Elusive Profits and Potential Solutions — Part #1 of Online Grocery Series

This is the start of a three-part series on the future of online grocery. The series will cover the following topics:

  1. Profitability challenges and solutions
  2. Competitive landscape
  3. Technology and HR strategy

Online grocery shopping has overnight made its way from the sidelines to the starting lineup due to the impact of COVID-19. Both delivery and curbside pickup have experienced unprecedented demand in every type of grocery store, from mainstream to organic to ethnic. The popularity of delivery can be seen in the # of shoppers that Instacart is hiring — a # that exceeds even the additional hiring of the likes of Amazon and Walmart by not an insignificant margin.

Data as of 5/14/2020 from public news sources — personal analysis

A recent analysis by The Information further demonstrates the staggering growth of Instacart vs. its competitors in the burgeoning online grocery space.

Source: The Information

Despite the growing demand and increased importance for grocers, it is not a very profitable endeavor. Barclay’s analyst Karen Short warns that grocery profitability will take a hit despite increasing demand due to higher e-commerce penetration and associated inefficiencies. Consultancy AlixPartners recently published a report noting that a permanent online penetration of between 7.5% and 20% could result in operating profit reductions of 0.75 to 2.75 points. Grocery stores can’t afford this — their margins are incredibly slim to start with.

Why is it hard to make money in online grocery?

There are three key buckets that I think drive low profitability in online grocery on the cost side. Direct labor, operational inefficiency, and infrastructure.

Let’s take a deeper dive into each of these buckets.

Direct Labor

From a fulfillment perspective, online grocery shopping is operationally no different than any other e-commerce business except that in most cases the fulfillment is being done in a store vs. a warehouse. Once you place an order, some person (or maybe robot in the future) has to go and pick each of your items and pack them up for you.

For each item they pick, it takes time, and time is money. This is totally fine if the price and/or margin of your products is high (or at least not too low). If you order three to four products from let’s say Sephora, you’re probably spending $100+ and the cost of labor for picking the products is inconsequential to the overall basket size. One of the things that I encountered when running a fulfillment center for an e-commerce beauty company was that we would offer $1 samples and sheet masks, which were great from a merchandising perspective but absolutely disastrous from an operating cost perspective as the labor cost of picking the item would literally eliminate all profits from selling it.

But for groceries, the cost of picking is tremendous as you get the triple whammy of many items, low margins, AND low prices. $2 milk, $1 beans, $3 bananas…you get the picture. When you go buy groceries yourself in-store you essentially assume the cost of picking items yourself which is quite a labor-intensive process. The below table is a back-of-envelope analysis of the impact of picking costs on online groceries. The impact on the bottom line is lethal without passing any costs on to the customer.

Illustrative — uses estimates from personal experience and quick Google searches :)

And this cost is just the act of picking the items in the store, we’ve yet to even consider the cost of putting bags of groceries in a car/truck/van and delivering them to the customer. I won’t get too much into detail on this aspect, but let’s just say that moving full bags from cart →car →house is a very labor-intensive process too, I do it every week and it always takes me more time than I think it should.

Photo credit-Extremely Decent YouTube channel

One may think that the easiest solution for these costs is simply to pass them on to the end customer through fees or increases in grocery prices (or both simultaneously), but it is not simple. These are both unappealing options because most customer’s willingness-to-pay doesn’t match the actual cost of service. Whether you charge an exorbitant fee or increase the prices of groceries, customers notice and may not choose to use the service. On the bright side, customer willingness-to-pay has significantly increased due to COVID-19, whether that can persist beyond the pandemic is anyone’s guess.

My hypothesis is that from a customer frame of reference, online grocery can be compared to either 1) standard online shopping (shipping is either free or paid) 2) food delivery (delivery fee is standard). Customers understand that they need to pay for shipping because it costs money to send stuff through the mail or have a delivery driver bring food to you, but online grocery is unlike the others due to the picking/shopping costs described above. A somewhat analogous way to think about picking would be a pizzeria baking and making a pizza for you, you pay more for someone to put that pizza together (the labor) and you expect that the cost of the pizza is more than the raw ingredients (this could be any other restaurant for that matter…). I don’t believe that this perspective is commonplace among grocery customers at the moment which makes it difficult to upcharge appropriately.

Operating Inefficiency

Adding on to the onerous burden of picking lots of low priced, low margin items is that a store’s layout is not optimized for e-commerce picking (an e-commerce fulfillment center meanwhile, is designed specifically for this purpose) but for shopping AND online order shoppers are competing for space/running into other people. This slows down the picking which leads to increased labor costs (time=$$$).

Another key shortcoming of online grocery is that inventory accuracy in-stores is awful, which is why a “feature” of online grocery is allowing your items to substitute for another if it can’t be found. This is somewhat understandable given that grocery stores are live environments with many perishable selections, but it leads to poor customer experience. In my last online grocery order from a major grocery chain, my order was only 35% fulfilled and I had a few items substituted. The result of this poor CX is an unhappy customer, but it doesn’t stop there. Unhappy customers go on to complain and this results in a large number of customer service tickets/calls which require an army of customer service agents to handle. That’s another increase in labor costs, albeit indirectly. Cha-ching!

So I understand your eggs were broken, the bananas too ripe, and the wheat bread wasn’t the right kind…let me see what I can do.

Infrastructure

Finally, for chains opting to run their own online grocery operations (vs. outsourcing to Instacart/Shipt/etc), the investment is no small check.

From a physical infrastructure perspective, chains need hardware for pickers, additional refrigeration for storing orders, and a fleet of delivery vehicles if they plan to run that part of the operation as well (I’ve seen Safeway trucks roaming around the city).

From a digital infrastructure perspective, chains need to invest in both developments of front-end experiences and back-end software to manage the supply chain and logistics. This can either mean substantial investment in software development teams for building homegrown software or enlisting the help of a systems integrator such as IBM/Accenture/Deloitte to modify commercial-off-the-shelf software to do online grocery. Firms can also opt for a combination of both in-house and SI resources. As online grocery is still a relatively new concept, I would expect cost overruns to be commonplace as grocers and SIs are both at the beginning of the learning curve and many unknown bugs/edge cases are not yet known.

Alternatively, grocers can also opt to outsource online grocery infrastructure to Instacart, which is less cap-ex intensive(but still requires some integration work) although you do need to pay Instacart a hefty fee for the honor. Many small grocers and even larger ones such as Sprouts have gone all-in on this approach.

Summary of Pressure

In summary, all these pressures combined work to depress profit margins. Here is an illustration I made to demonstrate the effect.

Margins being compressed

What can grocers do to improve profitability?

Grocers do not have to be resigned to lower profit margins from online sales, the format does present new opportunities to both lower costs and increase revenue. Let’s take a look at what grocers can do to turn profits around and ensure that they can have a thriving online grocery business that is beneficial to both the top and bottom line.

Grocers can look into the following strategies to reduce costs and address some of the challenges presented previously in this piece.

Dedicated Online Warehouses

Building dedicated online warehouses can significantly improve operating efficiency. Layouts are optimized for picking (vs. merchandising), shoppers don’t get in the way, and inventory accuracy is greatly improved ultimately leading to reduced operating costs. When online order volumes are sparse, it makes sense to utilize the nearest store to the customer to fulfill an order, but when order volumes are high enough eventually the efficiency gains of a dedicated online warehouse can outweigh the cost benefits of delivering from the nearest location.

HEB in Texas was one of the first to do this by converting an underperforming store in Houston into a dedicated e-commerce fulfillment operation. Whole Foods temporarily converted several of its urban stores into online-only operations to fulfill demand. If delivery demand (vs. curbside pickup, which would make more sense for local stores) continues to be high, I can foresee that more grocers will continue to explore this option.

Grocers can also opt to run “dark stores” within their physical stores, spaces that are dedicated to online fulfillment. This hybrid model can provide quick-wins and benefits while grocers evaluate and implement their future online strategies.

Ultimately, the best performing grocers in the online space will be those that adopt a mindset that asks “what does the grocery chain of the future look like?”. This involves fundamentally reshaping their strategies with a new digital vision as opposed to attempting to modify existing infrastructure and business models to adapt to the new environment.

Selection Limitation

Consumers would like to have the option of buying 1, 2, 3, or maybe 17 lemons to meet their cooking needs, but is that really necessary? If you’re shopping at the grocery store delicately picking 5 lemons, 3 limes, 2 potatoes, 2 onions that works because it is your time — but it is a costly affair when it comes to online grocery as someone else has to do that task.

Reducing selection by either removing the option to purchase however many produce products you want or aggressively marketing and pricing bulk packages instead could further reduce fulfillment costs.

Customer Service Automation

I had an issue with a curbside pickup order I placed with Safeway a few months ago. I called customer service but ultimately gave up after waiting for over an hour — resorting to emailing the customer service account. It took almost 4 weeks before my email was answered and the ticket addressed! This is not an acceptable service level agreement by any standard. Thankfully, it appears that Safeway is well aware of the issue and actively working to improve customer service for online groceries judging by the number of openings on their careers website for customer service related roles.

In contrast to this experience, whenever I have an issue with my Doordash food orders, the resolution is quick and speedy — I usually get a credit to my account instantly without ever interacting with a customer service rep. They’ve been able to automate many of their interactions and resolutions, significantly reducing costs and likely even increasing customer satisfaction (instant response>>>delay) even if it means overcompensating (or overcompensating) customers on occasion.

CS interactions, whether it be through phone or email are an expensive proposition, and automating resolutions can be a quick win for grocers. They’re already in possession of significant qualitative and quantitative data on customer tickets and resolutions, building the right models and processes to automate resolutions should be easily within reach.

Online spaces present new revenue opportunities for grocers — data being the key driver for these opportunities.

Advertising

Around 50% of my weekly snail mail is advertisements from grocery stores. In our non-digital past, brands reached customers through grocers by funding discounts and paying to be featured in ads and key locations around the store. This approach is inefficient, many of the products are not relevant to the customer and space in ads and key locations is limited physically.

My mail ^_^

In the digital-age, advertisement space expands beyond the weekly ad and a glut of data from browse, click, to purchase can be used to better match products to customers. Grocers can leverage their online properties as advertising platforms where brands can bid for spots, grocers have already begun incorporating tech into their websites for this very purpose. The matching of supply and demand through ad auctions can serve as an additional source of revenue outside of product sales.

Targeted digital advertisement practices not only function as a source of revenue for grocers, but they are better for consumers, brands, and the environment. Consumers see more ads that are relevant to them, brands can better understand their ROI and manage spend, and trees can breathe more fresh air without fear of being cut down :).

Personalization

Beyond selling advertising space, grocers can use data to personalize offerings and recommendations for their online customers. This can further drive revenue by showcasing products that might not have been on the customer’s radar to start with.

Imagine putting the ingredients for Vietnamese shaking beef into your digital cart and then a recommendation for a wine pairing appears on your screen. You purchase the wine and drink it with your meal — discovering that the wine really does elevate the cuisine to Cloud 9. Everyone wins — the grocer because they make $$$ from selling you wine and you win because you had a fantastic meal that would have only been great without the wine.

One of my favorite dishes! Could be even better with wine :) Source: Tasty.co

Personalization could be a perfect avenue for introducing new products into the market — data can allow grocers to identify customers most likely to adopt the products and easily target these customers.

The possibilities with personalization are endless for grocers and they have only started scratching the surface of what is possible.

Other Innovation

We’ve only scratched the surface of the possibilities available in online grocery. Other new online innovations for driving new revenue include recipe integration — look up a recipe online and add all the ingredients to your cart right away! This is already being done by several online cooking properties in collaboration with the likes of Walmart and Instacart.

Grocers could also take their online presence to the next level by becoming not only a place to buy products but to discover new recipes and creations. They can become content providers and deliver targeted recipes based on your purchases and tastes if you want. As they possess purchase data and history, they are uniquely positioned to do just this.

Grocers can also start to automate many consumer choices — if you always buy the same eggs, juice, and milk every week a cart can be prepopulated for you every week so you don’t have to shop. Voice-assistants from Amazon and Google could also be programmed for shopping and recommending recipes. The possibilities are endless with all the data available.

These are just a few of the strategies that grocers can take to generate revenue online.

Next Up

In the next article, I’ll review the competitive landscape for grocers from Amazon to Walmart to regional grocers to local grocers to new online entrants and identify which ones are poised to take advantage of the digital shift and which ones will struggle.

Retail, consumer goods, and technology aficionado. Fitness enthusiast. Proud Texas Longhorn and Columbia Biz MBA.

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