The business of selling below cost

BARNALI CHAKLADER | Updated on January 17, 2018 Published on July 15, 2016

The back-end of e-tail: Online retailers incur big expenses on warehouse services. A view of the Snapdeal fulfillment centre at Tikri, New Delhi

How can e-tailers sell for less than cost price? There is probably some sound underlying logic

Major players of the long established offline sector are complaining loudly about the low cost strategy of the online sector. Offline retailers are accusing e-tailers of selling products below cost. Online retail is being financed by private equity in a major way. If we think logically, private equity players will never invest in a business model that will result in losses. There is no doubt they want a decent return on equity. This forces us to wonder why these etailers are selling products below total cost.

People’s lifestyle has changed over the years and more so with technological innovations. A Comscore report says that three out of five internet users are shopping online. The survey also says that the number of online shoppers in India is expected to rise to 56 billion by 2023. Online shopping’s rapid growth and popularity is due to heavy discounts, convenience of shopping, growing traffic and parking problems in the metropolitan cities. Offline retailers have understood that e-commerce is going to give them tough competition.

Fewer overheads

Online retailers have a low overhead cost. Their fixed costs are fewer as compared to offline sellers as they do not have to maintain the shop with different levels of interior decoration depending on the customer segment they target to serve. Offline retailers have to bear the cost of holding inventory in the warehouses and shops, as a ‘just in time’ technique would not work in this type of business model. E-tailers take orders online and have tie-ups with the vendors who deliver the products directly to the customers. Online retailers incur huge cost on advertisements, offer huge discounts, cash on delivery and the cost of returning the products by the customers within a stipulated time period or even at the time of delivery of the product. Many bear huge infrastructure costs for maintaining back-end warehouse services.

As per the theory of cost-volume-profit analysis, in the short run, fixed cost is considered to be irrelevant for decision-making as it is incurred even if there is no sale. Employees have to be paid, so does rent, and the firm has to bear many other fixed expenses. If the selling price per unit of the product is more than the variable cost per unit of the product then there is a positive contribution margin per unit of product. The seller tries to maximise the total contribution by increasing the volume of products.

The total contribution is per unit contribution multiplied by the number of units sold. So, products may be sold below total cost, i.e., the sum of fixed cost and variable cost. As long as the variable cost is less than the selling price, the firm earns a positive contribution margin. This can continue for a short duration as the firm cannot ignore fixed cost for a long time.

Volumes at play

Online firms sell products at a low price and also negotiate on purchase price to keep the variable cost low so that they can maximise on contribution per unit and maximise total contribution by maximising volumes. Any extra total contribution over and above the fixed cost is profit for the entrepreneur.

At this point, online retailers are not obviously at a profit-making stage and the amount of discounts and the refund policy that they have clearly shows that they are considering fixed cost to be irrelevant at this stage. This is a short-term strategy for them.

For example: A firm has a capacity to produce 60,000 units. The price per unit of its product is ₹10, variable cost per unit of product is ₹6 and the total fixed cost the firm incurs is ₹60,000. If the firm sells all 60,000 units, total cost per unit comes to ₹7 (variable cost of ₹6 plus total fixed cost of ₹60,000 divided by 60,000 units) and if the firm sells 30,000 units, total cost comes to ₹8 as fixed cost in any way has to be incurred. The firm gets more profit by selling more products.

This gives a clue to the question why private equity players are allowing online retailers to sell below cost. E-tailers want to capture the market, increase market share and customer database.

Once e-tailers are successful in getting repeat customers and increase the number of buyers, they will be able to increase the total contribution margin without increasing fixed costs much as the volume of selling units will increase. Thus, the contribution margin after meeting the fixed cost will add to the bottom line or profits. E-tailers can be successful if they are ethical in dealing with the customers. Otherwise they have to bleed forever and exit the market.

It will be better for the offline retailers to understand the fact that e-commerce is the business model for the coming years.

But this does not mean that offline business will become extinct. Both will co-exist. Offline retailers can think of running a parallel e-commerce business. They might have the risk of having the same customer segment buying offline or online at one or the other time as per their convenience. But the business is all about risk and return and survival of the fittest.

Barnali Chaklader is an Associate Professor (Finance), International Management Institute, New Delhi

Published on July 15, 2016

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