Sean Camarella, Andrew Kuntjoro, Niranjan Yedlapati, and Felipe Caro
Amazon’s Prime Now is the company’s latest delivery service, offering one hour delivery of daily essential goods to Prime members for a nominal fee. The Prime Now delivery service offers benefits to both the company and its customers. Prime Now improves customer loyalty and converts non-Prime members into Prime members, who spend more on average. It has been estimated that the annual spend of an Amazon Prime member is $1,350 compared to only $650 for non-Prime shoppers. Furthermore, faster delivery enables Amazon to take additional market share from traditional brick and mortar stores. Meanwhile, customers receive nearly instant gratification from getting their orders fulfilled within an hour, and benefit from the convenience of a home delivery service.
Currently, Amazon’s outbound supply chain is comprised of fulfillment centers, sortation centers, and warehouses that specifically serve Prime Now customers. Fulfillment centers have existed since the early days of the company, and are the backbone of the delivery system. Sortation centers were introduced in 2014 and function primarily as hubs to aggregate outbound shipments, minimize third party transportation costs, and enable shipment on Sundays using the US Postal Service. Some sortation centers, such as the one in Atlanta, will also support Prime Now customers.
In recent years, Amazon has been spreading its warehouse facilities more evenly across high density regions of the US. As of late 2014, Amazon had 69 fulfillment centers and 16 sortation centers to satisfy US demand. It is unclear how many additional Prime Now warehouses will be needed but Amazon has shown that it can scale its operations quite effectively. In fact, its operating cost per square foot of warehouse space has remained almost flat at $100 during the last 7 years in which the warehouse area in North America increased from roughly 9 million square feet in December 2007 to 60 million in December 2014. In Q1 2015 there were reports saying that Amazon had opened Prime Now warehouses in Austin and New York City. Assuming that each of these new Prime Now warehouses has about 350K square feet, then the additional annual operation cost would be $70M (350K * 2 * 100 = $70M).
One big advantage of online sales versus brick & mortar is that inventory can be pooled. Put simply, online retailers like Amazon can essentially satisfy all demand from one large pile of inventory (it's well-known that Amazon warehouses "share" their stock) whereas brick & mortar retailers have to carry small piles of inventory at each store. Under some simple assumptions it can be shown that with inventory pooling the total safety stock needed by a retailer is √N·z·σ, , where N is the number of warehouse facilities or markets, σ is the standard deviation of demand, and z is the service level standard score (a 99% service level has a standard score z = 2.33). In contrast, without inventory pooling the total safety stock is N·z·σ. The speed of Prime Now service requires that inventory be disaggregated across a larger number of warehouses, not only increasing N, but also squaring its impact on safety stock.
The question remains as to whether Amazon can continue to maintain its cost structure despite even faster fulfillment times. An estimate of the Prime Now inventory levels is provided in the table here below. The standard deviation of demand prior to Prime Now was calculated using the 2014 safety stock and inventory pooling across 69 fulfillment centers. Amazon narrows its product assortment as fulfillment time decreases. For unconstrained fulfillment times, Amazon offers 230 million unique items whereas for Prime Now the company offers 25 thousand items. These items are likely to be goods with more predictable demand levels. Hence, in our calculations we assume that the coefficient of variation of demand for Prime Now is slashed by one fourth (1/4). As of Q1 2015 there were 7 cities where Amazon offered Prime Now, which represented 2.56% of the total population. With this information we obtain that the additional safety stock needed to run Prime Now is $38.5M. Therefore, assuming an annual cost of 20%, the added inventory holding cost is $7.7M.
|
Annual COGS (from Amazon 2014 10-K report) |
$62.8B |
|
Average Inventory (from 10-K report) |
$7.85B |
|
Cycle Stock |
62.8 / 52 / 2 = $0.604B |
|
Safety Stock |
7.85 – 0.604 = $7.25B |
|
Standard Deviation of Demand (pre Prime Now) |
7.25 / sqrt(69) / 2.33 = $0.37B |
|
Prime Now Markets (as of Q1 2015) |
7 |
|
Prime Now Demand (% of total population) |
2.56% |
|
Standard Deviation of Prime Now Demand |
0.37 * 1/4 * 2.56% = 0.0024B = $2.4M |
|
Prime Now Safety Stock |
7 * 2.33 * 2.4 = $38.5M |
A new Prime member adds roughly about $206.50 in annual profit to Amazon (1,350 – 650 = 700 * 29.5% = $206.50, where 29.5% was Amazon's gross margin in 2014). Therefore, Amazon must add 375K new Prime members to break even (70M + 7.7M / 206.5 = 375K). It has been estimated that Amazon already has 20M Prime members in the US, which roughly amounts to 500K existing Prime members in the markets where Prime Now is available. In other words, Amazon is expecting Prime Now to increase Prime membership by at least 75%, or maybe Prime Now is just a preemptive move against the many other startups entering the delivery business, such as Postmates and Uber’s planned merchant delivery program. It remains to be seen.
Sources (all accessed on July 8, 2015):
http://bgr.com/2013/12/17/amazon-prime-spending-study-cirp/
http://www.mwpvl.com/html/amazon_com.html
http://blog.splitwise.com/2013/09/18/the-2010-us-census-population-by-zip-code-totally-free/
http://techcrunch.com/2015/05/21/amazon-prime-now-local-stores/
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