The miraculous illusion of Amazon’s free shipping

People are funny about perceiving value. We all want value — we run mental calculators in our minds, trying to predict transactions of love or money in our favor, and yet typically we suck at this. In a world of millions of products, we can’t tell if $400 for a leather coat or $20 for a book is a good deal. So most companies resort to pricing games to bend our minds into a state where we feel we’re getting value.

My favorite pricing gambit is Amazon Prime — a daring attempt by Amazon to convince us that every time we drop scores of dollars on an order, the shipping that supports that purchase is “free.”

Yeah.

Amazon is playing a classic pricing game, used by everyone from Apple to Walmart, to make the perceived value of a purchase feel better. It includes a basic reference price — first, set up a higher price, or in this case, “shipping costs X” … and then discount below it, in this case, “shipping costs $0.” It also uses price obscurity, bundling the real cost of something into an unusual package (sort of like candy sold in unusual package sizes at movie theaters). Amazon Prime costs $79 annually. If you pay, Amazon says you get “free” shipping for one year plus streaming of some video content, and one free Kindle book to rent monthly. Voila! We feel like we’re getting a deal.

First, obviously, shipping costs something. There are no magic elves delivering books, and the guy in the big brown truck in your driveway makes a salary. Analysts have figured this Prime fee actually costs Amazon $90 in shipping and streaming services for a typical customer, so Amazon loses money per “Prime” customer … if you only count the cost of shipping and streaming. For every $79 covering shipping costs that comes in, Amazon spends $11 more than that to ship stuff out. All told, Amazon in 2011 had shipping revenue of $1.55 billion but paid out $3.99 billion in shipping and fulfillment costs, for a net loss on shipping of $2.4 billion. Yep, Amazon lost billions to get goods to your home.

But what about all the profit from all those books and clothes and shoes you order via Amazon.com?

Well, that is big. In 2011, Amazon made $48 billion in sales and $631 million in net income. That works out to a 1.3% profit margin per customer order — thin, because this is a competitive business, but one that Amazon certainly wants to scale. And “free shipping” is helping the company grow. Amazon sales have been accelerating, up 41% overall in 2011 vs. 40% in 2010 and 28% in 2009. Amazon notes in its annual report that “increased unit sales were driven largely by our continued efforts to reduce prices for customers, including from our shipping offers…”

When you add it up, it’s a clever gambit. Amazon loses $2.4 billion in shipping and fulfillment to gain $48 billion in sales … while jacking up growth to please investors at a torrid 41% rate per year. In balance, Amazon comes out way ahead. And all of this growth — in a world where Amazon has been the top e-commerce player for years — means on average, you’re likely spending 41% more at Amazon.com each year. Other retailers have noticed, which is why you’ll see “free shipping” on nearly every e-commerce site this holiday season. Morgan Stanley has predicted Amazon may approach $100 billion in sales by 2015, simply by moving its spending per customer from the current $275 per year today closer to the $750 per customer spent at Walmart.

Oops. Did you catch that? The typical Amazon customer spends $275 annually there today. If you sign up for $79 in Prime free shipping above that, $79/($275 + $79) or 22% of your annual spending goes to … free shipping.

So go ahead, get that shipping deal. At least, it feels like a deal if you don’t do the math.

Image: Selva

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