Free Shipping: Pros and Cons

Stephen DeAngelis

June 9, 2011

An employee of mine recently ordered replacement batteries online for the cordless phones in his home. He found a site that sold the batteries for $4.64 each, which sounded like a much better deal than the $6.99 price found at others sites offering the same batteries on Amazon.com. Shipping, however, cost him $14.97 (more than the price of the three batteries he ordered). Total cost of the batteries was $28.89. After he had made the purchase, his wife told him that she had signed up for Amazon Prime and those $6.99 batteries were eligible for free shipping. Total cost for the more expensive batteries would have been $20.97 — a savings of nearly $8.00! After having to admit to his wife that he had acted stupidly (a high price to pay for online shopping), he promised to run such purchases by her in the future. Brad Stone asserts, “Customers love Prime, Amazon’s two-day shipping program.” [“What’s in Amazon’s Box? Instant Gratification,” Bloomberg BusinessWeek, 24 November 2010] They love it so much, he claims, that “rivals such as Wal-Mart, Target, Best Buy, and J.C. Penney are copying it.” Stone continues:

“Amazon.com’s free shipping service, Amazon Prime, which guarantees delivery of products within two days for an annual fee of $79, … may be the most ingenious and effective customer loyalty program in all of e-commerce, if not retail in general. It converts casual shoppers, … who gorge on the gratification of having purchases reliably appear two days after they order, into Amazon addicts. Analysts describe Prime as one of the main factors driving Amazon’s stock price—up 296 percent in the last two years—and the main reason Amazon’s sales grew 30 percent during the recession while other retailers flailed. At the same time, Prime has proven exceedingly difficult for rivals to copy: It allows Amazon to exploit its wide selection, low prices, network of third-party merchants, and finely tuned distribution system, while also keying off that faintly irrational human need to maximize the benefits of a club you have already paid to join.”

By the way, those batteries that my employee ordered (the one’s that cost him an extra eight bucks), promised delivery in was in 7 to 23 days — not the two days he could have had with Amazon Prime. That’s another elbow to the ribs from the wife. Stone continues:

“Now six years after the program’s creation, rivals, both online and off, have sensed the increasing threat posed by Prime and are rushing to try to respond. Wal-Mart Stores, Best Buy, Target, and J.C. Penney … unveiled free shipping promotions for [last year’s] holidays. … [Last] August, eBay announced its first rewards program, eBay Bucks, which gives shoppers 2 percent back on items purchased on the auction site using PayPal. Last [October] a consortium of more than 20 retailers, including Barnes & Noble, Sports Authority, and Toys ‘R’ Us, banded together with their own copycat $79, two-day shipping program, ShopRunner, which applies to products across their Web sites. ‘As Amazon added more merchandising categories to Prime, retailers started feeling the pain,’ says Fiona Dias, executive vice-president at GSI Commerce, which administers the ShopRunner service. ‘They have finally come to understand that Amazon is an existential threat and that Prime is the fuel of the engine.'”

When the big retailers announced their holiday “free shipping” promotions, it sent ripples through the e-commerce world [“Wal-Mart Says ‘Try This On’: Free Shipping,” by Stephanie Clifford and Claire Cain Miller, The New York Times, 11 November 2010] Clifford and Miller report:

“Given Wal-Mart’s scale and influence in the marketplace, its free pass for shipping sets a new high — or low — in e-commerce. And it may create an expectation among consumers — free shipping, no minimum, always — that would make it harder for smaller e-commerce sites to survive. … Wal-Mart and other big retailers already have low-price contracts with shippers, and the stores maintain distribution centers nationwide that reduce shipping distances and costs. For smaller retailers and Web sites, which pay regular mail rates and may ship from only one location, free shipping is not nearly as affordable and often must be added into prices. ‘You’re trying to compete with the Amazons and the Zappos, who have so many different warehouses that they can significantly reduce transport costs,’ said Gary Schwake, director of business development at the Distribution Management Group, a consulting firm that advises retailers like Eddie Bauer. Retailers say that shoppers have already started to revolt against shipping fees. While consumers are sensitive to what an item costs online, shipping costs can have even more influence, according to market research.”

I want to reiterate that last sentence –“While consumers are sensitive to what an item costs online, shipping costs can have even more influence, according to market research.” That’s a pretty bold statement with profound effects for the supply chain. In his article about Amazon Prime, Stone reports:

“Analysts say Prime members increase their purchases on the site by about 150 percent after they join and may be responsible for as much as 20 percent of Amazon’s overall sales in the U.S. The company’s executives acknowledge only that the program gets people to buy more—and more kinds of items—on the site. ‘In all my years here, I don’t remember anything that has been as successful at getting customers to shop in new product lines,’ says Robbie Schwietzer, vice-president of Amazon Prime and an eight-year veteran of the company.”

Before returning to the subject of free shipping, I thought you might be interested in what Stone wrote about the origins of Amazon Prime. Frankly, the story surprised me because it begins with the time-honored “suggestion box.” Most suggestion boxes hang on the wall outside of a manager’s office gathering dust. The Amazon suggestion box didn’t gather dust because it was electronic; but even virtual suggestion boxes are probably not used very often. Stone relates the story:

“Prime came to life in late 2004, the result of a years-long search at Amazon for the right loyalty program. An Amazon software engineer named Charlie Ward first suggested the idea of a free shipping service via a suggestion box feature on Amazon’s internal Web site, according to Ward’s colleagues at the time. Bing Gordon, an Amazon board member and venture capitalist, says he came up with the ‘Prime’ name, while other executives, including Chief Executive Jeffrey P. Bezos himself, devised the free two-day shipping offer, which exploited Amazon’s ability to accelerate the handling of individual items in its distribution centers. According to several former employees who participated in the program’s creation, Bezos commissioned Prime in December 2004 at an unusual Saturday meeting in the boathouse behind his home in Medina, Wash. … The program is a ‘big idea,’ Bezos told the group that day in the boathouse, according to people who were there, and one that would help the company further capture the devotion of its best customers. … One challenge was selecting the annual fee for the service; there were no clear financial models because no one knew how many customers would join or how it would affect their purchasing habits. The team ultimately went with $79 mainly because it’s a prime number. ‘It was never about the $79 dollars. It was really about changing people’s mentality so they wouldn’t shop anywhere else,’ says Vijay Ravindran, who worked on the Prime team and is now chief digital officer for The Washington Post. After the launch, Prime broke even in just three months, not the two years the team had originally forecast.”

Having to pay an annual fee for “free shipping” doesn’t exactly make it free. Nevertheless, as noted above, the program has been a big success. Clifford and Miller bring us back to the subject at hand.

“When e-commerce took off a decade ago, free shipping was a rare perk. Now, 55 percent of consumers are at least somewhat likely to abandon their purchase if they do not get free shipping, according to comScore, the online-research firm, and about 41 percent of transactions online now include free shipping (usually with a minimum purchase). … [Starting last] October, J.C. Penney started offering free shipping year-round, with a minimum purchase of $69 for most of the year. Target is offering free shipping on purchases of $50 and up, on 800,000 items. … Bigger companies have a big advantage in the battle over free shipping: volume. According to the Distribution Management Group, air shipping prices for big retailers are about 70 percent less than for a small company. Shipping at Amazon costs about 4 percent of sales, and Amazon loses money on it because it offers marketing benefits, said Aaron Kessler, an e-commerce analyst at the research firm ThinkEquity. But shipping at small sites usually costs about 35 percent of sales, said Mr. Schwake, the retail adviser. Despite the costs, smaller retailers say they have little choice but to offer free shipping, in some form, these days.”

In their article, Clifford and Miller reported that “big retailers like L.L. Bean” said they couldn’t afford to keep offering free shipping after the holiday season. In an interview with Laurie Brooks, an L.L. Bean spokeswoman, Brooks told them, “We’d love to be able to offer free shipping, but free shipping isn’t free. It does cost a company money.” Obviously L.L. Bean had second thoughts. In March, the company announced “it would offer free standard shipping to all U.S. and Canada addresses.” [“Pros and Cons of Making Free Shipping Standard,” by Tim Parry, Multichannel Merchant, 30 March 2011]. According to Parry, the move “caused uproar in the direct marketing industry.” He explains:

“Other catalog marketers are wondering now [if] they need to follow suit. And the finance and fulfillment folks would have to weigh the affect of standard free shipping would have on the operation.”

For companies that aren’t as large as an L.L. Bean, Wal-Mart, or Amazon, Parry asks, “Should—or can—merchants try to compete with free standard shipping policies?” When he posed that question to experts, he received mixed responses. He reports:

“Debra Ellis, president at Wilson & Ellis Consulting doesn’t think so. ‘Merchants are already reticent to invest in improving customer service because operations are considered an expense,’ she notes. This latest move towards free shipping will result in a reduction of services, Ellis adds, ‘because shipping income and costs are typically allocated to the operational budget. In the past, an efficient operation could be a profit center, but not anymore.’ Shipping is the second largest cost center for most direct merchants, with labor being number-one, says Bill Kuipers, president of operations consultancy Spaide, Kuipers & Co. But if a merchant has a handle on its shipping contracts, it can make such free shipping offers work, he says. ‘There’s a balancing act involved as companies look to eliminate or reduce shipping costs,’ Kuipers says. ‘If they can manage their carriers tighter and make some other budgetary sacrifices, they can offer free shipping without a lot of internal damage.'”

Before moving on, I must admit being taken aback by Ellis’ statement that “merchants are already reticent to invest in improving customer service.” Amazon Prime is a good example of how improved customer service can generate more revenue. To read more about the sorry state of most customer service, read my post entitled Improving Customer Service. Parry continues:

“A $1 billion-plus merchant like L.L. Bean will have better leverage with its parcel carriers to offer free shipping than most, Kuipers says. Though merchants generally sign contracts of two years or longer with carriers, the carriers are usually willing to work to renegotiate terms of the deal if it benefits both parties. But merchants can also use less-expensive delivery services, such as UPS Basic, as a way to absorb some free shipping costs, Kuipers says. That service is primarily used as an alternative to the U.S. Postal service, and UPS in most cases acts as a zone-skipper and delivers those packages to the USPS for final delivery.”

Parry goes on to note that retailers can “recoup the costs of offering free shipping in a number of ways.” First, of course, is through an increase in volume. Second, they should find fewer online shopping carts abandoned once shipping costs are added in. Third, marketing costs could decrease as word of mouth public relations increases. Luke Knowles, cofounder of free shipping advocacy FreeShipping.org, told Parry, “We’ve already seen a lot of great publicity for L.L. Bean because of this move to free shipping all the time.” Finally, Bill Kuipers reminded Parry “that free shipping doesn’t necessarily mean everything ships for free. … Just about every merchant offers several levels of shipping, and in a world where consumers want instant gratification, they are willing to pay a premium to get their item faster.” L.L. Bean spokesperson Carolyn Beem confirmed this observation. She told Parry that during last year’s holiday “free shipping” promotion the company “found that most customers who received the offer chose to upgrade to two-to-five-day business shipping” making it a win-win situation.

 

Clifford and Miller report that there is a downside to free shipping for retailers that rely heavily on brick and mortar stores. Jordan Rohan, an analyst with Stifel Nicolaus, told them, “They’d much rather you buy that same item in the store for $50 and pick up a hundred dollars of other stuff you wouldn’t even think about.” For consumers who shop online, however, free shipping is probably going to remain a huge differentiator in the years to come.