February 12, 2006
Amazon's Core Business
Posted by Gordon Smith

AmazonIn the late 1990s, I taught "Accounting for Lawyers," and I used Amazon.com as a case study. Those were the days when e-commerce merchants were losing money on every sale, but hoping to make up the difference on volume. Or shipping. Those days are gone, right?

Maybe not. Amazon isn't saying whether it's core business is profitable, and Randall Stross (author of eBoys) is a skeptic:

The Amazon experiment has been under way since 1995, and its core business is taking a good while to fulfill its promise. It has grown from books to products in 35 categories, but most of the original elements of the business model are intact: attract customers with a deep inventory that no retail store can match, offer discounted prices, provide easy navigation and whisk customers through a trouble-free checkout process that is the best in the business.

One important assumption has fallen by the wayside: unburdened by the weight of a network of retail stores, the company was supposed to enjoy low operational costs and good margins. Geography turned out to be a spoiler. A single centralized distribution center in Seattle meant that many customers found that a speedy one-click purchase online would be followed by a frustrating wait offline for the order to arrive. To reduce delivery times, Amazon had to make colossal investments building a network of distribution centers — 15 in North America alone. Amazon "is not as efficient" as the most efficient offline retailers, said Scott W. Devitt, an analyst at Stifel, Nicolaus in Manassas, Va.

Amazon has turned out to be an expensive operation to run, not only because of those distribution centers but also because of heavy subsidization of shipping that insulates customers from the actual costs. Quirky consumer psychology makes this necessary.

About that psychology, Stross cites field work by Berkeley economist John Morgan on eBay shipping charges. You can Morgan's article here. Morgan and a co-author performed 80 auctions on eBay -- 40 CDs and 40 Xbox games. They wanted to test whether consumers reacted differently to items with the same "effective reserve" (i.e., "the minimum amount any bidder has to pay in the event that no other bidders bid in an auction," which in the case of eBay is the sum of the opening bid amount and the shipping and handling charge), but a different mix of minimum opening bids and shipping charges. Here is what they found:

When the effective reserve was $4, auctions with a low ($0.01) opening bid and high ($3.99) shipping charges attracted more bidders, earlier bidding, and yielded higher revenue for both CDs and Xbox games. With $8 effective reserve, the low opening bid was ($2) and high shipping charge ($6) generated higher revenue for Xbox games. In these cases, charging a significant portion of the price as shipping increased revenue. For CDs, the $8 effective reserve represents over 50% of the retail price of the item. Here, we find no systematic difference in the number of bidders attracted to the auction or revenues as a function of how the effective reserve is allocated between opening bid and shipping charges. An institutional detail of eBay may account for this non-result: A shipping charge of $6 is uncommon in eBay auctions of music CDs while is not uncommon for auctions of Xbox games.

Bottom line: on eBay, as long as the shipping charges are not viewed as extreme, embedding some of the price in shipping charges attracts more bidders and leads to more revenue. Amazon's experience has been exactly the opposite. Shipping charges, even if modest, are a big deterrent for consumers. Stross does not attempt to explain why, but this phenomenon requires Amazon to subsidize shipping.

So let's review. Amazon sells discounted books and subsidizes shipping. Does this sound like a recipe for long-term success?

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