they want to check delivery areas and delivery prices and don’t like what you offer. Delivery price regularly comes out high on online shopper requirements but is a constant challenge in the world of online retailing.
Maybe it is just your competitors checking out what you are selling?
Freak warning #2 – Percentage margin calculation will have a higher denominator
Here comes challenge number two to freak out your accountant. It’s a doozy.
In most business, the finance or accounting team will obsess about the profit percentage or ratio of cost / selling price.
While the total amount of sales is obviously important, the percentage profit or margin you make on a sale is a good indicator of the efficiency of your business.
Better to sell $1000 of products at 20% margin, than $10,000 of products at 1% margin.
So far, so good.
But what happens in most businesses who sell on to retailers, is they calculate the profitability not on the price the end consumer pays, but the price the retail customer pays them.
So, if your product costs $10 to make, you sell it to a retailer for $20, and a consumer pays $30 to buy it from a retailers, your profit is the $10 / $20 the retailer pays you. 50% margin.
The $10 the retailer makes is not part of your business, so it is ignored by the accountants. This is a basic principle in traditional profit and loss accounts.
The D2C denominator is what the consumer pays
You can see where this is going, right?
Let’s take the same scenario with D2C.
Your product costs $10 to make. You sell it direct to the consumer for $30. You now have $20 at the top of your P&L where you only had $10 before. So you now have $20 profit out of $30 or 66% margin.
That’s better right?
Except it isn’t, because you don’t have $20 profit at all. It’s an important point. You DO NOT have $20 profit in this scenario.
That $10 you effectively paid the retailer got the product in to their warehouse. It covered the cost of getting the product from their warehouse to their store and then out and delivered to a customer.
And retailers who manage thousands of products have spent years making sure the efficiency of that system drives the lowest delivery cost per item they can get.
By selling direct, you need to manage and pay for all of those things yourself. And as we discovered, $10 would be a pretty good delivery cost per item.
We’ve found it to be more in the $15-$20 range per delivery when you have low volume orders.
But lets say you could cover those delivery costs for $10. That’s sell for $30. Less costs to make of $10 and costs to deliver of $10.
So, $10 profit left.
To an accountant, you are now LESS profitable.
Because you’re making $10 from $30 income (33% margin) with those $20 in costs.
Remember ALL the benefits of the Direct to Consumer business model
If this sounds like a bit of a mindfuck, imagine when our accountant who was supporting us on the very first Direct to Consumer business model sprung this on us at 6pm the night before we were due to present the final business case to the board.
Let’s just say a considerable amount of fucks were given that night building a story in to the business model. And we can summarise it as this.
Look at all the other benefits you get with Direct to Consumer.
Because there are a lot.
Ownership of customer data. Customer connections and the opportunity to build unique customer experiences. Less dependance on the retailers. Speed to market. Test and learn capability. E-commerce skill building in your business.
Are you going to throw all of those away because of an accountancy rule of what should be in your P&L and not in your P&L?
In the end, our actually very supportive finance partner helped us get the case approved by pointing out that the D2C forecast sales were so small in year one, it would have no actual impact on the total business profitability percentage number.
This was actually what the board were more interested in.
Most of the board didn’t think it would take off, but were interested enough in it to let us run it as pilot to see what would happen.
And it also raised the question, that if an item was costing $10 to deliver, who should be paying that delivery charge?
Freak warning #3 – Delivery charges and costs sit where?
And here’s where it can get really crazy with your accountant.
Let’s say to keep the profitability per sale up, you decide the customer should pay $10 shipping on top of their $30 sale. This put your total ‘income’ up to $40 and your costs at $20 so we’re back to our 50% benchmark.
Except, now the consumer is paying $40 for something they can buy in a store for $30, so those customer order forecasts might well have to change.
So, you go back in a loop to find the price and delivery point that will generate the most unit sales at the best profit.
And here’s the thing.
Delivery costs change depending on where you have to deliver the product. It’s way cheaper to deliver to the Sydney CBD than it is to some remote cattle station in the Northern Territory.
And you don’t really know where your orders will come from unless you put on some geolocation blocks on your site. And your delivery charge is normally based on weight and a per delivery charge.
So if you have a couple of items that are not heavy and can be shipped together, your delivery charge will be the same as it would be for sending a single item.
How to build your Direct to Consumer business model and not freak out your accountant
Confused? We were too, and it took a couple of sessions with our accountants to nail the story down so that everyone got it. Here’s the three key messages we landed that got us through those conversations.
Comparing D2C on net profitability percentages with traditional channels is not a fair comparison. Because of where the selling price and the delivery charge sit on a profit and loss, it will always look less profitable on a percentage basis.
On an absolute net percentage basis, it can be very attractive. And there’s a lot of financial benefit when it comes to things like cash flow from D2C.
You get paid right away by a D2C customer and don’t have to wait 30, 60, 90 days like you do with a trade customer. Accountants love cash flow and it’s a great balance to the profit percentage challenge.
Holistic business model
And if you look at the D2C business model holistically – and isn’t holistically, a great passive aggressive, can’t argue with that word in the world of business term? – there are so many additional benefits to running a D2C channel as we shared earlier, that someone else will get in there first.
And who want’s to be remembered as a laggard rather than a leader when it comes to digital transformation?
Most of the board had little to no idea what digital transformation was at the time by the way. But we knew they wanted to be leaders rather than laggards in this area.
Hint that someone is a laggard in digital, it’s a real motivator for them to get off their arse and do something.
Direct to consumer business model – we can help
So, if your business is already in D2C and seeing the benefit of selling direct, then we hope our experience of building your profit and loss and direct to consumer business model rings a few bells for you.
We hope you got to a strong story that works with the accountants in your business.
And if not, we can help you build your D2C business case. Though we are marketing, creative and e-commerce creators at heart, we love building business cases with accountants.
Check out our skill guide on online store business models, or contact us, if we can help you prepare the story so that it doesn’t freak out your accountant. Even though, we secretly quite enjoy the idea of freaking them out. Everyone needs a bit of unpredictability in their life to make things interesting.