If retailers are hurting today, among the wounds — both self-inflicted and imposed from outside — is free shipping. On the demand side, customers are increasingly expecting free delivery and even free returns. The problem for retailers, of course, is that free shipping cuts deeply into profits.

Retailers
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The innovation bubbled up as a way to get customers comfortable with the idea that online shopping could be no more expensive than physical visits — that it leveled the online total purchase tab with the physical-store receipt.

It worked. The customer has moved online, and now retailers find themselves on the horn of a dilemma. The cost of free shipping to retailers is high, but the cost of yielding loyalty and market share to a competitor is even higher. How did retailers get here?

“One of the first online retailers was Zappos,” says Wharton marketing professor Barbara E. Kahn, who is also director of Wharton’s Jay. H. Baker Retailing Center. “People had thought no one would buy shoes online, because you have to try them on, but Zappos started free shipping and free returns, so that let people buy a size bigger and a size smaller, and free shipping and free returns minimized the risk. That set up the expectation of free shipping. For most of the legacy retailers, because of the costs of the delivery and the returns, they frequently make less money online than in physical stores. The costs are very high.”

Now, among the retailers offering free shipping are Dell, Kate Spade, L.L.Bean, Neiman Marcus and Nordstrom. Last holiday season, Target and Best Buy introduced free shipping, and retailers are reporting that the point at which they often lose an online customer is at the very end of the transaction — when shipping costs get added.

So, what now? Given that online shopping is woven into habit for most U.S. shoppers, might retailers be able to cut out free shipping?

“It might be too hard to walk that back now,” says Wharton marketing professor Peter Fader. “But there are so many areas costing retailers even more — promotions they run — that they should be trying to wean themselves off of.”

Instead, retailers will probably have to find other ways of recouping the cost of free shipping. Ironically, the answer may lie in a phenomenon best illustrated by Amazon, which is of course the source of much of the scramble for market share. Amazon refers to its Prime service as a way to get “fast, free shipping and more,” and many customers themselves refer to the service as being free. But of course, they are paying $10.99 a month or $99 per year for their “free shipping.”

People are good at creating “different mental accounts,” explains Fader. “They keep one account for membership and they are paying for membership, and that is coded entirely separately from this transaction. They are part of the club and they forget about the fee. It’s very clever on Amazon’s part, surrounding the customer with benefits that give the impression that the company has your best interest at heart. People like this.”

“Free shipping is certainly one aspect of how Amazon has recalibrated our consumer brains, to be honest,” says retail futurist Doug Stephens, author of The Retail Revival. Stephens says that Amazon innovations like quick and efficient searches, intelligent recommendations based on prior browsing history, fast and free shipping and making consumers increasingly reliant on online reviews “fundamentally changed our wiring as consumers” to such an extent that “many experiences we have with other retailers seem somehow dissonant now.”

“Free shipping is certainly one aspect of how Amazon has recalibrated our consumer brains, to be honest.”–Doug Stephens

Fast, Cheap and Out of Control

Studies and surveys show that customers increasingly want their stuff, they want it now, and they don’t want to pay extra. The number of customers who said they would pay nothing extra for next-day delivery increased to 38% from 22% between 2015 and 2016, according to a September Deloitte online survey published in the Wall Street Journal. The number willing to pay more for same-day delivery showed a similar increase in resistance, with 32% in 2016 saying they would not pay extra, up from 24% in 2015.

One study found free shipping to be the top incentive to online buying, “with almost nine in 10 consumers reporting that free shipping would make them shop more online,” according to a survey by Walker Sands Communications of 1,400 U.S. consumers. “This number has steadily increased over the past two years and has become significantly more influential than other logistics considerations, even as same-day shipping becomes more prominent,” says the firm in its “Future of Retail 2016” white paper.

Exactly how much is free shipping eating into profits? Jerry Storch, CEO of Hudson’s Bay Company, which includes Lord & Taylor and Saks Fifth Avenue, has pointed to the high costs as well as the larger, fundamental problem of e-commerce: “The economics are clear,” he said at the Shoptalk conference in 2016. “Direct-to-home has a supply chain cost three times higher than a store-based model. So, when we say the internet retailer can charge less, how can that be? Maybe this is why so many of us have so much trouble emulating Amazon’s model and making any money. It’s because it’s really expensive and it is also why Amazon [has] had trouble making money on merchandising sales. It’s a very expensive model and it’s not less expensive than the store-based model.”

The expectation for free shipping, and the heightened awareness around price generally, is something retailers brought on themselves, says Fader. “The reason we are having this conversation is because it’s a race to the bottom. Anything that retailers do that calls attention to price is not in their best interest. That plays to Amazon’s strength, and most retailers can’t win that battle.”

Amazon and other mega-retailers can negotiate lower shipping rates than smaller retailers, and Amazon Prime U.S. membership has doubled in the past two years, to an estimated 80 million members. Prime carries an increasing number of benefits, and Prime members spend more than non-Prime customers: an estimated $1,300 versus $700 per year, according to Consumer Intelligence Research Partners.

“Free shipping is not going away since Amazon knows that it is painful to them but much more debilitating for their competitors,” says Wharton emeritus marketing professor Stephen J. Hoch. “Amazon Prime is a two-part tariffs pricing policy, where Amazon sells stuff for close to cost and makes all their profit on the fixed membership fee, just like Costco. And free shipping is just another cost that Amazon absorbs in order to get the flat fee and longer term loyalty.”

“Free shipping is not going away since Amazon knows that it is painful to them but much more debilitating for their competitors.”–Stephen J. Hoch

Very specialized sellers don’t compete with Amazon and so should have little trouble passing on shipping costs to their buyers, Hoch adds. “I might also point out that, due to huge investments in logistics and IT along with massive scale, Amazon’s shipping costs are likely significantly lower than most competitors – even Walmart.”

While Amazon invests in the delivery

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