Retailers and Customers

I love patterns, especially emerging and evolving patterns.  In this context, anomalies are troubling, but always an opportunity for learning. For me, the Gap represented one of those anomalies for many years.

Almost a decade ago, I detected an intriguing pattern regarding the unbundling and rebundling of firms (purchase unfortunately required). Those of you have been following me for a while know the drill – I believe that most companies are an unnatural bundle of three very different types of businesses:

• Infrastructure management businesses – high volume, routine processing businesses – think of managing a logistics network or manufacturing assembly operations
• Product innovation and commercialization businesses – coming up with creative new products or services, getting them to market quickly and accelerating adoption
• Customer relationship businesses – getting to know a set of customers extremely well and using that knowledge to be more helpful in configuring tailored bundles of products and services to meet the needs of individual customers

These three business types have very different economics, skill sets and even cultures, yet they are tightly integrated into most companies today.  The first wave of outsourcing can be understood as the systematic carving out of the infrastructure management businesses from companies, but we’re just on the cusp of a second wave that will unbundle product innovation and commercialization businesses from customer relationship businesses. 

That’s the short story. Of course, the pace and trajectory of unbundling (and related rebundling) differs across industries and geographies – the patterns are complex and fractal.

Take retailing as an example.  Most retailers don’t own product businesses – they are primarily customer relationship businesses (merchandising) and infrastructure management businesses (store operations). When I first wrote about the broader unbundling pattern in the late 1990s – there was one big anomaly that many people kept pointing out to me – the Gap.  In the late 1990s, the Gap was a real highflier, with a share price that rose from about $10 to about $50 over a five year period.  It could do no wrong. It was taking the retail world by storm.

And it seemed to fly directly in the face of the pattern I outlined above.  Here was a highly successful retailer that was not unbundling, it was in fact adding a third business type – product innovation and commercialization – to the two business types that retailers typically operated.  I can still recall the triumphant smirks of executives who would cite the Gap and say “OK, John, what do you have to say about that?”

At the time, I said that it was an anomaly whose success hinged on getting the product innovation and commercialization business right – at the time, they focused on basics like khaki pants and wearable tops so it was not as risky as the more fashion-oriented part of the apparel business – but that trying to manage all three business types simultaneously would make it very hard for the Gap to sustain its success.  Of course, that came across as a lame attempt to downplay a troubling exception to the pattern I was describing.

Well, starting in 2000 the Gap began to hit the wall and it never really recovered.  Earlier this week, the company announced that it was weighing its strategic alternatives, including a possible sale of the company.  Rumors are swirling about private equity firms discussing how to team up to take the company private.

As is often the case in business, when the troubles first started to surface at the Gap, the search began for the guilty.  Mickey Drexler, the mercurial CEO of the Gap at the time and the guy who drove much of the growth of the retailer, was fired in 2002 and Paul Pressler, a well-respected executive from Disney, was brought in as CEO. Significant turnover throughout the management ranks has occurred since 2000, yet the business challenges persisted.

What if the problem is not about people, but something even more fundamental?  What if the problem stems from having to manage three very different business types in an increasingly competitive market?  When evaluating “strategic options”, one can only hope that the Board of the Gap takes a hard look at the strategic option of unbundling. In many respects, this would be a “back to the future” play for the Gap – the retailer’s first wave of growth, before it started adding its own in-house apparel designers, was driven by its aggressive promotion of jeans designed and made by Levi Strauss. Rather than shrinking the business, this unbundling may actually provide a platform for another wave of profitable growth.

Now, of course, retailers can still guess wrong in terms of fashion trends even if they do not have their own product design business.  But it is easier to guess wrong if you have your own designers who often become locked into certain styles.  Retailers with their own designers start to look inward to their designers for insight about trends, rather than interacting with a broad range of independent designers who are likely to have much more diverse views of potential market opportunities.  Attracting and retaining the best creative talent in-house also can become challenging if this talent has to cope with the divergent cultures required to run infrastructure management businesses and customer relationship businesses as well as product businesses.

But the Gap should go beyond simply shedding its product business.  The company should re-think what it means to be in the customer relationship business.  Retailers pride themselves on being in the customer relationship business, but when you take a hard look at their operations, most large retailers are really much more focused on the infrastructure management business.

Let’s take a simple, yet very revealing, indicator of business focus.  What are the relevant metrics of profitability?  Most retailers focus relentlessly on profitability by store and, even more granularly, profitability per foot of shelf – these are facilities-based measures of profitability.  True customer relationship businesses focus on profitability by customer, yet few retailers (with the possible exception of some direct marketers) even have a clue of their profitability by customer.  Ask them which 20% of their customers generate 80% of their profitability and you get a blank stare. Ask them about customer churn rates and they start looking for a way to change the subject.

Or, take a stroll down the aisles of your nearest “big box” retailer.  Try to find someone to talk to in order to get a suggestion for a product you need or to get a question about a product answered. Good luck. It is pretty hard to talk about being in a customer relationship business when you are not available to talk to a customer. Big box retailers are the epitome of an infrastructure management business – reducing operations to high volume, routine processing activities with as few people as possible.  They dream of even eliminating the cashiers and automating the check-out process.

Of course, merchandisers live or die based on their ability to anticipate the evolving needs of the market.  Some retailers have become very sophisticated in understanding certain customer segments – teens, techies, suburban soccer Moms, etc. In this sense, they are very customer focused. But that’s a pretty shallow notion of customer relationship – all businesses have to do that to stay in business.

True customer relationship businesses set a much higher bar.  Deep, lasting, trust-based relationships with customers – the hallmark of a customer relationship business – are generally built one customer at a time.  They require the investment to learn about each customer’s needs and then they require the skills to take that understanding and turn it around into relevant, timely suggestions regarding products and services that might be most meaningful for that customer.  Think of a good Mom and Pop retailer where the clerk knows you by name and greets you with a suggestion about an interesting new product when you walk in the door.

Ah, but that’s not scalable, the skeptic will say.  Ever heard of Amazon? They do something pretty much like that for millions of customers.  Ah, but that’s on the Internet and not in a physical store, the skeptic responds.  True, but that’s one of the problems – with few exceptions, we still draw hard lines between physical facilities and virtual services.

Now, this is not just an opportunity; it is rapidly becoming a necessity, shaped by the shift from shelf space scarcity to attention scarcity, something I have written about frequently.  In the face of this shift, retailers have two choices.  They can become vast, automated warehouses with a high return on assets – in other words, infrastructure management businesses.  Or they can find creative ways to build real relationships with customers in ways that significantly increase the return on attention for their customers – in other words, customer relationship businesses.

This is the vast blue ocean that awaits enterprising retailers.  It will require extraordinary innovation, inspired perhaps by examples of open distribution in unlikely places like India (not in conventional retailing, which is generally very inefficient, but rather in such unexpected arenas as financial services and diesel engines).

As the Gap assesses its strategic options, it might start by asking the most fundamental question of all – what business are we really in?  There’s a lot of money to be made by getting the answer to that question right.

Comments

[Craig Maginness]

Thanks for another insightful post on this subject. I frequently refer to your work in a course I teach on export market identification, entry and development because, while this is an important question for any business to answer, I believe it is critical to maximizing the chances for success when the challenge is to replicate your business in a different cultural context. When planning for business expansion into a foreign market with different norms for relationship building and inconsistent levels of infrastructure development, it is critical to know going in whether the success of the business model is dependent upon being very good at infrastructure management or at creating and sustaining customer relationships.

[Maciej Baranski]

Interesting article. Not sure if you are aware, but here in the UK a couple of food retailers, Tesco and Sainsbury's have quite successfully implemented loyalty programmes based around collecting points by using magnetic cards at the checkout. In the case of Tesco, every few hundred/thousand points you collect you can redeem for in-store discounts. They also send money off coupons to your home address for products based on your spending patterns on a regular basis. Personally, I use Sainsbury's programme, which also includes many other retailers both high street and online for collecting and spending points. However, I'm not aware of any overt use of the information they collect on my spending.

Otherwise, I'm not sure how you could build strong customer relationships in an off-line retail environment. Don't think many people would be interested in filling in a form giving their personal details in every shop they went to. Also, modern populations are very mobile and one-to-one relationships are more difficult to maintain, even in social lives.

Cheers

[James Taylor]

Great post. I think physical retailers underestimate how much more attention they could give to the customers who come to each store and how they could flex those stores to be more customer-responsive. When I read the Long Tail I thought that it underestimated what a physical retailer can do.

[Raimo van der Klein]

Hi John, just added a presentation on slideshare about the subject:
http://www.slideshare.net/Thinkmobile/value-chain-reshuffle

[Raimo van der Klein]

Hi John, thanks for sharing this post. This is something I have been feeling. The increased transparancy, openness and technology speed -up this process. I made a slideset whiches I removed from Slideshare about large scale and small scale companies. I stated that large scale companies are going to be pushed down the valuechain. Who says there is no margin there? Maybe you would like my slideset about 3D Value Chains. I recommend companies to split up the valuechain in recognizable functions and choose wisely the functions they can run effecient and then open up that function and focus on adding value.. You can find it here. I would a love to get your thought on it.
http://www.slideshare.net/Thinkmobile/3d-valuechains

Thanks again. I love the three business segments..That helps me alot..

[djysrv]

Airlines are interesting examples of firms that do keep track of profitability by customer. Why else would they promote "business class" seating for international flights?

However, at the commodity pricing level, e.g., deeply discounted airline travel, the industry has a lot in common with retailing. The mantra for this business model is "if it is not self-service don't bother."

Here's a case in point. large supermarkets offer a "service deli." Guess what, in most cases the employees behind the counter are so busy with the logistics of keeping the place running they don't wait on customers. Same goes for instore pharmacies where a pharmacist struggles to fill phoned in orders and a clerk scurries around stocking shelves and doing inventory.

The airline industry operates the same way. Coach class customers are shuffled through a system running at the edges of its capabilities. When a flight is cancelled there is no surplus capacity to absorb people, e.g., no extra space on planes, and, interestingly, no extra capacity in terms of "customer service" staffing in the terminal. Like the supermarket you are on your own.

What's the airline industry and the supermarket have in common is that both have calculated the value per customer at the low end and decided it isn't worth it to bother with customer service. The margins aren't there.

The cost of replacing a customer who stops shopping at a store, or flying on an airline, is small. Also, they know you will be back because the business model is based on pricing.

I think customer attention as a value proposition will only continue to be something pursued where the profit margin is high enough to justify the investment in support staffing including market research. Examples include diamonds, four star restaurants/resorts (Las Vegas), and high end cars (Lexus, BMW, etc.)

[Chao Lam]

What about Apple (ex-Computer)? It's clearly a "product innovation and commercialization" company, but it also, against conventional wisdom, managed to create a vast retail operation that is still growing rapidly?

Does this pattern also predict that they will ultimately fail by being both a product and retail operations company?

[Ben Rodenhaeuser]

I wonder whether the Gap isn't an example of a broader trend in retail (rather than an exception) - at least in Europe. Both H&M and Zara are extremely succesful in the european fashion retail market - both combine customer relationship and product innovation/commercialization (and infrastructure, of course). Indeed, both control their complete value chain. Both are extremely fashion trends oriented.

And isn't apple another example of a company that has been highly succesful by adding an infrastructure business (apple stores and apple online store) to its product business?

[Kevin Hillstrom]

In the world of the retail blogosphere, this is an absolute exception to the content we usually read.

Thoughtful, strategic, theoretical, and brilliant. While I don't agree with all of it, I'll read this over and over, because you dug into a topic and provided a unique perspective that goes beyond the "Gap needs to rebuild their brand" stuff that inundates the blogosphere.