April 03, 2011

Dear Catalog CEOs: Free Shipping

Dear Catalog CEOs:

The number one question I received, over the past week, goes something like this:
  • "What does L.L. Bean's free shipping announcement mean for me?  How do you see this decision impacting my business?"
I am not Nostradamus.  But there are a couple of thing we know about free shipping.  Let's explore what we know:

Known = Customers Love Free Shipping:  When a customer shops in a store, the customer knows that the merchandise was shipped, from a distribution center, to the store.  The customer knows that there was a cost associated with getting the merchandise to the store, the customer knows that the brand absorbed the cost of shipping the merchandise to the store.  Online, the customer knows that other brands offer free shipping.  The customer knows that you offer free shipping in November and December.  In other words, the customer has an expectation that cannot be changed.

Known = Enormous Demand Lift:  If you don't apply a hurdle to free shipping, you require a monster lift to cover the cost of free shipping.  For many folks I work with, you need a 30% to 40% increase in demand in order to cover free shipping without a hurdle.  Here's a profit and loss statement with a 10% increase due to free shipping:





Current Bus. w/ Free Ship
Demand
$100,000 $110,000
Net Sales 80.0% $80,000 $88,000
Gross Margin 50.0% $40,000 $44,000
Less Ad Cost
$25,000 $25,000
Less Pick/Pack/Ship
$8,000 $14,960
Profit
$7,000 $4,040
Profit:  % of Net Sales
8.8% 4.6%



That doesn't look so good.  Now, let's look at the profit and loss statement with a 30% lift:





Current Bus. w/ Free Ship
Demand
$100,000 $130,000
Net Sales 80.0% $80,000 $104,000
Gross Margin 50.0% $40,000 $52,000
Less Ad Cost
$25,000 $25,000
Less Pick/Pack/Ship
$8,000 $17,680
Profit
$7,000 $9,320
Profit:  % of Net Sales
8.8% 9.0%


That looks better.  What we know is that it is going to be unlikely for anybody to get a 30% increase in demand when nearly everybody is offering free shipping.  We know we won't cover the cost of free shipping via increased demand.

Known = Returns Erode Profit:  A low return rate won't save a brand that moves to free shipping, but can cushion the blow.  There will be a renewed focus on minimizing returns, because each return means a lost revenue opportunity --- a lost revenue opportunity that covers the cost of free shipping.

Known = Gross Margin Means Everything:  I'm not sure why nobody ever talks about gross margin.  Everybody talks about the importance of the size of a button on your home page, and that's probably important, but it won't help you address how to absorb the cost of free shipping.  Take a look at this profit and loss statement, at a 45% gross margin level:




Current Bus. w/ Free Ship
Demand
$100,000 $110,000
Net Sales 80.0% $80,000 $88,000
Gross Margin 45.0% $36,000 $39,600
Less Ad Cost
$25,000 $25,000
Less Pick/Pack/Ship
$8,000 $14,960
Profit
$3,000 ($360)
Profit:  % of Net Sales
3.8% -0.4%

That's not good news --- when gross margin isn't robust, it is hard to absorb free shipping.  Now, look what happens at a 55% gross margin.




Current Bus. w/ Free Ship
Demand
$100,000 $110,000
Net Sales 80.0% $80,000 $88,000
Gross Margin 55.0% $44,000 $48,400
Less Ad Cost
$25,000 $25,000
Less Pick/Pack/Ship
$8,000 $14,960
Profit
$11,000 $8,440
Profit:  % of Net Sales
13.8% 9.6%

See, even with free shipping, this business takes a bit of a beating, but is still profitable ... the only thing that changed in this equation is the gross margin line.  Here's what we know ... we know that brands with a robust gross margin line will be those that move to free shipping first.

Known = There Is Waste In Marketing:  You're not going to want to hear this one.  Catalog marketing is fraught with waste.  My Catalog Marketing PhD projects routinely find 20% or 30% housefile ad cost opportunities with minimal impact on top-line sales.  There is sooooo much waste in catalog marketing.  We know that smart companies are going to fund free shipping by significantly reducing catalog marketing expense against certain housefile segments.  Catalogers know that it is fatal to reduce customer acquisition activities, so, again, the reductions will come among housefile segments, especially among younger, suburban/urban customers who shop online or via mobile/social.  The profit and loss statement will look something like this:




Current Bus. w/ Free Ship
Demand
$100,000 $100,000
Net Sales 80.0% $80,000 $80,000
Gross Margin 55.0% $44,000 $44,000
Less Ad Cost
$25,000 $20,000
Less Pick/Pack/Ship
$8,000 $13,600
Profit
$11,000 $10,400
Profit:  % of Net Sales
13.8% 13.0%

Notice that profit is reasonably similar ... you absorb the added cost of free shipping, you lose demand by not mailing certain customers, you gain demand by having free shipping, with the result being that the p&l looks about the same.

Known = We Do What Is Easy:  It is hard to reduce return rate.  It is hard to improve gross margin.  And it is contrary to everything that a cataloger stands for to reduce circulation.  So, we're going to do what is easy.  We'll trim our staffing levels at the call center by 30%.  We'll demand that distribution center employees find ways to improve productivity by 30% or they, too, will be fired or will have to accept lower wages.  Heck, we'll ask salaried employees to "share the pain" and take a 5% pay cut and pay more for health care, and we'll eliminate profit sharing contributions in the process.  This is what people do, and we do it because it is easy to do.  It's not right, but it is easy.

Prediction = We're All Moving To Free Shipping:  It's not even worth discussing.  Companies with a healthy profit and loss statement will simply make the move, and will make the move in the near future.  Companies with average profit and loss statements will wait a bit longer, and will be forced to make improvements in the profit and loss statement to cover free shipping.  Companies with slightly below average profit and loss statements will go to free shipping with a hurdle (i.e. $100), and will cut marketing expense to fund the shift.  Companies with lousy profit and loss statements will wait the longest, will take a sales hit as a result, and will have to transform elements of the profit and loss statement in order to go to free shipping.  These companies will complain a lot.  Companies with big ticket items will be able to charge for shipping on big ticket items, but will have to move to free shipping on everything else.

3 comments:

  1. Anonymous11:24 AM

    The 30% increase in demand seems a difficult one to measure given that marketing doesn't happen in a bubble (likely this isn't the only campaign that would affect demand - for example, other marketing campaigns, changing economic conditions, seasonality).

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  2. Great points as usual, Kevin. I'm interested in how much revenue you think may be lost by not offering free shipping, how much does a competitor's free shipping cost cannibalize current sales? Do you see that happen or is it not much of a threat?

    Linda

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  3. Anonymous --- it is very easy to measure. In catalog or e-mail marketing, you give one segment free shipping, one segment doesn't get free shipping. You measure the difference, and you see the lift. All other marketing activities are spread evenly across the two groups.

    Linda, this is only a guess ... I think today, with few people offering free shipping in the month of April, you'd see a +25% or +30% (no hurdle) for those who offer it vs. a -3% for those who don't. In five years, when almost everybody offers it, you'll see a +3% for everybody who offers it, vs. a -25% or -30% for those who don't. Just my opinion.

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