Fallacy – DTC Will Make More Money

Earlier last week I saw a post on Linkedin about how Direct to Consumer (DTC) owns the data and you make more money directly and I couldn’t pass up the opportunity to debunk that latter part of that statement. First, you absolutely own the data, that is the major windfall but you do not necessarily make more money so let me break that down a bit.

First and foremost, I’m really talking about traditional vendors that are used to selling through outlets, this math doesn’t align exactly the same if you started fully direct but much of it is the same. When you are a traditional vendor and selling through retail outlets your margin percentage is absolutely lower, for the sake of argument let’s assume that at wholesale you make 25% margin, so you sell your $100 item for $125 to retailers who then sell it to their customer and let’s assume the same 25% margin at that stage and the end customer is buying it for $167.

People quickly point out that if you sell the item directly to the consumer you would sell it for $167 and pocket $67 on a $100 item, or 67% margin. The math checks out, if you sell the item at retail and have no ‘middle man’ you will absolutely have that amount of product margin.

The problem lies in the fact that that product margin is not the measure you should be using, it is variable contribution margin. The fallacy with “DTC will make more money” is that it assumes all other costs are constant. When you are selling at wholesale your advertising costs are very low, your shipping costs to send a pallet is vastly different than sending an individual item. Your customer service department no longer handles 500 retailers, they now handle each individual customer. To truly understand the real margin you would have to determine the contribution margin of DTC versus straight product margin, that would give you the starting point but even if that is higher you still may not be making more money. You have forgotten about pricing risk.

The worst assumption on margin is based on the premise that you will get full price throughout the whole selling cycle. If you are a DTC of a cut-to-sew, or anything that has a seasonal lifespan, you traditionally have booked orders six to twelve months in advance. You know your order book and maybe you buy a slight buffer to give retailers some limited reorder ability. Either way, you have a pretty known demand and projected margin. Inevitably you have some level of dead merchandise that you discount wholesale to some set of retailers when the season ends and you have broken size or color ways or retailers that didn’t sell through and want to return the items or get a credit. It isn’t perfect by any means, but if you sell through 500 retail outlets you have offloaded the risk across a wider universe.

Now thinking about DTC and that risk, if you either cut back on the number of retail outlets or start off without any thinking that you will make more money you have taken on a lot more risk and the likelihood of being ‘more profitable’ is less. If we stick with a cut-to-sew/seasonal and you are selling it all direct, over the course of the season your $167 price point will start to slip as the season goes on, traditional retailers are used to this and know their blended margin and the sort of pricing strategy to make sure they remain profitable, but they only have to worry about it for 1/500th of what you have to worry about. Since weather and other factors are often in play for seasonal and trendy products those experiencing issues are just a subset and they will work through their inventory, but if you own it all you have to derive the pricing strategy to work through it. 

After you have added all the variable contribution margin costs (advertising/CAC, pick-pack-ship, returns, customer service) you will be left with the real margin you are starting at and I would go out on a limb that holding all the risk or more of the risk of pricing and clearance inventory will eat up the remaining portion of the perceived gain selling direct.

This very reason is why the best vendors always built strong retailer networks with speciality retailers and not big box retailers. The big box retailers aren’t as valuable as they will push back risk and push down wholesale margin at the same time, but the smaller speciality retailers would embrace products sought by customers. With a healthy network manufacturers would traditionally avoid selling directly because taking on all that risk wasn’t worth the reward. 

Times have obviously changed quite a bit and there aren’t a ton of healthy retailers and the risk has shifted up stream but that doesn’t mean it is more profitable than when there were vast dealer networks and a healthy spread of the risk. These changes are why I laid out a simple 4-step plan in a prior blog post for accelerating growth in the current age. Those that understand variable contribution margin and are ready to take on the operational aspect and have a plan for the new risks will be successful, but you cannot blatantly say that selling DTC is more profitable.