Heading into the holiday season, the National Retail Federation (NRF) predicted that retail sales would be up and that, for the first time, the internet would be the most popular consumer shopping destination.

For online merchants, this is good news. At the same time, it highlights the corresponding Santa Claus problem that online retailers have to deal with: figuring out whether a given online transaction is naughty or nice (i.e., fraudulent or legitimate) quickly and effectively.

Balancing Three Business Objectives

At a high level, the total cost of e-commerce fraud reflects how online merchants are currently deciding to balance three fundamental business objectives.

1. Maximize the Nice

Online merchants naturally want to accept all genuine online orders. Declines are transactions that they don’t accept due to suspicion of fraud, but some of these transactions may actually be legitimate. These are called false declines, which can result in lost revenues.

2. Minimize the Naughty

At the same time, online merchants want to minimize online orders that should not be accepted in the first place. Transactions that are initially accepted but subsequently disputed are known as chargebacks, which can result in reversal of revenue, fees from payment card processors and other costs.

3. Make Better, Faster, More Cost-Effective Decisions

Making better business decisions about e-commerce fraud involves both people and technology. The timeliness of making these decisions is also crucial because customers are typically intolerant of even a few seconds of delay in the online experience. Should this happen, they are likely to take their business to another, speedier retailer.

For online merchants, finding the optimal balance of these three objectives can be tricky. This is the corresponding Goldilocks problem of e-commerce: creating acceptance policies that are neither too strict (leading to false declines) nor too liberal (leading to chargebacks), but just right, while still making transaction-by-transaction decisions in a timely and cost-effective manner.

How Online Merchants Are Performing

Primary research from Aberdeen across eight market segments provided some interesting quantitative insights into how online merchants’ current performance may be out of balance.

• Maximizing the nice: Declines ranged between 2.5 percent and 5.14 percent of annual online order dollars. However, online merchants are currently turning away between 11 and 100 times more order dollars due to concerns about potential fraud than they are actually losing on chargebacks.

• Minimizing the naughty: Chargebacks ranged between just four and 46 basis points (a basis point is defined as 1 percent of 1 percent) of annual online order dollars. But online merchants are currently spending between 31 and 167 basis points (between 2.3 and 13.9 times more) on making decisions about fraud than they are actually losing on chargebacks.

• Making better, faster, cost-effective decisions: For every dollar in overall industry profitability over the last five quarters, which ranged between 7.98 percent and 10.43 percent, the combined business impact of declines, chargebacks and decision-making was between 45 and 60 cents.

For merchants who focus primarily on minimizing chargebacks, this analysis shows why the total cost of e-commerce fraud is actually much worse than they think. The numbers suggest that retailers are missing out on too much of the nice by focusing too much on the naughty. Making better and faster decisions to minimize the impact of false declines represents a big opportunity to reduce the total cost of fraud and improve the bottom line. That’s why effective fraud protection tools should be at the top of every online merchant’s wish list this holiday season.

Download the complete IBM X-Force report: Security Trends in the Retail Industry