The Retail Profitability Paradox

When we think about the COVID-19 pandemic’s impact on how people shop — and on how retailers cater to their needs — it’s important to recognize that consumer preferences to “buy online, pick up in store” and to take advantage of other digitally enabled solutions are not simply short-term shifts. In fact, the current period is more likely a tipping point in the digitization of retail and in the shifting power dynamics between buyer and seller.

The traditional business-to-consumer retail model has unraveled in recent years, and COVID-19 has accelerated a push toward a new era of consumer-to-business relations. In this new model, consumers have become merchants in their own right, buying from a broad spectrum of retail channels, curating and promoting their own array of products via their social media accounts, reselling used goods through digital platforms, and setting the terms for how their purchases get to their doorsteps.

Consumers no longer rely on retailers the same way they did in the traditional model. Rather than trusting the same retailer for the best prices and the broadest selection, people are more likely to skip from source to source, powered by peer recommendations and price comparison shopping as they go.

Retailers have realized that their role in the customer journey has changed, and while their profit margins were already squeezed, many have invested heavily in expanding digital experiences and increasing convenience for consumers. They’re developing more partnerships with third-party providers of data-driven services and experiences to create more value for their customers, but these strategies can lead to a profitability paradox in which they struggle to capture value in return. Retailers can no longer rely on alleviating margin pressure just by cutting costs.

In order to thrive in this new era, retail businesses need to reinvent both how to go to market and how to leverage their own customers along the way.

A Competitive Customer Experience Comes at a Price

Deloitte’s April 2021 financial and strategic analysis of 100 retailers from 11 retail subsectors demonstrates how recent customer experience trends are compounding a margin crisis that was already playing out before the pandemic.

Price competition, coupled with demand for top-tier personalized customer experiences, increased customer acquisition costs by over 60% from 2013 to 2018.1 To deliver the types of services that consumers are now accustomed to, such as the ability to shop from a multitude of platforms, retailers now need new expertise.

Enter the third-party vendors, who support the shopping journey with services such as fit-predicting tools and product viewing technology; payment plans and platforms to power retailers’ websites; and third-party logistics, marketplace, and last-mile delivery solutions.

For example, “buy now, pay later” is becoming one of the fastest-growing payment options in the U.S. It’s projected to grow at a combined annual growth rate of 13% over the next five years, with third-party providers collecting transaction fees from merchants of up to 50 cents plus up to 10% of the purchase price per transaction, according to Deloitte research.2

Retailers are exacerbating their own margin erosion while fueling logistics companies’ success — essentially giving away personalized services and conveniences for free in order to compete. (See “The Profitability Paradox.”) While 50% of consumers say they’re willing to spend more on convenience, retailers can’t suddenly start charging for services that have become a standard element of the customer experience.3

Margins Erode While Additional Cost Pressures Loom

The pandemic exacerbated long-running retail profitability issues — many of which have been plaguing the sector since the early 2000s. According to our analysis of 100 public retail companies’ financial performance, median margins on earnings before interest, taxes, depreciation, and amortization (EBITDA) declined 300 basis points from 2012 to 2019, a period that reflects the high point of the Great Recession recovery up until just before the pandemic. Discretionary categories — especially department stores, and apparel and specialty retailers — experienced the greatest swings, partly because of increased competition from direct-to-consumer companies, subscription models, and even homegrown brands popping up on social media. Nondiscretionary categories, like grocery stores, operated at lower margins but also experienced less drastic swings.

Our analysis also revealed that all retail sectors are facing margin pressure from sales, general, and administrative expenses and that the median return on assets decreased 340 basis points on average, with all 11 subsectors in our analysis seeing declines. Rising variable costs of shipping, higher warehouse labor costs, and rising digital advertising costs — coupled with low conversion rates (especially for social media) — make retailers’ road back to recapturing margins even more difficult.4

During the height of the pandemic, many retailers reached for the only levers they had left, cutting costs wherever possible. In Deloitte’s 2021 retail outlook survey of 50 U.S. retail executives, 7 in 10 rated realigning cost structure as an investment priority.5 However, given the focus on cost cutting for the past several years, there might be little left to cut going forward, and that strategy alone is not likely to return retailers to profitability.

Other concerning factors on the horizon might continue to threaten margins, including rising commodity costs and potential transitory inflation, increased labor costs, and continuing supply chain issues. Larger players might be able to scale accordingly to absorb these additional costs. For example, a large mattress retailer said it expects to pass along 80% of upcoming cost increases through higher pricing and efficiency gains.6 However, it could be more difficult for smaller players and those operating at lower margins to push through.

Leaders Can Find Success by Embracing the Paradox

If nothing changes, and if margins continue to erode, we’re facing a retail future of online platforms, mass merchants, and a handful of companies with unique value propositions. What can retailers do to ensure their sustained success?

As part of our profitability analysis, we investigated how leaders (those above the median EBITDA margin) and laggards (those below the median) were strategizing for the future. We found that leading companies are pursuing two approaches: exploring new revenue streams and monetizing existing assets, and embracing a consumer-to-business mentality.

Explore new revenue streams and monetize existing assets. Twenty years ago, private-label credit cards were a boon for retailers, helping to create loyalty while driving additional revenue. Retail leaders today are looking for new ways to easily access new revenue streams, such as adding subscriptions and membership programs and expanding into value-adding services that align with their core offerings. For example, some athletic apparel retailers have launched fitness apps or expanded into selling wearable gadgets and hardware to generate additional income and foster more brand loyalty.7 Other examples include lifestyle brands venturing into travel services, and big-box and grocery retailers exploring financial and health care services to meet the needs of their consumers in a more holistic way. This effectively creates a second-level membership based on the size and type of customer and employee base.

Other retailers are monetizing their existing assets, expanding into platforms and services, and getting creative with their “intangible assets.” For example, companies may use their expertise in consumer data to offer advertising support as a service to other businesses.8 Another example is in-store technology and experiences that can be developed and sold to other retailers. This can range from queue management, innovative signage, and computer vision (teaching computers to understand the content of images) to create more frictionless offerings.

We have also seen leaders explore areas such as logistics as a service where, by partnering with real estate investment trusts, companies can leverage physical locations for fulfillment and customer connection points. This strategy offers an opportunity for job creation while at the same time bringing the supply chain closer to the customer.

Embrace the consumer-to-business mentality. Innovative services and partnerships certainly can shore up retailers’ profitability, but the shift to the consumer-to-business paradigm requires a more holistic retail reinvention. We’ve identified three initial steps for retailers to consider as they approach this new era of retailing.

1. Remove friction. Consumers have made it clear they want a different retail journey. Instead of relying on a favorite, trusted retailer to serve up the best options, modern consumers prefer to be their own merchants and rely on themselves or their peers to refine their selections. Retailers will need to find ways to remove friction across this new customer journey: from various purchasing formats (text, livestream, social media, web) down to the way items are fulfilled (drop shipments, “buy online, pick up in store” options, regular shipping). Consider the value of a platform with noncompeting or even competitive retailers joining together to give the consumer more ease of choice. This may blur the boundary between stores, but it can also save retailers significant expenses in reaching and fulfilling the needs of this new kind of consumer.

2. Redefine service. With consumers shifting their role in retail from last-mile delivery to chief merchant, the service experience needs to be redesigned. Product marketing is more critical than ever, and retailers have the chance to monetize their digital properties to help build product awareness at the new point of purchase while creating an alternative revenue stream, essentially shifting trade dollars from in-store marketing to digital platforms. Additionally, retailers have the opportunity to leverage the extended ecosystem outlined above to alleviate customer pain points. For example, consumers are offered multiple ways to receive products but often have limited options for returns. Working with partners, there is an opportunity to offer more options and create new service expectations in the marketplace. Many last-mile partners are already in the neighborhood, so home pickup of returns, even for a modest fee, may be a way to offset some last-mile costs.

3. Organize operations by customer segment. Many retail organizations are set up in silos, with each group owning a small piece of the customer experience — often without a centralized function to coordinate customer touch points. In the consumer-to-business landscape, companies should consider a more cohesive approach governed by a designated customer management team, to establish accountability and the authority of the customer. Imagine creating segment teams that have full accountability for that customer. Across the customer journey — from products, to specific marketing campaigns and targeting, to in-store and unique digital experiences — retailers can meet consumers where they are to address their specific needs and provide a more intimate experience.

The future of retail is more complex and multidirectional. That future is hard to envision for those retailers facing declining margins that have yet to evolve their operating models to fit the needs of consumer-led retail. The pandemic has prompted a retail reckoning, and for those who are investing in the way forward, the promise of future profitability lies in embracing the customer-to-business mentality.