Jeff Bezos, CEO and Founder of Amazon, has once, famously drawn up Amazon’s virtuous cycle. Selection and lower prices drive customer experience. Selling products at lower prices was Amazon’s key objective from day 1. But Amazon’s competitors already had scale and low unit costs as Amazon was just starting out. While Amazon had no scale but they had a low cost structure mainly driven by the fact that they saved on the costs of brick-and-mortar stores.
Amazon has the choice to translate their lower cost structure into higher profits and give some of the profits back to the shareholders via dividends. But Amazon passes it onto customers via sustained low prices and reinvests the rest of their surpluses into growth. A fair chunk of these growth investments go into their fulfilment and delivery network as shown last time. This, in turn, helps to further lower their unit costs which amplifies the subsequent elements of the virtuous cycle. And so it goes round and around.
Read the ultimate overview of Amazon’s business model here – it is the epic summary of my 8 reports on Amazon (with additional content). Must read for anyone who wants to understand Amazon!
Amazon’s key customer value propositions
Jeff Bezos regularly points out Amazon’s three customer value propositions:
- Low prices
- Fast delivery speed (often same day and with options of free 2-hour delivery) and a
- Vast selection (“Earth’s biggest selection”)
Today, we are going to look at these elements, starting with the mind-boggling amount of selection, moving onto the prices and then covering the customer experience (with fast delivery being an important element thereof).
Earth’s biggest selection
Amazon has expanded beyond books and media for a long time as we all know. But you’d be forgiven for not knowing just how far Amazon has gone. From diapers to car tyres to jewellery and everything in between, Amazon almost certainly has anything you’re after.
Below are the departments as Amazon categorises them. You can go to Amazon.com and just hover over the “department” link. It will display further details as you hover over each department. If you have not done this recently, it is worth checking out to get an impression of the amount of choice that Amazon has amassed (or check out below a quick guide around the navigation and browsing options).
- Prime Video
- Amazon Music
- Appstore for Android
- Echo & Alexa
- Fire Tablets
- Fire TV
- Kindle E-readers & Books
Things, media, food
- Books & Audible
- Movies, Music & Games
- Electronics, Computers & Office
- Home, Garden, Pets & Tools
- Food & Grocery
- Beauty & Health
- Toys, Kids & Baby
- Clothing, Shoes & Jewelry
- Sports & Outdoors
- Automotive & Industrial
- Home Services
- Credit & payment products
We all would agree that a large selection is a great customer proposition. But it also is a very costly one. At least if your sourcing model was that of the brick-and-mortar retailers. But Amazon has gone a different way. Let’s look how Amazon makes it possible to offer the selection without inflating costs or having inventory sit in the warehouses for ages and bind working capital.
Given such a staggering amount of categories, let alone individual items, the question arises where do all these products come from? It’s not just the storage and logistics but also inventory costs, especially for low-frequency items. Here are the most common sourcing models:
Amazon uses three approaches for the books it sells. The following three approaches first applied to their book inventory are quite typical for most of Amazon’s selection (though there are more complexities to it):
- Standard inventory: holding only the most popular books in their own fulfilment centres
- Just-in-time inventory: arrangements with the publishers (rather than wholesaler) to ship the book to either Amazon or (depending on a number of factors) directly to the customer when an order comes in
- 3rd party sellers: this is another case of inventory not owned by Amazon and sold through Amazon Marketplace. These can be other professional sellers or other users who want to sell their used items. In most cases, the inventory would be held and shipped by the 3rd party unless they use Fulfilment by Amazon and/or Shipping with Amazon services
Not holding the inventory that you use to fulfil customer’s orders is also called drop shipping and it comes with some disadvantages when below scale.
There are many partners and sellers on Amazon. One of the large partners is Ingram Micro who are a large supply chain services provider themselves:
- Ingram Micro partner with Amazon on fulfilling orders of electronic goods, computers and other product categories
- They complete their own order fulfilment. Additionally, they offer fulfilment services similar to Fulfilment by Amazon to their own suppliers. This is a complementary as well as competitive approach
- Last but not least, they accomplish at least some of their orders under the Amazon Prime banner
Amazon has a number of fully owned subsidiaries as well as brands offering various types of products. Here are a few examples:
- Zappos.com: the famous online shoe and apparel retailer has their own pages and runs their own warehouses and inventories. However, they have handed the operation of two of their warehouses to Amazon (still retaining control over the main one in Nevada). Zappos further has a discount deals page, called 6pm.com and one physical outlet that they have retained control of
- Whole Foods Market: are a subsidiary operating some 300 brick-and-mortar stores acquired by Amazon recently. But it is certain that Amazon looks at synergies
- Other subsidiaries have been integrated into the Amazon system after they were acquired. E.g. go to diapers.com and you will be directed to their storefront within Amazon.com.
- Amazon brands: Amazon essentials (clothing), Amazon elements (nutrition and vitamins), Amazon Basics (everyday items) and other Amazon brands are examples of Amazon-sourced products. You would know this approach from other large retailers
- Amazon fashion brands: Amazon launched seven fashion brands with some observers wondering if Amazon wants to get into the high margin apparel business at large scale
- Amazon designed: the ever-increasing selection of Amazon designed and deloped products that I will touch on next time, Amazon Kindle, Fire, Alexa, Echo and many more
Multi-tier supply chain
By now you can get a glimpse of the complexities of Amazon’s supply chain. On a macro level, it looks like this:
- Products may be in one of Amazon’s own warehouses. In this case, it will be directly shipped to the customer
- Items may come from a middle tier consisting of wholesalers and other intermediaries. Depending on a number of factors, these products may be shipped directly to the customer or via Amazon to the customer
- And there is a first tier that may send directly or through one of the subsequent tiers to the customer
I am skipping digital media for now, such as audiobooks, movies, TV shows, etc as I will be elaborating in more depth on this in a future article. There are different sourcing methods here, such as authors directly publishing through Amazon’s Kindle Direct Publishing platform.
Amazon’s cash conversion cycle
Amazon’s mastery in inventory management can be seen in one of the most important inventory metrics, the cash conversion cycle (CCC).
The CCC is calculated using three other metrics:
Cash Conversion Cycle = Days Sales Outstanding (DSO) + Days Inventory (DI) – Days Payable (DP) = -28.7 (Dec 2017)
- Days inventory = Total Inventories / Cost of Goods Sold * Days in Period
- Days sales outstanding = Accounts Receivable / Revenue * Days in Period
- Days payable outstanding = Accounts Payable / Cost of Goods Sold * Days in Period
These three metrics can be determined by looking at their financial report (here is the one for 2017, pdf). Or you can click the links above where this has been done for us.
Amazon scores very well on this metric, especially compared to their brick-and-mortar competitors. Here is a comparison from HBR. For 2017, this metric read as -28.7 (the lower the better).
Negative cash conversion cycles basically mean that Amazon uses their suppliers’ cash to operate and grow where others take up debt and pay debt servicing costs. This doesn’t mean Amazon is debt free but it means they are less dependent on capital markets than otherwise warranted.
This is quite a macro approach and thus not necessarily 100% accurate. You can see this when you follow the above link to GuruFocus’ses always excellent pages. The inaccuracy comes from the fact that it uses all revenues as well as all accounts receivables, etc though not all revenues are generated by inventory sales activities (e.g. Amazon Web Services-generated revenues get factored in). This is not a big problem and if you wish you can do your own calculations with more accuracy as Amazon has started splitting out AWS revenue since recent.
Amazon’s decision to expand the amount of selection comes at a cost: at dropping inventory turnover rates. In the mid-2000s, Amazon turned over its inventory 15-16 times per year. That is an impressive number for any retailer. By 2017, this ratio had dropped to 11 times per year. Still a good number but not as impressive as before. It ranks Amazon close to Costco and Walmart.
On the other side, Amazon offers a mind-boggling range of 488 million different products. This compares to 140,000 different items that Walmart sells (hence Amazon has 3,500x more choices). Having such a large amount of choice makes some products sit in warehouses longer than focusing on top-selling items only (note, as per comments above that Amazon does not keep all inventory in its own warehouses). It is an important strategic trade-off. The way that inventory turnover is calculated is a very macro approach and prone to at least some inaccuracy. Amazon’s innovations in the field of robotics and data are drivers to achieve great inventory KPIs despite the staggering amount of selection.
It is often said that Amazon offers low(est) prices and that this is one of their competitive advantages. But the truth is much more complex in that Amazon does not always offer the lowest prices. Amazon changes millions of prices daily and keeps their pricing strategies secret. There are still a lot of things we know – here it is:
- Price dynamism: Amazon makes millions of price changes every day. By some estimate, they change the pricing of 15-20% of their products per day
- Price perception strategy: One e-commerce service company points out that Amazon’s “[…] consistently low prices on the highest viewed and best-selling items drive a perception among consumers that Amazon has the best prices overall”. As an example, Amazon then increases the prices of items that people are likely to buy together with the discounted product. Example: discounted TV and a price-increased HDMI cable (that Amazon conveniently points out you may need during the purchase process)
- Demand/supply pricing: It is presumed that inventory levels (supply) and demand influence the dynamic pricing. For example, when demand for a product spikes within a short period, say, due to a promotional campaign, this may lead to surging prices. Some accounts state that Amazon keeps surplus profits on a Marketplace product for themselves rather than passing it onto the merchant.
- Competition monitoring: Here is an example how prices change for popular items change within one day as each retailer constantly checks their competitor’s prices and reacts algorithmically: “[…]the magazine cites an HP Project 8600 printer that for sale on April 30 at Sears Marketplace at about $160, while Amazon had it at $120, Office Depot at $130, B&H at $110, and Amazon Marketplace at $100. At 9 am at Sears Marketplace the price went up to $190, while B&H upped it to $120. Then Sears Marketplace dropped it to $155, but bounced back to $190 at 2pm. At the same time Amazon raised its price to $130. By 6 pm the lowest priced seller on Amazon Marketplace raised its price from $100 to $105. While Sears changed its price four times on this date, B&H and Office Depot kept their price constant.“
- Seasonal prices: up to 30% of annual sales are concentrated in the period between Black Friday and Christmas, with some categories being particularly popular in this time frame. Amazon reduces their prices as do others. One study (though a small sample size of 167 items) came to the conclusion that this year’s Prime Day deals were better than last year’s Black Friday deals. The more important message here is that select occasions will have their own pricing strategy.
- Dynamic pricing for Marketplace: An interesting research paper (pdf) recommends 3rd party sellers to use the algorithmic pricing capabilities offered by Amazon Marketplace as it can lead to more sales: “Sellers we identified as using algorithmic pricing receive more feedback and win the Buy Box [through which over 80% of sales go] more frequently, likely suggesting higher sales volumes and thus more revenue than non-algorithmic sellers. Furthermore, we observe cases where algorithmic sellers change prices tens or even hundreds of times per day, […] “
- Bundling/recommendations: Another tactic is bundling (sometimes with discounts) whereby Amazon suggest similar products for you to buy, e.g. under “customers who bought this item also bought”
- Deals/promotions: e.g. “today’s deals“
- Data network effects: it is known that Google uses over 200 signals for it search result ranking. No such figure is known for Amazon but we can be sure that the list still extends beyond the above signals. You can see Amazon’s low prices also as an investment into capturing valuable customer data in terms of search, purchase patterns, seasonalities, etc. When done right this can create a virtuous cycle of optimised pricing algorithms that can form a competitive advantage and increase the network that reach beyond pricing
- Deceptive pricing(?): rumours were out that the FTC may be probing Amazon for deceptive pricing. Amazon refuted the claims therein immediately. Nothing official has come out in the 1 year since
Intriguing? I think so! Just a final reminder in this context before we move on.
You can only offer low prices if your cost structure is low. Last time, we talked about some underlying business model economics that are the enablers for being able to offer low prices.
Shopping experience and presentation of products
There are many elements to the customer’s experience. One of them is the presentation layer and shopping experience. Let’s have a bit of a look what Amazon’s pages do in this dimension.
Amazon has patented their 1-click solution in 1999. It has quite a legal history. Amazon has managed to keep large parts of protected under the patent and forced e.g. Barnes & Noble to refrain from copying the functionality. They have licensed it to Apple for use in the iTunes store. The patent has expired in 2017.
Amazon will determine a “default seller” where one product is offered by several 3rd party sellers. This is based on a (secret) algorithm with prices, reviews and ratings being used in this determination. The default seller will “win” the Buy Box. Winning this spot is very important for 3rd party sellers since 82% of sales go through this box. The article that I linked above shows the price wars among sellers to get this featured spot. It is similar to ranking 1st on Google (also very desired by many bloggers like myself).
In the earlier days, Amazon’s pages were purely functional (if I may say that) centred around the search function which is likely still the most-used function. But with an ever-increasing amount of selection navigability and browseability have become more important. Here are a few examples of Amazon’s recent innovations in this space:
Apart from low prices, reviews are one of the most important factors driving customer decisions. Would you buy something low-rated just because it’s cheap? Likely not. Reviews are also one of the most important factors for the ranking of products on search pages. With this, there is big money at stake for sellers. And that means there are people trying to rig the system with fake reviews.
- The review system is one of the most important decision and ranking tools
- It is of significant value for Amazon as well as for 3rd party sellers on Amazon
- Amazon has a range of community and review guidelines
- Amazon encourages reviews, e.g. via the early reviewers program
- They allow other users to vote on the helpfulness of reviews and display more helpful ones higher up (but this system has been used for manipulation itself)
- Amazon shows the list of top reviewers based on helpful votes and has even a hall of fame for them
- Like all review pages, Amazon has filters and machine learning tools to weed out fake reviews
- Estimates of the number of fake reviews range from 1% according to Amazon vs 30% stated by fake-review detection sites
- I have covered the topic of fake reviews in more detail here
Speed of delivery
Amazon has achieved a number of remarkable things through the speed of delivery:
- They have shaped customer expectations to shorter delivery times simply by demonstrating that it is possible
- In many cities same day delivery, with free 2 hour delivery on about 15,000 item in large cities
- Speed of delivery has become a real customer experience factor that has reduced the gap to brick-and-mortar’s advantage of instant gratification
- Introduced Prime where customer pay an annual subscription fee for “free” delivery this gives Amazon revenue certainty that they can invest into their infrastructure
- As you can see from the survey results at the beginning of this article people call it “free delivery” though they fork out the annual fee of $120 currently
- Amazon are relentlessly continuing in this …. delivery drones, anyone?
- I have covered Amazon’s fulfilment innovations in great detail here
Fulfilment options are another important aspect. Amazon has to compete with an increasing amount of fulfilment options provided by brick-and-mortar and other online retailers. If you check out the previous link to Amazon’s fulfilment innovations you will see that they too have a number of last-mile delivery options (such as Amazon Key, Amazon Locker, etc).
More customer experience
I have covered the topic of delivering a great customer experience without human touchpoints here with 21 easy tips
This article by Murat Uenlue is licensed under a Creative Commons Attribution-ShareAlike 4.0 International License.