Management & Finance

Free Shipping: The How-to Economic Model

Free shipping is a growing trend in the ecommerce industry.

As the owner of an ecommerce fulfillment company, I work with hundreds of successful webstore merchants and am in a unique position to see both the threats and opportunities posed by free shipping strategies.

Different Types of Delivery Offers

Most online retailers already offer limited delivery discounting that takes the form of absorbing unreimbursed shipping expenses such as dimensional weight minimums or rural area delivery surcharges.

Another common discount strategy is a set shipping-and-handling fee that is good for any size order, such as a $6.95 fixed rate, no matter the actual shipping cost. This, of course, encourages larger orders.

The fastest growing discount offer is free shipping in exchange for a minimum order in dollars. This is often in the range of $75.00, but the minimum varies widely.

In many cases, merchants offer free shipping for a limited time only, such as four weeks prior to the Christmas shipping deadline.

Online consumers, predictably, prefer 100 percent free delivery with no minimum, or a free upgrade to express delivery.

Free Delivery Can Produce Benefits, Downsides

There can be big profit potential in free shipping offers, such as:

  1. Increase in the total number of orders.
  2. Average revenue per order may increase.
  3. Item prices could be raised resulting higher gross profit.
  4. With larger volume, per-order costs may decrease.

The downside risks inherent in free shipping offers are equally large. They include:

  1. The revenue per pound may be too low for shipping discounts.
  2. Additional gross profit may be insufficient to replace lost shipping revenue.
  3. Some customers may comparison-shop free shipping deals.

The problem is working out the bottom line impact of free shipping offers when costs and benefits are so difficult to calculate. A good starting point, however, is to gather the facts and figures for your unique situation in a spreadsheet format like this one, which you can download here.

Screen capture of "Free Shipping Model" spreadsheet.

Screen capture of “Free Shipping Model” spreadsheet.

The benefit of an economic model like this is the various free shipping options can be compared side-by-side in terms of net contribution to overhead and profit.

A decision model makes getting started easier, but the fact remains that the key decision factors can only be known by real world testing.

Consider a “What-if” Decision Model

The example spreadsheet assumes an average of 12,000 orders a year with revenue of $100 per order, gross profit at 40 percent of sales, an existing $15 per order shipping and handling fee and $13 per order actual shipping cost. You can, of course, enter your own assumptions about your ecommerce project.

This sample analysis considers four alternatives.

  1. Don’t change anything.
  2. Switch to a $6.95 fixed delivery fee.
  3. Offer free delivery on at least a $200 order.
  4. Offer free delivery period.

For each of the discount offers, an initial estimate of the outcome for each new shipping strategy has been entered subject to later testing of offers that look promising.

In this example, the merchant’s contribution to overhead and profit presently averages $504,000 per year on product sales of $1,200,000 and shipping and handling revenue of $180,000 per year.

Option 2: Fixed Shipping Fee of $6.95

The example merchant is interested in a $6.95 fixed shipping fee offer. The initial assumption is the average order would increase by $20.00 and there would be a $1.30 net increase in the average shipping cost. These assumptions would need to be tested, but if the real world outcome were the same as the economic model, there would be a $16,200 loss of operating margin. In this example, the added revenue was not enough to cover the reduction of shipping and handling income and pay the added shipping expense.

Option 3: Free Delivery With Minimum Order

In the case of free delivery subject to a $200 per order minimum, the initial assumption is there would be a 1,200 order per-year reduction in sales volume. But because of the higher revenue per order, there would be an overall increase in dollar sales. Because of the heaver package ship weights, there would be an associated increase of $8.50 in shipping cost. If these assumptions were proven true by subsequent testing, the net result would be a $127,800 per year increase in operating margin.

Option 4: Free Delivery With No Minimum Order

If the offer were free delivery with no minimum, the initial assumption is a 3,600 increase in order volume per year and no meaningful change in per-order ship cost. If this were the real-world outcome, the merchant would see an $82,800 per year decrease in operating margin.

These are just arbitrary examples of how various free shipping offers could be analyzed. The main thing to keep in mind is there is a simple way to model free shipping economics, but real world testing must be conducted to project actual outcomes.

Per-pound Costs Decrease as Weight Increases

There is a vital fact that supports an offer of any kind that results in larger orders: Shipping cost per pound decreases as ship weight increases.

You will note from the carrier comparison chart in one of my earlier Practical eCommerce articles, “Shipping Rates: Comparison Shopping Save Money”, that the delivery cost of a 6 ounce package sent first class mail is $7.65 per pound, but the average cost of a 6 pound package delivered UPS ground is only $2.02 per pound.

In effect, as order size and weight increases, revenue goes up, but delivery cost as a percentage of revenue goes down. This opens the door to discount offers of all kinds.

Summary

Free shipping or some form of shipping discount strategy is perhaps a desirable alternative for your ecommerce business. A good way to begin the assessment process is to gather the basic per order revenue and expense data and model the possible outcomes of various shipping discount offers. From there you can conduct a set of real world sales tests to accurately gauge the cost versus the benefits.

John Lindberg

John Lindberg

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