In 2010, Patrick Roman was transferred from corporate headquarters...

In 2010, Patrick Roman was transferred from corporate headquarters of Saharis.com in Seattle, WA to spearhead expansion efforts in Central and Eastern Europe. He was appointed general manager of a newly created business unit, Saharis Central Europe (SCE), and charged with developing a newly created Saharis.cz domain and replicating the successful U.S. online retailing model, which was already taking foothold in several major European countries. The business opportunities and challenges facing SCE were quite different from those encountered in other countries. The heavy discounting strategy of Saharis appealed to price- conscious customers in the region. Another strategic advantage was access to low-cost labor and an efficient warehouse just outside Brno, Czech Republic. The warehouse was the largest of its kind in Central Europe and was located within two-hour drive of four metropolitan areas with population of around 3 million, including the capitals of the Czech Republic and Slovakia. Given that no other online retailer established a major presence in the region, SCE competed against brick-and-mortar retail chains relying on stores in expensive downtown locations and charging higher prices. Bigger malls outside of downtown areas were gaining in popularity but were less common than in the U.S. because of the relatively high cost of owning a car. However, much of the infrastructure Saharis relied on in other countries was underdeveloped. Slow postal service by ?esk Po?ta took 4 to 6 business days to deliver a package. Premium services such as next day or second business day delivery, offered by DHL and FedEx, were expensive because the business volume in the region was still relatively low. SCE considered fast service critical to their success and set up their own delivery in selected areas. Members of the "Elite Team" loyalty program who made sufficiently large orders qualified for second (business) day delivery. SCE charged a 5% shipping fee for this premium service or offered free shipping by postal service. Non-members paid the standard 5% shipping fee for the slower postal service. SCE enticed customers into the Elite Team program by offering online perks such as unlimited streaming of movies and music for a monthly fee of CZK 299 in the Czech Republic and ?9 in Slovakia. A large majority of customers in the metropolitan areas had access to

sufficiently fast Internet connections to make these perks attractive. However, many customers did not take full advantage of the perks and only streamed movies to their small- screen devices because smart TVs or set-top boxes enabling streaming from the Internet were only beginning to penetrate the market. Moreover, content distribution contracts in Europe were less favorable than in the U.S. Although Elite Team customers enjoyed unlimited streaming, Saharis had to pay copyright fees based on the number of customers and their online content consumption. How much to charge for Elite Team membership was a point of continuous debate within SCE. Patrick Roman was willing to subsidize Elite Team membership to get customers used to online transactions, to win their loyalty, and to increase capacity and utilization of internal delivery services. The membership program was critical in changing the local habit of ordering by phone and/or seeking the support of customer representatives to process payments, arrange for returns, etc. This habit had roots in the past when mail order catalogues relied on phone communication to win customer trust. SCE adjusted to customer expectations and set up a call center but the goal was to wean customers off this expensive service. A clause in the Elite Team membership contract limited the number of free phone transactions. Another initiative launched in 2011 was to sign up customers into "Subscriber" services. Close cooperation and exclusive distribution contracts with consumer product companies such as Procter & Gamble and Unilever allowed SCE to offer a large number of everyday consumption items at 5-15% discounts relative to competition. Subscribers committed to a minimum order size and selected a day for regular monthly or quarterly deliveries. Although Subscriber orders were typically larger and/or heavier than other orders, SCE only charged the standard 5% shipping and handling fee and used their internal delivery service to fulfill these orders. This service attracted a new type of clientele. Most Subscribers were not Elite Team members but an increasing percentage of customers with a year or more of active Subscriber service signed up for the Elite Team program. Also, many Subscribes quickly grew accustomed to online transactions even if they chose not to become Elite Team members. Patrick described the customer base and business growth opportunities as follows: We have essentially three major types of customers?the Users, the Subscribers, and the Elite Team. The Users demand call center support and, for now, we are happy to provide it at the right price. We make money on some of the bigger purchases such as electronics or jewelry. We are willing to sacrifice profitability of many other items to get them accustomed to the great deals we offer and to the reliable service. The Subscribers are an unremarkable but steady source of revenues. They also help us reach delivery volumes that make the second day service feasible. The Elite Team is where we see our future. Our vision is to offer free second or even next day delivery and make online shopping the default choice for most purchases of our customers. Now, the big question is how to make it happen. We can sacrifice profitability in the short term but we are already dealing with huge start?up costs and we cannot afford to lose too much money. We are lucky that Seattle does not push us to break even quickly but, you know, their patience is going to run out at some point... Exhibit 1 provides more details on actual and forecasted growth in sales and customer acquisitions (internal reporting and consolidation guidelines call for financial results to be reported in Euros). Patrick strongly felt that the strategy of emphasizing sales growth at the cost of short-term profits was justified. At the same time, he knew that it is time to increase the focus on the bottom line. The current cost system was not much of a help because it allocated all overhead as a percentage of sales and thus made all sales look equally profitable. Patrick needed to better understand profitability of different types of customers. He hired a new business controller, Petr Mldek, to design a better cost system. Overhead Cost Analysis Petr could retrieve revenue and cost of goods sold per customer using income statement data (see Exhibit 2 and 3). The challenge was to how to assign overhead costs related to warehouse personnel, warehouse depreciation and equipment, shipping, call center support, marketing, technology, and administration. Petr collected additional information in the following areas. Warehousing The main warehouse processes were receiving, inspecting, storing, picking, packaging, and preparing customer orders for shipment. The warehouse featured robots, conveyor belts, and other automated equipment to deliver ordered items from shelves to packaging staff, although some items still had to be picked up manually. A warehouse supervisor commented as follows: Most of what we do is managing "loads." Each manual pickup or each container being transported automatically from the shelves to the packaging area is one load. Multiple smaller items can fit into one load, e.g., multiple items of the same SKU1 or different SKUs that are on nearby shelves. Most orders have multiple loads as customer maximize order size to reduce shipping costs. We can typically fit each order into one package for shipping but sometimes it is more than one package, especially if it is passed on to our second day delivery guys?they rather move two regular size packages than one big one. If you think in terms of costs, the more loads we have, the busier we are, and the more people I have to hire and schedule. Over the last couple of years the number has been increasing steadily. The total number of items and loads processed in 2012 was 18 and 11 million, respectively. The warehouse supervisor suggested that his staff was busy processing loads most of the time; the average downtime was only around 10% and could not be reduced much further. Small increases in loads could be accommodated but sizeable increases meant additional

hiring. In contrast, only about 60% of the warehouse space and equipment capacity was utilized because SCE built in slack for future growth. The goal was to reach an industry standard of about 80% within a year or two. Shipping Packaged items were shipped either by standard postal service or by internal second day service in case of qualifying orders by Elite Team customers. In total, 5 million packages were shipped in 2012, of which 2 million went by postal service. SCE negotiated discounted postage rates that varied slightly depending on size and weight but were about the same for most packages. The remaining 3 million packages were shipped internally through 2.5 million deliveries. Delivery vans operated by SCE were underutilized when travelling to other than the most popular destinations. Managers estimated that they could accommodate 50% more deliveries with the same van fleet if they could increase the demand in some areas. Call Center Petr struggled to learn about call center operations. Ana Navrtilov, the department manager was not very cooperative. She expressed her frustrations: I do not think our work is appreciated very much. We are squeezed in the smallest facility they could find and there are budget cuts every year. I am sure they would outsource us to India if only they could... It is very stressful to handle calls all day long with almost no downtime. Employee turnover is very high... In the end, Ana helped Petr collect 2012 data on call center processes. They identified three main activities. The first one accounted for 30% of call center capacity and involved phone order set up including the recording of customer name, address, shipping and payment preferences, explaining of return policies, etc. In total, the call center processed 1.2 million phone orders. The second activity accounted for 40% of call center capacity and involved processing of SKU choices, which included looking up item codes, verifying availability, explaining product features, refining choices (e.g. item size or color), recommending alternative products in case of stock-outs, etc. The amount of work associated with this activity reflected the number of SKUs, i.e., no additional work was necessary when customers ordered multiple items of the same SKU. In total, 2.4 million SKUs were processed over the phone. The third activity, general inquiries, accounted for the remaining 30% of the call center's capacity. It resulted in no new orders and included for example advising of customers not yet ready to make a purchase or processing of returns. In total, there were about 500,000 such calls. Other Expenses Finally, Petr combed through expenses related to technology, marketing and selling, and general administration. He was not quite sure yet which expense subcategories would be relevant for his customer profitability analysis. Nevertheless, he identified the following 2012 expenses as potentially important: content licensing fees (?12 million); website

development and maintenance (?3 million); IT support of internal operations (?1 million); marketing expenses related to promotion of Elite Team Membership (?3 million); administration, coordination, and support of internal delivery service (?2 million). Now it was time to put it all together and report back to Patrick Roman with recommendations on how to increase customer profitability without losing track of sales growth targets.

Exhibit 1 Actual and Forecasted Growth Actual Results Forecasts 2010 2011 2012 2013 2014 2015 Sales (in thousands) E1 10,000 E160,000 E250,000 E350,000 6450,000 6550,000 Number of customers Elite Team 100,000 140,000 200,000 280,000 370,000 450,000 Subscribers 12,000 20,000 25,000 30,000 35,000 Users 140,000 150,000 157,000 170,000 180,000 190,000 Marketing of Elite Team Program (in thousands) E5,000 64,000 E3,000 E2,000 E1,000 E1,000 Exhibit 2 2012 Average Annual Gross Margin per Customer (in () User Subscriber Team Elite Product Sales 400 500 800 Service Sales (Shipping & Handling) 20 25 20 Service Sales (Membership Programs) 0 0 108 Cost of Goods Sold 328 390 640 Gross Margin 92 135 288Exhibit 3 2012 Income Statement (in (5 thousands) Product Sales 232,800 Service Sales 29,240 Cost of Goods Sold 187,296 Gross Margin 74,744 Salaries & Benets of Warehouse Staff 9,600 Depreciation of Warehouse and Equipment 11,000 Postal Service Shipping 9,800 Intemal Delivery Related Expenses 18,000 Call Center Expenses 5,400 Technology 17,000 Marketing and Selling 6,000 General and Administrative 13,000 Operating Income 45,056 Exhibit 4 2012 Annual Service Usage per Representative Customer User Subscriber Team Elite Number of items ordered 15 60 70 Number of loads in the warehouse 12 20 40 Number of packages 10 20 20 Number of deliveries 10 10 16 by postal service 10 0 8 by internal second day service 0 10 8 Number of phone orders 8 2 0 Number of SKUs on phone orders 15 4 0 Saharis.cz (B) After a few weeks on the job Petr Mladek established a good working relationship with Ana Navratilova, the call center manager. She helped him collect additional data on call center operations. First, he summarized the information obtained earlier. The 2012 costs of call center operations was 54 million and the three main activities were as follows: Percentage Volume Phone order set up 30% 1.2 million orders SKU processing 40% 2.4 million SKUs General inquiries 30% 157,000 non-members Second, he put together all additional information he could collect: o SCE employed 275 call center agents. 0 On average, it took 7 minutes to set up an order for a new customer, i.e., to collect shipping address and payment information, to explain return policies, etc. Orders of returning customers could take as little as 3 minutes to set up if they had their payment information stored or 5 minutes if it had to be re-typed. 0 About 50% ofphone orders came from new customers and 50% of orders were from returning customers. One out of five returning customers had agreed to have their payment information stored for future use. 0 It took 4 minutes on average to look up each SKU. 0 There were 500,000 general inquiries in 2012. The average inquiry took 14 minutes to process. Petr planned to use this information to get an even better insight into the call center costs. The idea was to set up a simple time-based activity-based costing system, which would also allow a better management of capacity utilization, an issue Ana Navratilova kept complaining about