Study: Understanding Amazon Through Walmart

Introduction

Walmart was created 20 years before Amazon. Both companies have been economic wonders and their successes are precious study material.

Walmart’s success is one of the wonders of the modern world, built from scratch in the competitive retail environment, scaled from nothing to the largest company in the US by revenue and headcount, all resulting from a singular vision of everyday low prices. It is a testament to the power of a focused plan executed relentlessly for decades.

But Amazon is something else entirely. Its amalgamation of businesses don’t seem to make sense. It lacks a cohesive product strategy. It defies norms of focus, yet it executes faster than what seems possible for an entity of its size. To understand Amazon, we should begin by understanding Walmart. We will explore how Walmart revolutionized the retail game and how Amazon “borrowed” Walmart’s playbook as a starting point and innovated its way to dominance.

What is Walmart?

Few outsiders realize Walmart’s historical scope of innovation. It built the largest private satellite communications network, enabling unprecedented coordination at enormous scale. Computerized point of sale systems, a massive trucking fleet for logistics, innovations in Electronic Data Exchange (EDI), Sam’s Club etc. But all of these innovations were really just developed in order to optimize SKUs with respect to these factors: selection, pricing and inventory.

Of course, it took a lot more than that formula to run a store well, Walmart had to give customers all the things they really wanted. To reduce it simply: “a wide assortment of good quality merchandise” at “the lowest possible prices”.

For the first 40 years or so, Walmart became the best in the world at doing exactly that: using the square footage it had in each store as effectively as possible, stocking it with good quality merchandise at the lowest possible prices, and maintaining sufficient inventory to satisfy demand.

All of the complexity and innovation that happened in the background was in service of each store’s merchandising efforts.

Walmart’s buyers became gatekeepers for access to the largest supermarket on the planet. The buyer’s job was to identify high-quality merchandise that the customer might want, and then negotiate the best possible price. As Claude Harris (Walmart’s first buyer) put it:

I always told the buyers: You’re not negotiating for Walmart, you’re negotiating for your customer. And your customer deserves the best price you can get. Don’t ever feel sorry for a vendor. He knows what he can sell for, and we want his bottom price.

In the business of retail gatekeeping, the cost of errors is high. Stocking a Walmart store with inventory that the customer did not want was a compounding error: not only did it provide zero value to the customer, it also robbed the opportunity to buy something that they did need.

Shelf space was a zero-sum game. And, even if Walmart procured items that customer wanted, there were many other factors to consider with the vendors:

• Are they be able to supply enough quantity?

• Can they deliver the items accurately and on time?

• Are they in strong enough financial condition to absorb Walmart’s payment terms?

• Are they accurate in their costing to make sure that they aren’t selling at a loss, after indirect costs were taken into account?

Walmart became the best in the retail business at weighing these considerations. The buyers became proxies for the customers, deciding what customers were likely to want and negotiating for ever-lower prices for those items. Sam Walton drilled the idea of focusing on the customer into Walmart’s culture: What will the customer want when they walk into the store? What price will they want to pay? How many will they want to buy?

Walmart reviewed increasingly many vendors and SKUs. Most did not make the cut, but with the ones that did, Walmart’s selection grew rapidly, and it expanded the size of its stores as much as the local communities could sustain, and stocked them with as many viable SKUs from quality vendors as it could find.

The key is this: Sam Walton didn’t place every aisle, product, promotion, or set every price and inventory level. Rather, he was the “intelligent designer” behind Walmart’s playbook:

• A wide assortment of good quality merchandise

• Offered at the lowest possible prices

• Backed by guaranteed satisfaction and friendly, knowledgeable service

• Available during convenient hours and a pleasant shopping experience

• Within the most efficient store size and location permitted by local economics

So, back to our question: what is Walmart?

Walmart can be thought of as a bounded search for the optimal selection, inventory, and pricing of SKUs that a local market could support. It was bound, or constrained, by the characteristics of the local economy, and so each Walmart location was a direct reflection of the local market dynamics. The immensely difficult job of the local management team was to predict and implement the optimal mix that could theoretically have been found if every possible permutation were tested by the local economy.

Having too few/too many SKUs, or too little/too much inventory, would be a costly mistake. By the same vein, higher-level managers were responsible for estimating the optimal size and location of the store, and for choosing the best associates to manage it. Each level of management was then tasked with managing their own level of the algorithm.

Walmart executed on this playbook uninterrupted for over 30 years, and it got very good at it, until something happened during the birth of the internet.

Enter Amazon, 1994

Jeff Bezos had a big realization in 1994: the world of retail had, up until then, been a world where the most important thing was optimizing limited shelf space in service of satisfying the customer. However, that world was about to change drastically with the advent of the internet and online shopping. This meant that an online retailer had infinite shelf space. While Amazon did not have the capital to stock every item on the planet, nor a warehouse large enough to do so, it didn’t have a constraint on the actual shelf space. The online retailer would be limited not by each local market, but by the economics and behaviour of an international population.

While a traditional retailer was constraint by finite shelf space, the online retailer could display page after page of items with near-zero marginal cost. Instead of choosing which items to stock, Amazon could let its customers do so. It would add all sorts of items to its catalogue, measure web traffic for each item, and bring the items into stock that seemed most likely to sell.

In other words, Amazon wanted to build an unbounded Walmart playbook. By removing the constraint of geography, and by adding search functionality, the new thinking became simpler:

• The more SKUs it added, the more items would be discovered by customers.

• More items discovered lead to more customer purchases.

In this world of infinite shelf space, it wasn’t the quality of the selection that mattered, it was pure quantity. With this insight, Amazon didn’t need to be as proficient as Walmart at the game of vendor and SKU selection. It just needed to be faster at aggregating SKUs and therefore faster at onboarding vendors.

Thus, back in 1994, Amazon started its unbound search for the optimal selection of SKUs. Its playbook borrowed and modified from Walmart was:

• Super large selection

• Fast delivery

• Lowest possible prices

• Backed by guaranteed satisfaction

Amazon added as many vendors as it could. But the pace was too slow; Amazon was adding customer traffic faster than it was adding supply (vendor selection). The company had hit its first constraint: the speed at which it could add new vendors to its catalogue and associated inventory to its warehouses.

Because vendor selection was not important in the world of infinite shelf space, it follows that the vendor onboarding process would be the bottleneck to growth. In other words, Amazon did not have enough resources to fill the infinite shelf space that they had created. Even for the available supply, they did not have the resources to effectively negotiate terms with the thousands of new vendors.

Amazon would never be able to match Walmart’s skills in fighting on the customer’s behalf for better prices, even with a small set of vendors, let alone the exploding vendor base it was starting to manage.

Amazon Marketplace

In its effort to remove this bottleneck, Amazon had an insight that would dramatically accelerate its strategy of mass SKU-aggregation. Instead of the traditional slow process of onboarding and negotiating with vendors, Amazon opened its website to third party sellers.

No matter where a seller was located and no matter what products that seller carried, the seller could start selling on Amazon immediately.

Amazon Marketplace solved a whole set of problems at once. By allowing sellers to bypass the vendor selection process, Amazon could rapidly fill its infinite shelf space with a vast selection of SKUs not available from other retailers. Instead of slowly building its own inventory on promising SKUs, Amazon could make a seller’s ready inventory instantly available to customers.

Most importantly, it solved the problem of how to negotiate pricing with an expanding SKU base. When Amazon was competing against sellers for a given SKU, there were two possibilities: either Amazon negotiated the best possible price with the vendor and would win the sale, or it had failed and another seller would win instead. However, Amazon would collect a commission, and gain a data point that can be used in future price negotiations. Furthermore, losing the sale to a third party seller still meant that Amazon would keep the customer.

The internet resulted in an increasingly connected world which meant that more overseas products coming in, and it was also easier than ever for US companies to launch and expand new product lines. Amazon Marketplace took advantage of this trend; it systematically removed friction from the seller onboarding workflow, doing things like eliminating the Universal Product Code (UPC) requirement. All of these small changes started to add up and Amazon became the fastest way for a company to start selling online. Customers began to associate Amazon with selection, and the company became the global storefront for e-commerce.

Walmart optimized towards shelf space constraint which was completely disrupted. Even if Walmart had recognized this immediately, it would have been impossible to react as quickly as the younger Amazon. In the meantime, Amazon’s SKU aggregation was running an unbounded search for customer value worldwide, while Walmart’s army of finely-tuned retail gatekeepers was still running a bounded search in local geographies. The effects began to compound, and Amazon’s e-commerce growth accelerated further.

Exposing Tech Infrastructure

Things get difficult when running an unbounded search at global scale. What was initially solvable, albeit quite impossible, at Walmart’s scale, suddenly becomes unmanageable when shelf space went to infinity. Amazon had to find a way of abdicating responsibility for solving these problems altogether.

After removing the vendor bottleneck, Amazon had discovered the next constraint: computing power and data storage. In the early days, Amazon’s software engineers were waiting for weeks for technical resources like servers and storage to be provisioned. Instead of being limited by how fast they could write code, they were limited by how fast they could deploy that code to Amazon’s infrastructure. The code base has evolved into a mess after a few years. To solve this Amazon began to build a platform that would allow its software engineers to provision on-demand resources immediately. In a radical move, the platform would be made available to external developers too. This is the Amazon Web Services (AWS).

Exposing Product Catalogue

Another constraint had emerged around the same time on the customer-facing front: Amazon could no longer keep up with the pace of innovation that its exploding SKU catalogue had enabled.

It could not possibly develop features on its website fast enough to take advantage of all the merchandising opportunities. This became apparent as other independent sites (third party members of Amazon’s affiliate marketing program) began scraping the catalogue in order to surface new items, track price changes, and other functionalities.

Now the limitation is not demand or supply, it was the conversion rate and average order value it could achieve with its current catalogue functionality.

Amazon needed to get faster at implementing new catalogue functionality internally, and it could also benefit immensely from allowing the outside world to innovate using that same toolkit. In a similarly radical move, Bezos decided to expose Amazon’s entire product catalogue via an application programming interface (API) so that any software developer could access Amazon’s catalogue and use the SKU data.

Creating Platforms

Amazon was becoming a platform, defined by an aggregation of resources made available through a series of interfaces.

In the case of Amazon Marketplace, the resource was customer demand, and the interface was a web portal called Seller Central.

In the case of AWS and Catalogue, the resources were computing power and a monetizable e-commerce catalogue, and the interfaces were APIs opened to software developers.

Platforms spring up as a necessity when running at internet scale. A company like Walmart, despite being massive in terms of revenue, can only operate within a finite problem space. Walmart’s problem space was limited enough such that it could solve its own problems internally with sufficient effort and innovation.

However, we want to point out that Walmart also went towards the platform route, it build Retail Link (a reporting software developed by that gives suppliers access to point of sale data, documentation, reports, store information). It was the first step to expose internal resources to the outside world, allowing vendors to manage purchase orders and take the burden off Walmart.

Like with Amazon’s various platforms, Walmart built Retail Link out of necessity. Without it, the purchasing process would have remained a constraint to Walmart’s growth. The difference is that, with infinite shelf space, Amazon was encountering these problems and implementing solutions everywhere.

Opening Platforms

There is an important economic difference between Retail Link and Amazon platforms. Suppliers have no choice but to use Retail Link; the supplier is a “captive” of the Retail Link service. The problem with having captives: a service begins to degrade over time when lacking external competitive pressures. The service provider is removed from the feedback loop, since given sufficient market power, suppliers can’t feasibly stop using the service, and the service provider itself doesn’t experience the pain of using its own service.

Amazon was different, for example with AWS, instead of just building an internal platform, it would open the platform to outside customers as well. Amazon used the exact same tools and products that its customers used, and would get the exact same benefits that its customers enjoyed. In other words, Amazon would become one of many AWS customers, solving its own bottlenecks without the trap caused by vertical integration.

Bezos then issued the famous memo, known as the API mandate, in 2002:

1. All teams will henceforth expose their data and functionality through service interfaces.

2. Teams must communicate with each other through these interfaces.

3. There will be no other form of interprocess communication allowed: no direct linking, no direct reads of another team’s data store, no shared-memory model, no back-doors whatsoever. The only communication allowed is via service interface calls over the network.

4. It doesn’t matter what technology they use. HTTP, Corba, Pubsub, custom protocols.

5. All service interfaces, without exception, must be designed from the ground up to be externalizable. That is to say, the team must plan and design to be able to expose the interface to developers in the outside world. No exceptions.

6. Anyone who doesn’t do this will be fired.

7. Thank you; have a nice day!

This principle would enable Amazon to become a big complex company without collapsing under its own weight, effectively future-proofing itself from the bloat and bureaucracy that the law of large numbers inevitably cause.

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From infinite shelf space comes a problem: how do customers discover new products? For a given item category, Amazon can have thousands of pages of search results.

Again, Amazon outsources the problem to its users. It relies on a ranking algorithm that weights product reviews and sales velocity. The more reviews a product has and the more units it sells, the higher it climbs in rankings. Of course, this creates a positive feedback loop.

But then this creates another problem: sellers who want to sell exciting new items would find it hard to climb the rankings.

Amazon answered in typical platform fashion. Amazon Advertising allowed sellers to feature “Sponsored Products” (paid ads that appear at the top of search results). Sponsored Products solved three problems at once:

• New product discovery for the customers.

• New product introductions for the sellers.

• Pure gross margins revenue for Amazon from ad revenues.

The problem with Sponsored Products is that they are not actually good for customers. More specifically they are good for sellers who excel at advertising and bad for everyone else. Paid digital advertising is a very specific skill set; the odds that the brand with the best product also happens to employ the best digital marketing is low. Furthermore, the ability to buy the top slot in search results means that the products has high margins which doesn’t benefit buyers.

The issue is compounded by the fact that the average customer is unable to tell the difference between an organic search result and a sponsored product, which means that the average customer is likely to be purchasing a sponsored product.

However, the huge amounts of ad revenues generated probably cause Amazon to ignore this issue.

Problems with Platforms

The hidden cost of SKU proliferation is a reduction in overall quality. This is not a particularly meaningful problem when it comes to some categories (eg. phone cases), where the cost of a sub-optimal purchase is minimal. But there are some categories (critical accessories parts, grocery, health products) that are sensitive to customer frustration.

With its Amazon Marketplace platform, it has created an environment for sellers with all of the tremendous benefits and pitfalls that come with it. Amazon’s challenge would be to maintain order in a marketplace of global scale, if it wants to represent itself as “Earth’s most customer-centric company”.