From online to offline: cost structures and sunken costs

The future potential of a business is closely linked to where it stands in the present. If the future is headed north but the current business is positioned south, it's going to take a lot of work to reorient itself. In the commerce world, the most evident manifestation of this idea is brands—especially online only ones—increasingly opening up retail stores. The fact that brands who started on an online-only premise less than ten years ago are now popping up in the physical world is a testament to the industry's rapid change. Amazon, Everlane, Bonobos, Warby Parker, Outdoor Voices, Casper, Combatant Gentleman and many others started online and now exist offline. These are often referred to as Digitally Native Vertical Brands (DNVBs). Not all of these brands said they would only exist online and never offline, but these brands are increasingly expanding their offline presence, which is telling.

It's one thing to pay attention to the fact that these brands are opening up stores. But understanding the structural advantage they have over traditional retailers is much more interesting. Doing so comes down to two elements: cost structure and sunken costs, which are linked. A brand's cost structure is the set of infrastructure and expenses it's built on. These investments, from people to real estate to technology, are sunken costs. Once money has been spent there's no way to get it back. Therefore, a brand's cost structure is made up of sunk costs. While it's possible to evolve a cost structure over time with lots of resources, doing so is about as easy as pushing a boulder up a hill.

Traditional retailers—Macy's, Gap, Sunglass Hut, Walmart, Men's Warehouse, Sleepy's, J Crew and many others—have highly burdensome retail footprints and cost structures. They have too many stores that are too big with too many products and not enough customers. The wave of store closings and consolidations over the past few years has slowly addressed this problem. However, the issue is these retailers mere existence more than their store count. These retail fleets were built for the industry and the customers of the past decade, not the next decade. These retailers were built on pre-internet cost structures. This is a problem because ecommerce really exploded in the past ten years while many traditional retailers kept growing the business as if the internet never really happened.

DNVBs, on the other hand, have a fresh start. They operate on a post-internet cost structure, and, although they all have sunken costs, these expenditures are on modern infrastructure that gives them a unique advantage in the future.

Amazon is working backwards from it's massive logistics infrastructure to build out bookstores and soon connivence stores that take advantage of the physical world with all of the synergies of the digital world. At its bookstores, the company's algorithm plays a central role curating the selection, effectively only showcasing books it knows will sell. Customers can also order books online right in the store and use the millions of reviews and ratings online to help find the best books. Most importantly, the stores are geared towards Prime members, who receive the lowest prices and the fastest shipping.

Amazon is using its cost structure and wildly strong loyalty program to drive and improve the physical experience. The size of Amazon's stores is one of the more telling aspects, which average around 5,000 square feet. This is one-fifth of the size of a Barnes & Noble, as Amazon is able to use its advantage to make much better use of real estate than it's pre-internet counterpart. A smaller footprint allows the company to open more stores that are more profitable, while also being more experimental, with dozens more shops planned in the coming year.

Bonobos has also used its post-internet cost structure to open Guideshops that don't carry any inventory for customers to walk away with. Given the brand's logistics capabilities and its digital starting point, it can guarantee fast delivery directly after one's purchase so it doesn't need to hold any excess inventory in massive stock rooms. As a result, it can open much leaner stores than its counterparts, with the average shop clocking in at only 1,500 square feet and many of them doing over $1,000 per square foot in sales. The hope is that these stores are more profitable and more can exist since they are run on a post-internet cost structure.

The other benefit of a post-internet cost structure is the ability for experimentation. Everlane is probably the best example, as the company has opened up over a dozen popups in the past few years as it explores how the brand best exists in the physical world. This experimentation is much easier for the brand because it has the right infrastructure in place for these experiments and is able to setup shops relatively cheaply. Sometimes the shops have a POS system for customers to check out and walk away with their purchase, and other times customers order through the company's website and receive their items a few days later. Either way, the brand has been able to experiment with different types of retail more than any other DNVB that comes to mind and it will likely channel these results to open up the best stores possible, permeant or not.

The common thread between all of these examples is the move to smaller stores from mega-stores of the past. It's unclear if big stores will exist in the future, or if they will soon be relics. The problem is that retailers today are forced to use the retail stores they have, not the retail stores they need, all because of their pre-internet cost structure. DNVBs, conversely, can create the retail stores they need because of their post-internet cost structure. Evaluating a business's future potential will often come down to a simple question: are the business's cost structure and sunken costs an advantage or disadvantage? If it's the latter, the company is in trouble. Retail isn't dying. The underlying cost structure is just rapidly evolving.