If you are offering free shipping, or at least considering offering free shipping, and have never sat down to calculate the impact of that offer on your profits, you’re in for a big surprise.
To begin, I’d like to say that I do understand the rationale for offering free shipping.
Free shipping does have some benefits:
Whether that increase in average expenditure per order actually results in people buying more, or just grouping more orders together and therefore decreasing your shipping and handling costs, it is a positive thing, since it would at least lower the logistical burden.
So I do understand the rationale behind offering free shipping, and I do think that it might be a good thing ins some situations.
However, you have to be careful with it, because it can ruin your business. So, before deciding whether to charge for shipping, there are two analyses that we must perform:
Let's use an example to illustrate what we would need to do:
Let’s assume that we have an online store selling a physical product, and currently:
- We offer free shipping on purchases of $36 or higher.
- And, on purchases below $36, we charge a flat rate of $5.
We have a gross margin of 25% (meaning that for every $100 worth of sales, $25 are our margin, and $75 is what the product we are selling cost us. Note that we’re not considering cost of shipping here).
Our shipping supplier charges exactly $5 per delivery, regardless of weight. And that’s the cost we pass on to customers below the minimum purchase threshold of $36.
The big question then becomes:
Analysis #1: By how much does a sale need to increase to compensate for offering free shipping?
To understand the impact of the free shipping on our profits, we would have to see what happens to our contribution margin above, and below the free shipping threshold.
And if you aren’t familiar with the contribution margin concept, I have a post about it. But for now, just think of it as the money that you make from each sale, without considering fixed costs.
So, let's see what would happen to our contribution margin per sale as the value of purchases varies.
In the first row, we can see hypothetical sales values, ranging from $16 to $55. And I'm inserting a line to denote a barrier between sales of $35 and $36, which is the value above which we would be offering free shipping.
In the second line, I'm showing how much the goods we're selling would be costing us.
We know that we have a gross margin of 25%, so the cost of the goods we’re selling is 75%. And that's what you can see represented in the second line.
Then, if we subtract the cost of goods sold from the revenue we get from a sale, we get the gross margin we're making from that sale. And that's what you can see in that line.
And the interesting thing to note now, is what would happen if we added the impact of free delivery.
So, if we look at this from the perspective of our profits, below $36, the shipping cost has no impact on our profits, because our shipping supplier charges us $5, but we pass that cost on to the customer.
That means that the impact of the cost of delivery on our bottom line is zero. And that's what you can see in the "impact of delivery" line in the image above.
However, on purchases of $36 and above, we do not pass on the cost of shipping to our customers. So, that cost must come out of our profits.
That's why in the "impact of delivery" line line I'm showing the impact of delivery on orders of $36 and above as a negative impact of $5 on our contribution margin.
Finally, in the last row, you can see the contribution margin per sale we would have with each one of these sales, assuming that will have no other variable costs per sale, beyond the cost of delivery.So, have you spotted the pattern?
To cover the $5 cost of shipping we are offering for free at $36 and above, in our example, we need to increase sales by $20.
Now… why $20? Where do those $20 come from?
Remember when I said that we have a gross margin of 25%? and that our shipping costs were $5?
In order to give away $5 in the form of free shipping, those $5 have to come out of our margin. And since we know that we have a gross margin of 25% of our sales, for us to make $5 of margin, we have to make a sale of $20.
In general, what we have is that the increase in sales needed to compensate for the free delivery is equal to your delivery cost, divided by the percentage gross margin.
And that’s where the required $20 increase in sales comes from. It’s the $5 shipping cost, divided by the 25% gross margin. $5 / 25% = $20.
And that’s why we need to increase our sales by $20 to compensate for giving away $5.
2 important considerations:
The first one is that, depending the % of our margin, the impact of giving away free shipping can be huge.
In this case, because we are working with a gross margin of 25%, to compensate for the delivery cost that is coming out of our pocket, we need to increase the sales by what the delivery costs us, multiplied by 4 (and if you’re not into math, that’s just equivalent to dividing by 25%).
But, if our gross margin was 10% instead of 25%, we would need to increase our sales by $5 divided by 10%. That’s $5 x 10! We would need to increase our sales by 10 times our delivery cost to compensate for the free shipping offer!
And the second important consideration here, is that above the $36 threshold, free shipping isn’t an incentive for the customer to spend more.
Customers are as motivated to spend $100 as to spend $36.
So, while below the minimum $36 threshold the free shipping can serve as a motivation to spend more and possibly increase the sale by the required $20 to compensate for the free shipping, those who were going to spend above $36 anyway, aren’t any more motivated to spend any more.
So the relevant question now becomes: does offering free shipping increase the average sale by more than $20?
If it does, then great! Let’s offer free shipping! And if it doesn’t… we would need to do one further analysis.
This leads us to a new question:
Analysis #2: Will the cost be compensated by selling to more people that wouldn’t have bought because of the shipping costs?
If we come to the conclusion that our average $ per sale isn’t likely to increase enough to compensate for the cost we are having because we are offering free shipping, it would be time for us to see whether despite having a lower margin, the number of sales would be higher enough to compensate for not charging for shipping.
To analyze this, we would have to see what would happen with and without free shipping.
We need to see by how much the sales are increasing when we offer free shipping, and when we don’t.
Let’s look at our numbers again:
Notice that while without free shipping you could make $10 with a single $40 sale, with free shipping, you will need to make two $40 sales to get to the same $10.
That's a required 100% increase in sales of $40 to get the same profit.
And while a $60 sale would have made you $15, with free shipping, you'd only get $10. So, to get to the same $15, you need to make 50% more $60 sales.
Even in the case of a $90 sale, to compensate for the shipping costs, you would need a 29% increase in the number of sales at $90 to compensate for the loss in margin.
Remember that above $36, free shipping won't make customers spend more.
So… can you really afford to offer free shipping? Or are you working just to cover your free shipping costs?
Note that the point I want to make isn’t that you shouldn’t offer free shipping. It does have its benefits.
You are the one who knows your business, your margins, your customers, and you may have very good reasons to offer it. And in any case, you shouldn’t be taking any advice regarding what to do and what not to do on your business from someone who knows NOTHING about it.
But, regardless of whether you charge for shipping or not, I do think that you need to make an informed decision.
And that means taking into account its full impact before deciding on making such an offer, or setting the minimum threshold over which you will be offering it. Otherwise, you do risk working just to cover your shipping costs.
Anyway, that's it for today! I hope you found this useful!