Selling wholesale for the right reasons: gross margin vs net cash

A recent article in Business of Fashion called Can Young Luxury Brands Bypass Wholesale? looked into the relevance of wholesale given the rise of direct to consumer labels. The piece had some interesting insights, drawing on points from Warby Parker co-founder Neil Blumenthal and Feit co-founder Tull Price (one of my favorite brands).

But one section highlighted a false dichotomy between selling direct and wholesale.

For some upstart fashion labels, going direct-to-consumer has its limits, however. When New York-based Nicole Najafi launched the upscale denim line Industry Standard in the spring of 2014, her goal was to offer American-made jeans for a fraction of what her competitors charge by routing around middlemen and selling directly to customers.... But the company’s rate of annual growth — 35 percent year-over-year from its first to second year — was less than what Najafi had aimed for.

In October 2015, she decided to take on her first wholesale account, selling to the well-regarded New York concept store Fivestory, where her $100 denim sits alongside $2,100 Giambattista Valli capes and $1,995 Olympia Le-Tan clutches.... “In the beginning, I relied on press and word of mouth. If I wanted to keep growing online, I’d have to start paying to acquire customers,” Najafi explains. “Wholesale is really great because I get to access a new audience. It also gives me a storefront: a place people can come and try on the jeans in person. I think the desire to try something on before you purchase it still exists.”

(The analysis that follows is not picking on Najafi specifically. These issues are emblematic of the entire industry).

Najafi looked to wholesale as a fix when she didn't hit her growth targets. This is logical. However, she decided to open up wholesale because she didn't want to pay to acquire a customer. This line of thinking is an oversimplification of retail math. The result is a lack of understanding about customer acquisition and gross margin versus net margin.

It's worth noting up front that I am not anti-wholesale. As I've written:

Retailers exist because they are primed to own the relationship with the customer, offer a high taste level and have experience putting many different items and brands together cohesively. These are three very important values retailers bring to the table.

What I am against, though, is opening up wholesale for the wrong reasons.

Customer acquisition

Customer acquisition is essential for a fashion brand. As I've previously written:

Customer acquisition often means spending money to find customers, and then ensuring that the math makes sense. This is called your Customer Acquisition Cost (CAC). The other important metric is Life Time Value (LTV), which is the lifetime value of your customer.

Let's say you sell jeans for $200 and it costs you $20 to find a customer who buys your jeans, and this person buys two pairs of jeans a year. That's pretty good, leaving $380 (2 pairs at $200 x 2 - $20 CAC) minus your cost of goods and other expenses. Here, you have a chance. But if it costs you $80 to find your customer and they only buy one pair a year, you are in big trouble.

If you start working on your CAC and LTV early, and also factor it into your retail pricing, you are on the road to having a good business. (These two numbers work as levers together, and should not be considered in isolation.)

Najafi moved to wholesale because she didn't want to pay to acquire customers. But paying to acquire customers is not inherently bad if the math makes sense. A pair of Najafi's jeans cost $100 at retail, and likely wholesale for $44. There's a $56 delta between the retail price (which she earns when selling direct) and the wholesale price. Technically, she has up to $56 to spend on customer acquisition to equal what she would make on wholesale. That said, $56 is a lot to acquire a customer in this price range, and I would venture she can do it for less.

Gross margin vs net margin vs net cash

This brings us to gross margin vs net margin vs net cash. You need to look at all three of these metrics in tandem. There's a tendency to oversimplify and judge purely on margin and ignore net cash.

Let's say the jeans retail for $100 and wholesale for $44, and they cost $20 to make. (The accuracy of the numbers in this specific case doesn't matter to make the point.) This yields a direct gross margin of 80% and a 55% wholesale gross margin. Let's say it costs $25 to acquire a customer (CAC), which is a bit expensive and brings the direct margin down to a 55%. The direct margin with CAC is now equal on a margin basis to selling wholesale. However, the net cash from wholesale is $24 ($44 sale price - $20 cost of goods) while the net cash for direct with CAC is $55 ($100 retail - $25 CAC - $20 COG). The net cash from direct is more than twice as fruitful as the net cash from wholesale, even though the gross margin is identical. This also leaves more padding to acquire a customer for more than $25 if the brand struggles to early on.

Deciding to open up a wholesale channel needs to be an informed decision, and shouldn't just happen because you don't want to pay to acquire customers. In fact, it is often cheaper to acquire a customer and still sell direct than selling wholesale, as demonstrated above. Wholesale is not inherently bad. Rather, it needs to happen for the right reasons and when the math checks out.

It's important to look at metrics like net cash and gross margin as levers, not individually. The same goes for evaluating the pros and cons of direct versus wholesale. Don't make the calculation purely on margin. Additionally, it's very limiting to write off all forms of paid customer acquisition. Cash can be tight for a fashion brand, but if you understand your CAC when you price your items and decide on your margins, you will have some operating funds to plow into paid CAC. It will consistently pay dividends.