Wharton's Senthil Veeraraghavan and Northwestern's Tarek Abdallah discuss how Amazon is attempting to balance low prices with unsustainable shipping costs..

E-commerce giant Amazon is facing pressures to revisit its business model as recent events threaten to upset its strategy of winning customer loyalty with low or free shipping offers. FedEx last month allowed its ground shipping contract with Amazon to expire, which comes two months after it ended its air cargo shipment agreement with the company. Amazon deliveries through the U.S. Postal Service (USPS) have steadily fallen over the years, which leaves the company with United Parcel Service (UPS) as the only major delivery partner.

With customer satisfaction and low prices as its chief tools for growth, Amazon has continued to expand its Prime program, where members get free two-day or same-day deliveries. That has forced the company to invest in its “last-mile” delivery infrastructure — moving goods from fulfillment centers to customers’ homes — with programs to sign on local truckers and also to encourage employees to set up their own local delivery firms. However, last-mile delivery is the most expensive part of its shipment chain, and that means it has to innovate itself out of what could be a losing business model, according to experts at Wharton and Northwestern University.

Wharton professor of operations, information and decisions Senthil Veeraraghavan noted that Amazon has for long been a big transportation and logistics operator as part of its e-commerce delivery platform. In 2018, shipping costs consumed nearly 12% ($27.7 billion) of Amazon’s revenues of $233 billion, according to its annual report filing. Amazon said it expected those shipping costs “to continue to increase” to the extent its consumers choose its discounted shipping offers or if it uses more expensive shipping methods. Third-party sellers account for about half of Amazon’s revenues, and they rely on Amazon to deliver their products, Veeraraghavan pointed out.

Customers have also grown their expectations to receive faster delivery, and that has become a key factor in purchase decisions, according to Tarek Abdallah, assistant professor of operations at Northwestern University’s Kellogg School of Management. He said surveys have revealed that “75% of consumers wouldn’t even shop if a seller promises a delivery date of more than three days.” He noted that while Amazon tries “to push the frontier” for same-day deliveries, it is a “very expensive” strategy.

In order for that strategy to succeed, Amazon needs a highly efficient last-mile delivery system. “The last-mile delivery is the most expensive part of the supply chain for e-commerce companies,” Abdallah noted. According to him, Amazon’s shipping costs at current levels are “not sustainable in the long term, especially with their push towards same-day delivery.”

Veeraraghavan and Abdallah explored the challenges Amazon faces with its delivery model and how it might overcome them on the Knowledge at Wharton radio show on SiriusXM. (Listen to the podcast at the top of this page.)

Much of the increased costs of Amazon’s logistics operations has been because of the frenetic pace at which it has expanded its network of fulfillment centers, according to Veeraraghavan. “There was a time when you could count all of Amazon’s fulfillment centers with one hand,” he said. “But now they have north of 250 fulfillment centers and data centers all over the U.S. States, especially because they’re pushing closer and closer to customers.” A study by logistics consulting firm MWPVL International details the company’s global fulfillment network as of September 2019.

“The last-mile delivery is the most expensive part of the supply chain for e-commerce companies.” –Tarek Abdallah

Amazon feels the pressure to bolster its last-mile delivery infrastructure also because about a quarter of the third-party sellers on its platform are from China, said Veeraraghavan. “If you’re a seller in China and you want to sell to a customer in the U.S., there’s no way for you to set up a logistical arrangement with UPS or USPS or, any transportation company as easily as with Amazon,” he noted.

Changing Delivery Mix

Over the years, Amazon has complemented its own delivery fleet with third-party providers such as the U.S. Postal Service, UPS and FedEx. That mix has changed considerably with Amazon’s share in its deliveries increasing while those by USPS have steadily fallen. Amazon’s use of USPS services has attracted sharp criticism from President Trump. Last year, Trump tweeted that the USPS was effectively subsidizing Amazon, and described it as Amazon’s “delivery boy.”

Now, with a declining share of USPS in its deliveries and expiration of its contracts with FedEx, Amazon has to depend on UPS and other smaller local delivery firms for its last-mile deliveries. The upshot of that is “they have to innovate in terms of how they handle their logistics,” said Abdallah.

Managing relationships with third-party carriers has become all the more important now for Amazon. “Without these third-party logistics, Amazon would not exist in the first place,” Abdallah noted. “So they have to keep good connections with those other carriers.”

The Last-mile Push

To be sure, Amazon has been firing on several cylinders to meet its last-mile delivery challenge. A program it launched in May incentivizes employees who set up their own package delivery company with $10,000 in startup funding and three months’ pay. That is part of a larger delivery service partner program created last year, under which 200 entrepreneurs have launched delivery businesses using their own Amazon-branded trucks or leasing them from a third party with whom Amazon has partnered. A third effort in the delivery space is a “Flex” program where individuals are encouraged to take up local deliveries with flexible schedules.

The program to provide seed money to employees who start their own local delivery businesses is significant because “warehouse jobs are hot jobs and there are not many of them” said Veeraraghavan. “It makes sense for them to have enough of a labor supply to do the last mile delivery. One way to encourage and guarantee this is to have businesses that can take part.”

Abdallah saw the seed money program as a win-win for Amazon. “It gives this extra option for its employees. It can help it retain its customers, but also encourage entrepreneurship among its employees,” he said.

“The new markets where Amazon is moving in with its Prime program like India are low-revenue, high-cost and low-margin.” –Senthil Veeraraghavan

However, signing on local delivery partners may also not be an easy way out. A caller on the show who is an owner-operator with FedEx said he finds Amazon’s lease terms for renting equipment like trucks uneconomical. “Amazon is just pushing prices down, and it’s going to be difficult for them to draw us as servants or as hard workers to come over to their organization for less money,” he said. “That’s one reason why FedEx’s business model is much better than the Amazon model at this point … unless [Amazon] can figure out how to pay more money to the truckers.”

Veeraraghavan agreed with the caller. “The trucking industry has a fairly deep understanding of its local market and costs,” he said. “UPS and FedEx have this core skill of understanding that. And so, that’s going to be new and challenging – for Amazon to figure out what is the right reservation price or the entry point price for contractors or [owner-operators] to come in and see whether they can be a partner.”

Amazon is also investing in strengthening its longer-haul shipping infrastructure. The A Wall Street Journal article provides a snapshot of Amazon’s shipping infrastructure and compares that with FedEx and UPS, citing latest data from the companies. Amazon has a fleet of 60 planes and 20,000 vehicles that are either leased or owned; it plans to rent 10 more planes by 2021. FedEx has 681 aircraft and 160,000 vehicles, while UPS has 564 aircraft and 123,000 vehicles.

Experiments with drones and robots are part of the response to meet the challenges in last-mile deliveries, Abdallah said. Amazon’s network of lockers at retail locations — where consumers could pick up their orders — is another aspect of meeting the last-mile delivery challenge, said Veeraraghavan.

Amazon said in its 2018 annual report that it aims to mitigate its delivery costs with higher sales volumes, extracting efficiencies in its fulfillment network and elsewhere in its operations, and negotiating better terms with suppliers. However, increasing shipping rates for consumers is not one of its options. “We believe that offering low prices to our customers is fundamental to our future success, and one way we offer lower prices is through shipping offers,” it stated.

Revisiting the Business Model

Amazon has used those shipping offers effectively to grow its customer base. It has actively marketed its Prime program, where members get free two-day shipping on about 100 million items and same-day delivery for about 10 million items, according to the Wall Street Journal report. Consequently, its Prime membership base has grown to an estimated 105 million, up from 85 million in 2017, even after it increased its annual subscription fee from $99 to $119 in May 2018.

But that Prime push brings a fresh challenge for Amazon: New customers will be more sensitive to the subscription price for Amazon’s Prime program. “They’re going to be harder customers to get,” Veeraraghavan said. “The new markets where Amazon is moving in with its Prime program like India are low-revenue, high-cost and low-margin.” That means Amazon will face challenges in scaling its Prime subscriber base in ways that are profitable, he added.

The upshot of that challenge is that Amazon may have to revisit its business model, according to Abdallah. He noted that the company already has a 50% market share in online sales in the U.S., but extending that reach to “marginal customers” will be “very costly” for the company.

Abdallah wondered what options Amazon might have in that setting. “Are they going to raise prices in order to offer same-day delivery? Probably,” he said. “The real problem for [Amazon] is: How do they continue to be competitive as an e-commerce platform while increasing their quality of service in terms of same-day delivery and whatnot, but still without compromising on their healthy revenues?” However, Amazon is well positioned for the task. “They have lots of data and know a lot about their customers – where they are, their schedules and when they’re available.”

“The real problem for Amazon is: How do they continue to be competitive as an e-commerce platform while increasing their quality of service in terms of same-day delivery and whatnot, but still without compromising on their healthy revenues?” –Tarek Abdallah

According to Abdallah, Amazon’s strategy going forward would be “to build its network gradually, trying to tackle strategically those customers that are closest to their fulfillment centers and those in dense areas rather than suburban areas.”

Loss-leader Model?

As Amazon plots its strategy to build out its last-mile delivery network with third-party providers, it would “most probably run a loss-leader model,” said Abdallah. “They will be very generous in terms of their compensation [in the beginning]. And then, over time, as they gain power, they’re going to start being more aggressive with their pricing.” Some media reports have talked of Amazon offering large discounts to third-party sellers, in order to encourage them to ship with Amazon instead of rivals like FedEx, he noted. “They will probably do the same thing with the drivers.”

If Amazon does go with its loss-leader model for last-mile deliveries, rivals like FedEx would feel compelled to review their own business models, according to Veeraraghavan. He noted that FedEx has in some ways been “ahead of the curve” in terms of how automated its warehouses and its sorting locations are. “FedEx has to make a very good call right away in thinking, ‘These are these are areas or core parts of the businesses for us, so we will continue to grow them. Some of them are uneconomical and hard to scale, and we shouldn’t jump in just because Amazon’s doing that.’” FedEx could also try to build close relationships with other major e-commerce firms or retailers like Walmart and Target, he added.

Amazon’s push to grow its delivery infrastructure using third party providers has courted much controversy, too. An investigation by ProPublica, co-published with the New York Times on Thursday, identified more than 60 accidents since June 2015 involving Amazon delivery contractors that resulted in serious injuries, including 10 deaths. The report noted that Amazon’s contention is that it is not responsible for the actions of its contractors, citing agreements that require them to “defend, indemnify and hold harmless Amazon.” It added that the agreements cover “all loss or damage to personal property or bodily harm including death,” citing recent court testimony by an Amazon operations manager.

A week earlier, Buzzfeed had published a report which held that “Amazon’s gigantic, decentralized, next-day delivery network brought chaos, exploitation and danger to communities across America.” Such stories have provoked strong rebuke and calls for increased regulation of Amazon by Sen. Richard Blumenthal, the top Democrat on the Senate’s Manufacturing, Trade and Consumer Protection subcommittee, and presidential candidate Andrew Yang, Buzzfeed reported. “One of the largest companies in the world cannot be allowed to continually pass the buck,” Blumenthal said.