Free Shipping Isn't Hurting Amazon

There’s a lot that has to happen from the time you click “Place Your Order” on Amazon.com to the time that item arrives on your doorstep a day or two later. There are Amazon workers who have to grab the item from the bin where it’s kept, workers who pack it in a box, and people who drive the trucks (or fly the airplanes) that bring that box from the warehouse to a sortation center to the carrier that will deliver it to you.

Though those workers aren’t necessarily paid a lot of money—Amazon disclosed last week that the median compensation of its employees is $28,466—delivering these packages is a costly proposition. In 2017, Amazon spent $21.7 billion on shipping costs, it said in its most recent annual report, nearly double the amount it spent in 2015. Some of those costs are undoubtedly because Amazon spends a lot of money sending packages for free to its 100 million Prime members around the world. This is, in some ways, smart strategy. Prime customers get so accustomed to free shipping that they just start buying everything on Amazon. “They are trying to get you hooked on the convenience,” David Vernon, an analyst with Bernstein, told me. “Once they get that Prime ID stuck in your wallet, and you start hitting the buy button, are you really paying the attention to what the price is?”

But many of those customers could be unprofitable Prime customers like me. Even though I pay the annual Prime membership fee, I return so many orders that I’m not convinced it covers my shipping costs. In the last two weeks alone, I’ve ordered and returned two items, meaning Amazon paid to ship the package four separate times and got no sale. As the costs of shipping rise, Amazon may find more and more of its customers similarly unprofitable.

This may be why Amazon seems to be coming up with more ways to get its customers and sellers to help subsidize the cost of free shipping. On Thursday, during the company’s quarterly earnings call, Amazon said it would raise the cost of annual Prime memberships to $119, from $99, effective May 11. The increase in costs comes as 100 million items are now available for two-day shipping, up from 20 million in 2014, said Brian Olsavsky, Amazon’s chief financial officer, on the call. In January, Amazon also raised seller fees for various apparel categories; it raised fees for book and video sellers last year.

Some analysts think that the rising cost of shipping is going to be a problem for Amazon down the road. After all, shipping is a “variable cost,” which means the more physical goods the company sells, the more it has to spend to mail them. (Fixed costs, by contrast, stay the same no matter how much a company sells or doesn’t sell.) “I see no end in sight for the escalating fulfillment costs for Amazon,” Robert Hetu, a research director with Gartner, wrote me in an email. “I see this as a tremendous risk for Amazon because at some point they will have to make it much more expensive to be a Prime member and at that point lose a major part of the value equation for the customer.”

The cost of shipping a package—not counting the expenses of moving it around in a warehouse and getting it ready for the post office—varies depending on the size of the package. Small items cost around $2 a package, while medium-sized boxes cost around $3 to $4, according to Vernon, the Bernstein analyst. It’s possible that Amazon recoups some of these costs because the company’s markup on items is higher than the cost of shipping. But these shipping costs are almost definitely going to get higher in the coming years. With unemployment low, carriers like FedEx and UPS will have to offer higher pay to attract new employees, Vernon says, and they could pass the costs of these higher wages onto Amazon and other e-commerce companies. The U.S. Postal Service, which delivers many of Amazon’s packages, could also raise rates: President Trump ordered the creation of a task force to study the beleaguered government agency, which he has repeatedly attacked on Twitter.

In a note last year, Vernon wrote that he expects shipping costs to grow 7 percent a year, a number that companies like Amazon are going to have to continue to absorb. “We think we are in the middle of the period of cost discovery when it comes to e-commerce, and that the market as a whole has underestimated how expensive the convenience of buying everything online will ultimately prove to be,” he wrote.

Amazon does not break down exactly how much it costs for it to bring an item from its warehouses to a customer’s doorstep. It reports “fulfillment expenses,” which are the costs of operating its warehouses, customer-service centers, and physical stores, and it reports “cost of sales,” which includes the purchase price of products and inbound and outbound shipping costs, among other items. Fulfillment is certainly getting more costly as the company reaches more customers. Fulfillment expenses in the first quarter of 2018 grew 66 percent from the same time last year, the company said. That’s a faster rate than net sales from North America and abroad combined in that same time period, which grew at a rate of 43 percent from the same period last year. “We expect our cost of shipping to continue to increase to the extent our customers accept and use our shipping offers at an increasing rate,” Amazon said in its annual report.

So far, however, those rising expenses haven’t hurt the company’s profits. Amazon had a huge first quarter in 2018. The company said it made $1.6 billion in profit for the first three months of the year, more than double what it made during the same time period last year. Amazon reported earnings per share of $3.27, much higher than the $1.26 analysts had been expecting. While expenses outpaced income on its international segment, where Amazon is spending heavily to expand its infrastructure, its North American segment has been able to grow sales more quickly than expenses. Its operating income in North America was $1.1 billion in the first three months of 2018, a 93 percent jump from the same time last year.

These numbers speak partly to the success of Amazon businesses that don’t include shipping packages to customers’ doors, including Amazon’s advertising business and Amazon Web Services, the company’s hugely profitable cloud-computing platform. Yet analysts say Amazon is gaining something essential when it hooks customers on Prime, even though it may be losing money on many of those customers for now. Prime customers spend more than the average customer, studies show. “They’ve got a very valuable mousetrap,” says Josh Olson, an analyst with Edward Jones Research. Those customers are also likely to sign up for other Amazon offers that could generate money eventually, such as grocery delivery. Olsavsky also said that the company was seeing higher engagement with Prime, which led customers to buy other things like music and movies.

And even if they don’t, Amazon has many options for offsetting these rising shipping costs. It is already charging higher fees for its third-party sellers, who use Amazon’s fulfillment network to send items to Prime and other customers. The company is also doling out incentives for Prime customers who choose to receive their items in a week, rather than in two days, something it will likely continue to do. And in the future, it may offer lower prices for customers who pick up goods at stores or central locations, rather than having packages delivered to their doors.

That analysts and investors don’t seem particularly worried about rising shipping costs speaks to the peculiar nature of the Amazon investor. They are more likely than investors at many other retail companies to stomach high spending if they think it will pay off in the long term. After all, the company has made big investments before that didn’t necessarily look like they were going to pay off, and then did, says Olson. Amazon Web Services, which was initially launched to help scale its retail business, has has since grown to host thousands of other companies and is now one of Amazon’s key profit drivers. When it expanded its warehouse network for the holiday season and then looked for ways to fill that space year-round, Amazon started handling sales for more and more third parties, which has become another profitable business.

“The shareholder base is driven by a forward view that says, at some point, Amazon can turn off the investment spigot and lower its expenses and generate more profitability,” Charlie O’Shea, an analyst at Moody’s, told me. “When any other retailer does that, its shareholders react differently.”

It’s too late for Amazon to walk back its commitment to free two-day shipping for Prime members. But it may not have to. Customers might be so accustomed to the convenience that they’re willing to pay more and more for it, even if the company isn’t.