The Truth Behind Free Shipping

In 2017 Amazon spent $21.7 billion on shipping costs, nearly double the amount from two years ago. That is $21.7 billion in losses, since Amazon doesn’t charge for most shipping. One hundred million items qualify for free two-day shipping now compared to only 20 million in 2014.  The company’s bet, of course, is that by offering free shipping to customers they will become addicted to the convenience and spend more. But do the increased sales make up for the shipping losses?

Probably not, which is why Amazon recently announced the cost of a Prime membership would rise by 20% effective May 11. In addition to raising the cost of a Prime membership, Amazon is also raising seller fees in certain high-volume categories such as apparel and books.

There’s no such thing as a free lunch. Costs have to be absorbed somewhere, either through lower margins or by investor subsidies, which has been Amazon’s strategy for most of its existence.

In business, there are fixed costs, defined as costs that remain basically the same no matter how much a company sells, and then there are variable costs, which rise and fall with sales. Shipping is a variable cost and therefore a price factor in every purchase. Some analysts expect shipping costs to increase by 7% per year going forward, a variable cost that will have to be absorbed either by e-commerce sellers or their customers.

The secret sauce to e-commerce may ultimately turn out to be convenience over price as the competitive landscape finds its natural level. Brick-and-mortar rents are falling, for example, while e-commerce shipping rates are rising, which may start returning some leverage back to the brick-and-mortar business model.

Some analysts say that the supply-chain cost to retailers for direct-to-home sales is three times that of an in-store purchase, yet customers don’t pay three times as much to have items delivered to them. In fact, they often they pay less, with the difference in cost being absorbed by the retailer. How long will that continue?

Amazon Prime membership fees only recover about 55% of the money that Amazon spends on shipping, which is why Amazon recently raised the minimum purchase for free shipping to $49 from $35.

How can smaller e-tailers compete with Amazon as the promise of free shipping bites deeper into margins? One way is to ship through fulfillment 3PLs that receive shipping discounts from the major carriers, reducing shipping costs. Another way is to improve packaging. Shipping costs are determined by weight and dimensions. The weight of the product usually can’t be controlled, but often substantial savings can be found in packaging variables.

Another strategy is to create a sales niche or buyer-community that is loyal to your product. Then the e-tailer can charge more and cover the costs of increased shipping.

Whichever route one chooses, shipping costs will play an increasingly important role in retail decisions going forward.