Amazon is Pursuing a Cost Advantage, Not Low Margins [Updated]

by mjfern

…I believe Amazon is anything but irrational when it comes to how they think about margins. I believe it’s a calculated strategy on their part, and anyone competing with them had best understand it.

Source: Amazon, Apple, and the beauty of low margins

Low margins, per se, isn’t a strategy. Amazon is pursuing a cost advantage, and it’s choosing to keep its prices very low, hence the low margins. [1] With a cost advantage and low prices, Amazon gives away a lot of value to customers, instead of capturing a lot of value for itself in the form of profits. Its primary objective is to gain market share (i.e., both new customers and a greater portion of existing customers’ everyday shopping). With an increase in market share, Amazon can further reduce its costs through economies of scale (i.e., spreading its fixed costs, such as infrastructure and R&D, over a greater number of customers served and products sold).

Amazon’s cost advantage and its low prices explain why most other online retailers have been unable to gain significant market share and why Amazon is now posing a serious threat to companies like Costco and Walmart. In 2011, Amazon’s total operating expenses as a percentage of revenue were about 91.3%, or about 6% less than Costco’s and 3% less than Walmart’s. [2] [3]

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[1] I’d argue that Amazon is actually pursuing a dual advantage, both a cost and value advantage (at least for customers that favor convenience over impulse buying). This value advantage stems from features such as home delivery, extensive product reviews, excellent customer service, broad selection, etc.

[2] Looking at Amazon’s 10-K for the year ending December 31, 2011 and Google Finance (Financials, Annual Data), I found the following. Amazon’s total operating expenses as a percentage of revenue was 98.2%; Costco’s was 97.2%; and Wal-mart’s was 94.1%. Since Amazon also has the Kindle and AWS businesses we have to back-out revenue and operating expenses for these non-retail business. By reviewing Amazon’s 10-K and drawing on published data, I determined the following: Amazon’s total revenue was $48.077b, AWS revenue was about $1.586b, and Kindle revenue was about $2.404b. This yields $44.087b in revenue for Amazon’s retail business.  For operating expenses, I allocated the following to Amazon retail business. 95% of “cost of sales,” assuming 5% of Amazon’s sales can be attributed to the Kindle, two-third’s of “fulfillment” costs, and one-third of the remaining line items (technology and content, marketing, G&A, and other operating expenses). Based on reading Amazon’s SEC filings, I’m assuming the bulk of fulfillment costs are for its retail business. I’m splitting the remaining line items equally across the three businesses (retail, Kindle, and AWS).

[3] Given Amazon is still scaling aggressively, I anticipate this cost advantage to increase overtime. Looking at the latest four years of financial data in Google Finance, Amazon’s revenues are growing at a 25.85% CAGR. This contrasts with 8.54% for Costco and 2.54% for Wal-Mart.

  • http://twitter.com/craigweich Craig Weich

    Hi Michael,

    Thoughtful piece, thanks.

    Can you say more on why you think it’s valid to back out all of the $2B in 2012 R&D for comparative purposes?  Neither AWS or Kindle are new, why wouldn’t the bulk of those expenses be as similar to Wal-Mart or Costco investments in Distribution Centers?  I understand from an accounting standpoint that the expenses can be classified as R&D, but practically speaking aren’t they representative of the cost of maintaining Amazon’s “digital leadership”?

    On related note, had a strange experience yesterday with Barnes & Noble that underscored the challenge retailers are having in competing with Amazon.  I considered going to my local B&N for a book only available in hard copy (Human Face of Big Data).  Online, they matched Amazon’s price of $27.83.  To pick it up in the store?  $50.  I called them to verify that it wasn’t just a website error — it wasn’t.  As a customer, made me feel like they’d given up on getting my business (bought it using Amazon Prime).  I thought the point was to encourage you to come into the store?

    Thanks,
    Craig
    @craigweich:twitter 

  • mjfern

    Thanks, Craig. I appreciate the comment! Great question on backing out R&D. My logic when writing the post was as follows: (1) retail is Amazon’s oldest business (founded in 1994, hard to believe) so I assumed that most of the R&D has already happened, (2) most current R&D is now focused on the Kindle (launched in 2007) and on AWS (launched in 2002), both are still developing products in highly competitive areas. Note, my understanding is that Amazon’s retail business is largely built on top of AWS infrastructure so continued R&D for AWS will also benefit retail. 

    I found the original R&D figure using Google Finance. In responding to this comment, I decided to review Amazon’s recent 10-K. It looks like what Google Finance called R&D is actually a line item in Amazon’s “Consolidated Statement of Operations” called “Technology & Content.” Here is how Amazon describes this line item: “Technology and content expenses consist principally of technology infrastructure expenses and payroll and related expenses for employees involved in application, product, and platform development, category expansion, editorial content, buying, merchandising selection, and systems support, digital initiatives, as well as costs associated with the compute, storage and telecommunications infrastructure used internally and supporting AWS.”This sounds like much more than just R&D for AWS and the Kindle. As a result, we need to attribute a portion of this amount to Amazon retail. I don’t have any precise way of dividing up the amount without access to Amazon’s internal financial data. We should also look at Amazon’s other line items (cost of sales, fulfillment, marketing, G&A, other operating expenses) and attribute portions of these to the three separate businesses. Again, there’s no surefire way of dividing up these figures given public data. 

    As a quick and dirty analysis, I will allocate the following to Amazon retail: 95% of “cost of sales,” assuming 5% of Amazon’s sales can be attributed to the Kindle, [1] two-third’s of “fulfillment” costs, and one-third of the remaining line items (technology and content, marketing, G&A, and other operating expenses). Based on my reading of Amazon’s SEC filings, I’m assuming the bulk of fulfillment costs are for its retail business. I’m splitting the remaining line items equally across the three businesses (retail, Kindle, and AWS). I also noticed a logical flaw in my original analysis. I needed to remove AWS and Kindle revenue from Amazon’s total revenue so we’re left with just retail revenue. For the year ending December 31, 2011, Amazon’s total revenue was $48.077b, AWS revenue was about $1.586b, and Kindle revenue was about $2.404b. This gives us $44.087b in revenue for Amazon’s retail business. 

    In the end, with this more complete analysis, Amazon retail’s operating expenses as a percentage of revenue is 91.3% or about 6% less than Costco’s and 3% lower than Wal-Mart’s. This is based on the rough assumptions above, and the actual numbers probably vary to some extent. Regardless, the take-away in my mind is that Amazon likely has a cost advantage relative to Costco and Wal-Mart. And, given Amazon is still scaling aggressively, I anticipate this cost advantage to increase overtime. Looking at the latest four years of financial data in Google Finance, Amazon’s revenues are growing at a 25.85% CAGR. This contrasts with 8.54% for Costco and 2.54% for Wal-Mart. I am updating my post to incorporate this new data.

    [1] http://www.businessweek.com/news/2011-07-27/amazon-com-jumps-as-kindle-digital-media-fuel-sales-growth.html

  • http://twitter.com/craigweich Craig Weich

    Hi Michael,

    Thanks for such a thorough response!

    Craig

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