Surge pricing a dead-end for logistics

A recent analysis for Channel 4 Dispatches indicated that the big supermarkets are losing as much as £100m annually as a result of charging customers an average £5 for home delivery when the real cost is actually £20 or more.

When online / home delivery represented a tiny percentage of total sales, these costs didn’t really matter. They were easily absorbed into overall costs, as retailers were investing heavily to win market share in the online space. However, as online sales has now grown into double figure percentage of total sales, these costs can no longer be ignored.

A common problem is that many retailers don’t really understand how the different costs break down across the delivery channels, and the most complex of these is the cost of home delivery, known as “the last mile”. In order to try and control this element, many retailers are turning to 3rd party logistics carriers who offer extremely low prices to fulfil home delivery orders – but it turns out that their charging structures are unrealistically low in many cases.

Over Christmas 2014, some carriers simply ground to a halt because they weren’t able to cover their costs. One carrier (City Link) threw in the towel and went bust. Last Mothers’ Day saw similar national chaos as flowers went undelivered, causing mass outrage from thousands of disappointed customers. The economics of the current home delivery model are simply not working and it’s a problem that is only getting bigger as online grows.

So what is the answer?

Retailers (well, most retailers) are in business to make a profit, and at some point they know they will have to balance the books. Two major players (Tesco and John Lewis) recently increased delivery charges and angry customers flocked to social media, threatening to close their accounts.

Some are suggesting that the answer is a dynamic (or “surge”) pricing model, similar to how Uber regulates demand at high peak times: when demand suddenly peaks, Uber raises prices until things settle down.

But how would this work for home delivery? Customers need to know the delivery charge when they place their order. Retailers cannot suddenly double it if things get unexpectedly busy on a Friday evening. And it doesn’t address the real problem. It’s not a matter of regulating demand – the issue is that delivery charges are too low in the first place. Retailers must accept that this is partly their own fault: they are the ones who have educated their customers for the last ten years that there really is such a thing as a free home delivery. And there simply isn’t, at least not if you are one of those old fashioned retailers that needs to report profits each year.

What retailers should be doing is to calculate exactly how much a home delivery costs them, for different products, times, locations, and so on. There are probably around 25 components – from marketing, to picking the product in a distribution centre and the price charged by a courier – that make up the cost of fulfilling an online order. It really is quite surprising how few have developed an accurate “cost to serve” model for this.

Once retailers understand the detailed cost model, they can then consider a menu of prices. For instance, if a customer insists on a delivery arriving at 7pm on a Friday evening, then the cost might be £25. However, if a customer is happy with 2pm on a Wednesday, then it’s £8. And so on, along a sliding scale, just like hotel rooms or airline seats.

And then these costs must be communicated very clearly to customers, along with any other conditions or offers (e.g. if someone regularly spends £500 a week, then perhaps  they can receive a saving; whereas that would not be offered to the customer who might buy a pint of milk every few weeks).

Surge pricing is certainly not the answer. In fact it’s not even asking the right question. If retailers start to adopt surge pricing, all they are doing is trying to hide the symptoms of the problem, not dealing with the real cause.

Many retailers are still convinced that if they just continue to grow their online sales and market share, then at some point it will suddenly become profitable. That’s a bit like saying that if I can only sell more ten pound notes for a fiver, I will eventually reach breakeven. It’s called living in dreamland.