Retailing is an industry characterised by constant change. New retail formats and concepts emerge of which online retailing is the latest one while the existing formats fade away. In 1958, the wheel of retailing was proposed as an important hypothesis to explain retail evolution patterns. The fundamental argument was that innovative new retail formats always start as low-margin, low-price, low-status operators, often with a limited assortment for example, the original Walmart discount store or Aldi. Over time, they gradually invest in more elaborate and expensive premises, furnishings and services, necessitating higher prices, which provides the opportunity for a new retail format to emerge that undercuts the original innovator’s prices.

Traditionally, new retail formats have been delivering their price advantage through lower service levels. For example, Aldi provides a limited assortment, mostly their own private labels, in a bare shopping environment with no fixtures. Usually, the supplier’s outer case or carton in which products are delivered to the retailer is used for the merchandising display. The customer must bag their own groceries and pay a deposit to collect the shopping cart, ensuring that they return it to the appropriate place. This reduces the labour that Aldi needs, as shoppers do much of the work that is usually done by employees at supermarkets. Similarly, by leaving transportation and final assembly to the shopper, IKEA replaces employee costs with customer efforts. Since IKEA originated in Sweden, a relatively high social cost country, the labour costs for a retailer were substantial. There was a strong incentive for shoppers to do it for themselves and in return, have IKEA pass on the cost savings through lower prices. The big takeaway here is that traditionally, retail innovation and low prices have been a result of customer labour replacing retailer labour.

At first glance, and the way it was sold to investors, Amazon and online retailing appear to fit the narrative of retail innovation at lower costs. In classroom discussions on Amazon, with executives or MBA students, the participants immediately note that relative to brick-and-mortar stores, Amazon benefits from no capital investment in physical stores and much lower inventory, given its ability to concentrate the stock in a few large warehouses versus hundreds, or even thousands, of stores that retail chains like Walmart need. Furthermore, an online retailer has no merchandising or store operating costs. All the staff that are needed to provide service at traditional physical retailers are unnecessary, such as the two million-plus army of workers that service 10,000-plus Walmart stores worldwide. Given fewer assets (stores, inventory) and operating expenses (labour, merchandising), the reasonable expectation is that online retailing will be a financially lucrative business model with high margins and high return on assets. This, combined with the growth prospects, explains the trillion-dollar-plus market capitalisation of Amazon.

Yet, a deeper exploration reveals that online retailing flies in the face of historical precedent and the “wheel of retailing” hypothesis. Instead of offering lower prices by having shoppers participate more heavily in the marketing flows, e-tailers are offering greater service without a price penalty. The e-tailers pick the products from the shelves, pack them adequately for transport and then deliver them to the shopper’s premises all activities that shoppers previously did for themselves.

While some online retailers do charge something for delivery, customers in general seem resistant to paying the full costs of delivery. Why? First, shoppers are ignorant of the full costs of picking and delivery that a retailer pays. Second, customers perceive these logistical activities as being of low value because they do not place a large enough monetary value on their own labour and transportation costs. Third, competition between online retailers is often on how little shoppers will be charged for delivery and how fast they will receive their orders. This competitive dynamic has been enabled by lots of venture capital seeking to establish dominant positions, and thus, tolerating unprofitable last-mile delivery business models (e.g., DoorDash, Instacart, JustEat, Uber).

Overlooked in all this is that an online retailer like Amazon must invest large amounts of capital in building the last-mile delivery infrastructure to meet shoppers’ expectations with respect to speed, certainty and accuracy of delivery as well as manage a convenient process for returns. Furthermore, these delivery costs must be recouped from relatively small orders in terms of dollar value and in categories that typically yield small dollar margins for the retailer. We will see that while Amazon’s online retail is perceived as a high-tech business, it may simply be a capital-intensive, low-margin, physical logistics business!

Excerpted with permission from Clash: Amazon versus Walmart, Nirmalya Kumar, Penguin India.