Free Shipping Is A Lie

When shopping online, you tend to run into the lie pretty quickly.

Spend a certain amount—perhaps $15 or $20—and your shipment is free. Take advantage of competitive holiday promotions that promise free shipping on any item, no minimum required. Or subscribe to a service like Amazon Prime, which, for $99 a year in the United States, offers members free shipping on millions of eligible items.

But the truth is that, like virtually everything else, “free” shipping is not actually free.

The implications of the lie aren’t often felt by us consumers, who have come to expect free shipping. The biggest impact is felt by e-commerce businesses, particularly smaller ones, which face what some have called an emerging crisis: The cost of free shipping, in many cases, is unsustainable.

For many online shops, the cost of a free shipment is either folded into the prices for items or funded by investors. Jerry Storch, CEO of Hudson’s Bay Company, a brick-and-mortar giant that includes Canada’s The Bay department store, Lord & Taylor, and Saks Fifth Avenue, says it’s much more expensive for retailers like them to deliver products to a customer’s front door than to have them shop in the store. For the retailers that can pay for it, he says, free shipping is becoming a loss leader.

“The economics are clear,” Storch explained at the Shoptalk e-commerce conference in Las Vegas this spring. “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’s also why Amazon’s 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 cost of free shipping can be especially onerous for smaller e-commerce companies, but it’s even impacting Amazon and Target, two of the giants often considered responsible for popularizing the trend to begin with. Typically, Amazon recovers only about 55% of the amount it spends on shipping, a number that has drawn new scrutiny after the company’s third-quarter earnings significantly missed expectations. As it expands its Prime service and other recent offerings, Amazon’s net shipping costs—the difference between what it pays for shipping and the amount customers pay in shipping fees and Prime memberships—reached nearly $1.75 billion in the third quarter, its highest quarterly total ever outside of the peak holiday season, according to data compiled by GeekWire from the company’s earnings reports.

In the face of rising shipping costs, Amazon is building up its own shipping operation and seems to be quietly pushing Prime customers toward buying from add-on pay-for-shipping services such as Prime Pantry. In February, Amazon raised the minimum for free shipping in the United States to $49, up from $35, a change it repeated in Canada last month. Earlier this year, Target alerted store credit card customers they now have to pay a handling fee for special items.

Your average customer, of course, doesn’t care about supply chains when they’re buying new shower curtains or Bluetooth speakers. Even if the cost of shipping is folded into the prices of items or memberships, customers generally prefer their purchases without any extra fees. According to a 2016 survey from public relations firm Walker Sands, free shipping was the top factor that would make customers buy from e-commerce sites more frequently: 88% of respondents said free shipping was more persuasive than easy returns or same-day shipping.

This is why a wide variety of online retailers offer a “Free Shipping Day” annually on December 16, in an effort to boost holiday sales, and why Best Buy and Target have announced that they would offer free shipping for many online purchases at least until Christmas.

Still, someone has to pay the cost of shipping. If customers or investors aren’t footing the bill, e-commerce companies could easily lose money on every free shipment. That’s sustainable if a new round of financing is coming; otherwise it can plunge a retailer or e-commerce company, especially a smaller one, into financial oblivion.

In fact, free shipping was partly responsible for one of the most prominent crash-and-burns of the 1990s dotcom boom. Pets.com, whose commercials are still seared into the consciousness of many readers of a certain age, offered free shipping on expensive-to-ship dog food. In his book Thinking Inside The Box, author Kirk Cheyfitz explained how low profit margins due to an insistence on free shipping helped sink Pets.com.

In an era of Amazon Dash buttons, smartphone shopping, and competitive new niches like mattresses and subscription boxes, smaller and medium-sized e-commerce companies are thinking more carefully than ever about how offering free shipping works for their business—or doesn’t.

Logistics, Logistics, Logistics

Kristian von Rickenbach is the cofounder of Helix Sleep, an online retailer that sells customized mattresses and raised $7.35 million in funding earlier this year. Helix works in an extremely crowded industry vertical dominated by Casper and where a host of smaller startups aggressively fight for the dollar of everyone from budget-minded college students to convenience-obsessed suburban families.

Helix offers their customers both free shipping and free returns. As a company, Helix–and any competitor wishing to sell mattresses online to a mass audience–has little choice. Casper offers free shipping, as do rivals Tuft and Needle and Leesa.

“Purchasing a mattress online is different from what people usually do,” Von Rickenbach explained to me. “They want to get the product as quickly as possible and to do returns; [Free shipping] makes people more comfortable about buying the product online.”

But, he said, “in terms of how we do our pricing, shipping somehow has to be paid for.”

In the case of Helix, the company does what many online retailers do: Work out a bulk rate with a shipping company like UPS. Von Rickenbach told me that his company’s rate is determined by factors such as the amount they are shipping, the size of the box, and the physical locations they are shipping to. The company has also sought efficiencies in its packaging. “We’ve spent quite a bit of time optimizing our packaging to both hold up during shipping and to fit within size constraints to minimize shipping costs,” he said.

Still, Von Rickenbach believes in not having a separate shipping charge for customers. “Free shipping is something where, even if it’s not directly passed onto the consumer, it’s usually a better model for the consumer because it lets the company be more efficient and streamlined with shipping policies.” Amid a competitive online mattress market, his main goal was not to ward off potential customers with additional pricing. Free shipping means “a much more transparent pricing experience [for] mattress buyers who are frustrated with hidden fees at retail mattress stores.”

The Importance Of Niche

Other online retailers avoid offering free shipping as much as they can. As the Wall Street Journal’s Laura Stevens recently detailed, smaller online retailers don’t benefit from the economies of scale that large competitors like Amazon and Walmart enjoy.

Jerry Hum, the CEO of Touch of Modern, an online men’s fashion retailer, says his site doesn’t offer free shipping but relies instead on a different tactic to woo shoppers: A sense of community. The store markets itself as a “membership site,” and uses frequent emails to customers to draw them to the homepage as a destination in itself.

Hum was frank when he spoke with me on the phone: For retailers like his company (which raised $14 million in a 2014 Series B), the most effective way for them to compete with larger e-commerce companies was to specialize in a niche–in this case, men’s fashion. Touch of Modern is one of many online retailers that are what we’d call midsize: they have large customer bases and have a relatively large volume of orders, with a revenue run rate of $100 million as of February 2016. But they are still tiny compared to the Walmarts and Amazons of the world.

Like those other retailers, Touch of Modern enters into close relationships with corporate account managers at large shipping firms to negotiate bulk rates. For them and for other smaller companies, the rates they obtain reveal one of the most frustrating parts of e-commerce and shipping’s economies of scale: The more business a retailer attracts (often through “free shipping”) the cheaper these bulk rates become.

For Touch of Modern, shipping and logistics (and what customers are charged for shipping) all tie into sales margins and profitability.

“We treat the cost of shipping like we do the cost of goods,” Hum explained. “Whatever we do on our side, it eats into margins. But on the customer side, no matter whether they pay for shipping as a separate line item or we bump up the price to offer free shipping, it doesn’t change a lot… Customers are smart about doing the math and looking at the price they are paying.”

Offsetting The Price Of Shipping With More Shopping

Another retailer, JackThreads, recently embarked on a very expensive initiative: A free shipping and return program called “TryOuts.”

JackThreads sends customers items for free that they’re expected to “try out,” customers are then charged after seven days if they don’t return the item. The heavily streamlined process even includes giving customers prepaid shipping bags so they can drop their unwanted items in the mail without tracking down a cardboard box.

The company is a newcomer to offering free shipping, which it rolled out at the same time as TryOuts. According to CEO Mark Walker, this was part of an ongoing effort by the company to improve shipping experiences that also included launching guaranteed seven-day shipping earlier in 2016. Walker says the changes were necessary for the company’s growth.

“For shipping, what I’ve seen and what influenced the decision to do TryOuts, was the fact that when you do discounts or negotiate with stores, the customer expects 50% or 75% off,” Walker explained. “Free shipping over $100 is something a customer expects all the time. If you spend a certain amount [with these stores], there’s free shipping. In my opinion, customers are frustrated when they try to make a purchase and see they pay for shipping.”

In JackThreads case, the company’s internal research made a case that the economic blow of unlimited free shipping and returns for their customers would be justified by the extra business it would attract.

“You absorb the cost of shipping through repeat shopping, but that conversation doesn’t fit nicely into an Excel spreadsheet,” Walker added. “It’s not easy to quantify the repeat rate and referral rate.”

There was one other key piece to the “free shipping” puzzle that I learned from the conversation with Walker: If companies adjust the way free shipping works so that many items are mailed or returned in the same box, it can benefit the retailer economically.

“The benefit for us is the big shipping companies put you into a cost structure based on your revenue,” says Walker. “The more packages you ship, the cheaper it is to ship a single package. In our relationship with UPS, we ship a lot more boxes and a lot heavier boxes now. So we spend more money with them, but get better rates because they are heavier.”

JackThreads benefits from something any e-commerce company offering free shipping needs: Lots of capital. JackThreads shared a $54 million funding round with Thrillist last year before the two split into separate companies. The company also has a merchandising partnership with T-Mobile, and launched a footwear line this year.

Will Free Shipping Last?

Not everyone is a cheerleader for free shipping or resigned to it in one way or another. Bob Schwartz, an e-commerce veteran, is best known as the former president of Magento and as the founder of Nordstrom.com, back in the early days of online shopping. Schwartz took a darker view: That free shipping for customers is an unsustainable trend fueled by giant companies like Amazon that aren’t accountable for profitability to investors in a meaningful way.

Schwartz told me he saw free shipping as part of a historic arc in e-commerce. In the early years of online shopping in the late 1990s and early 2000s, venture capitalists funded free shipping. “We were spending venture money trying to get customers into a market that really wasn’t quite ready for it, and training customers that shipping should have been free.”

This continued until a massive surge of growth in online shopping in the last decade, with Amazon by far the breakout retailer. “Amazon is pulling everyone into the gutter to play that [free shipping] game,” Schwartz explained in a telephone conversation. “Amazon to me is the anchor that forces the industry to free shipping because Amazon isn’t held accountable to be profitable. This pulls all the other retailers into the same gutter, yet these other retailers are held accountable to be profitable–even if they’re not held to the same metrics that Amazon is held to.

To Schwartz, our perception of what constitutes free shipping–and the future of e-commerce–is intimately connected to giant companies like Amazon.

“I believe that one pattern that’s similar here is instead of venture guys funding free shipping, Wall Street has a perception of Amazon being a tech company with crazy multiples that doesn’t have to be profitable. They’re funding Amazon’s ability to create a retail crisis where they pull other retailers down. Other retailers are held accountable each quarter, but Amazon isn’t.”

For Amazon, investing in shipping and logistics—including underwriting part of the cost of shipping for both Prime members and non-members—means massive expenditures. In October alone, Amazon opened five new fulfillment centers, CFO Brian Olavsky said during the company’s Q3 earnings call. By the end of 2016, he said, Amazon will have opened 26 new fulfillment centers, mostly in North America. By comparison, it opened 14 in 2015. (According to Piper Jaffray analysts, about 44 percent of the U.S. population now lives within 20 miles of an Amazon facility, up from about a quarter in 2014.) This investment in shipping is a significant cost for any company–even Amazon.

Last year, packaging company Shorr published a detailed report on what it called “The Amazon Effect,” a massive growth in shipping caused by Amazon and its customers’ behavior. It highlighted, for example, Amazon’s ability to let customers purchase small add-on items without additional shipping charges when ordering more expensive items. Even though the items may be small, they add up to a massive amount of shipping material, physical space occupied, and gasoline and worker hours spent bringing them from Point A to Point B.

But Amazon’s paying an enormous amount of money to sustain the Amazon effect: Last year, the company spent $11.5 billion on shipping while only generating $6.5 billion, according to its annual report, and as its recent earnings reports indicates, its costs are growing.

Although Amazon reports a staggeringly good 45% annual percentage growth in shipping revenue, those numbers would create challenges for pretty much any other company. However, Amazon’s massive size means the company benefits from an economy of scale that most of its competitors (save Walmart and Target) don’t: Amazon has the profits from Amazon Web Services, as well as a staggeringly large chunk of global online shopping transactions helping to underwrite it. And the wealth of data the company has about shoppers’ preferences means that it knows, perhaps better than any other retailer, how best to tailor perks like free shipping.

Large shippers like Amazon and Target also have another extraordinary advantage over other e-commerce retailers when it comes to shipping: Extremely close relationships with the USPS and other shipping companies. Whereas an average retailer would pay about $7 to $8 for ground delivery, that same delivery might cost an Amazon about $4 to $5, according to estimates by Barclays.

And, as its shipping costs rise, Amazon has sought new advantages by starting to build up its own shipment infrastructure, with fleets of cargo planes, tractor-trailers, and, someday, drones.

Still, it may be unfair to blame Amazon or Walmart or Target for pushing retailers into a free-shipping arms race. Thousands of retailers now offer it in one form or another. As a result, customers have come to expect free shipping, regardless of how it’s built into the cost otherwise, and it impacts the kinds of e-commerce businesses that can succeed in the future. Free shipping is built in part on companies’ own big expectations, like relatively low fuel prices and a consistently growing appetite for online shopping that can fuel near-perpetual growth. But if there’s a sharp increase in fuel prices or another recession in the near future, e-commerce companies could find themselves in a very uncomfortable place.

The Future Of Free Shipping

Schwartz, like Storch, imagines that alternative models will emerge, such as picking up online orders at stores, or using off-site drop boxes. Schwartz says he likes the idea of charging for shipping but offering free returns to encourage customer goodwill.

In September, Touch of Modern conducted A/B tests for free shipping, offering it to some customers if they spent a certain amount. “We wanted to see what we do if we offered free shipping above a certain amount and make the math shake out at a certain point to be same for us on the margin,” Hum told me. “However,” he added, “we quickly found trying to message it as free shipping doesn’t work overall. If we message as free shipping and make the margin the same, it doesn’t work out. It’s more honest to offer a fair price and be honest about what the shipping [cost] is.”

Honest or not, it’s a buyer’s market for customers looking to have goods cheaply shipped to their home or office these days. Large mega-retailers are able to chalk off the cost of free shipping as just another business expense; smaller e-commerce companies may have to go into debt to compete with the big guys. Other companies might simply opt to raise the price of their items, and then offer “free shipping” instead.

As Touch of Modern’s experience illustrates, it’s completely possible for online retailers to avoid charging for shipping in 2016. But they and other companies that choose not to ship for free face a challenge: Convincing customers that charging upfront for shipping is actually cheaper.