I wish I had spent more time analyzing Amazon in earnest years ago. But late is better than never. I’ll console myself with the fact that e-commerce penetration in the US is still <10% of all retail sales…and relative to that statistic, even the word “late” seems a bit premature.
Having spent a number of months learning more about Amazon’s history, assets, business model(s), and philosophy, one thing I’ve realized is that Fulfillment by Amazon (FBA) affords the company immense advantages on the supply side that I think are largely glossed over in mainstream media and investor dialogue.
FBA’s benefits to consumers (e.g. demand side) are very well understood: 2-day delivery and potentially faster depending on the category and geography, but I believe FBA builds as great or even greater competitive advantages on the supply side. These supply side advantages are probably key reasons why an FBA-like strategy will be hard (which does have a meaning that is distinctly different from impossible) to replicate for a follower (e.g. Walmart in the future).
It All Starts With Control
I found it easiest to understand trying to work backwards from 2-day speedy delivery. Amazon didn’t invent 2-day delivery. FedEx and UPS have been doing it faster for even longer and Amazon does rely on partners for last mile delivery. Both UPS and FedEx have been offering overnight delivery for decades. So what are the benefits to doing fulfillment in-house? It starts with control.
But before we get to that, I discovered there’s a whole universe and art to product delivery. So some background might be helpful.
Shipping Models – Dropshipping vs Fulfillment
I’ve never dabbled in merchandising/retailing until my recent experiments selling on Amazon Marketplace, Ebay, and Shopify. Hence, I didn’t even know there was such a thing as dropshipping and how that differs from fulfillment, but the differences are large and important.
Starting with the most basic model (e.g. what Ebay started with) where inventory is owned and controlled by the seller – When a transaction occurs on the platform, the seller sends the inventory. This could be some used trinket or old iPhone in your garage, which formed Ebay’s legacy image of being a “used goods” platform. Simple enough. Under this model, inventory is only handled by the seller. The platform never touches the inventory.
Then there is something called dropshipping, which divorces inventory storage from the seller as well. These are the resellers that are buying cheap inventory from China and reselling it on Amazon or Ebay, etc. But big department stores like Macy’s also rely on this method as well. When a transaction goes through, the seller relays that order to the manufacturer / supplier (e.g. a factory in China) and has that manufacturer ship the product to the end buyer (or ship it to the seller that then forwards it to the buyer). This effectively reduces inventory handling and storage for the seller because the seller becomes more of a middleman. Under this model, the platform never touches the inventory, and the seller might also never touch the inventory depending on how the supplier leg of the process is set up.
Bigcommerce.com has a wonderful piece going over the details of dropshipping, including this helpful image:
One thing that is interesting with the dropshipping model is that it can be a service offered by the platform as well. For example, Shopify offers dropshipping services as does Mercadolibre, the Alibaba of Latin America. When offered by the platform, the platform handles the shipping details. The seller simply has to get the manufacturer to deliver the product to the local dropshipping drop-off point.
Then there is fulfillment. Under this model, inventory is stored and handled by the fulfillment partner (which is also the platform in the case of Amazon FBA). The moment a transaction happens, the fulfillment partner (e.g. Amazon) handles and ships the inventory. The seller does not need to do anything post-transaction. The only obligation for the seller in terms of inventory is pre-transaction…how to get the inventory from the supplier to the fulfillment partner.
Also from Bigcommerce.com:
Back to Control
For FedEx and UPS to accomplish fast delivery, it’s essentially a three step process:
- Quickly / efficiently take the package from the drop-off location to your long-haul network (probably airfreight if cross country). This process should take just a few hours if done efficiently.
- Transport the package to a location close to the final destination. This is probably done by air overnight if distance is far.
- Once the package is close to the final destination, do last mile delivery. This process probably takes just a few hours.
In toto, 2 day delivery is not difficult with enough scale and at a price. An efficiently honed operation like that of FedEx and UPS can reliably do one day delivery.
The key word is efficiently. Whereas FedEx and UPS and Amazon are all efficient, without fulfillment, Amazon can’t reliably offer 2-day delivery on 3rd party merchandise because there is no guarantee that the seller will be efficient in handling the parts of the process they are responsible for. Without fulfillment, Amazon does not have control over the inventory, and therefore the process is only as efficient as the weakest link.
What about dropshipping? As mentioned, Amazon could offer a dropshipping model that effectively gives them control of the shipping and handling process, but the passing of that control from the seller to the platform only happens post-transaction. The core difference between a dropshipping model and a fulfillment model is when the platform gains control of the product – under a fulfillment model, the platform has effective control of the product before the item is sold, while dropshipping model only transfers control once the product is sold. The moment the product is sold, the 2-day count down starts immediately…despite the efficiency of the combined Amazon/USPS/FedEx/UPS network, the seller does have to play ball and immediately get the package to the delivery partner at the local dropshipping drop-off point within a short period of time. Any delay (e.g. the seller didn’t read their notifications quickly enough) means the 2-day promise is potentially toast.
With Control Comes Cost Efficiencies
There are several awesome benefits to having control of the inventory, and a number of them are related to reducing system delivery costs.
Let’s start with a baseline example where the seller handles the shipping process (like how it usually happens on Ebay). Transaction occurs, seller sends the item. Unless the seller is high volume, they likely do not have sweetheart deals with their shipping partner and thus pays retail shipping price, which tends to be high.
Under a dropshipping model, the dropshipping partner can group together the volumes from a large number of merchants, and hence negotiate volume discounts. The same goes for a fulfillment model.
There is one area where fulfillment ends up costing more than the dropshipping model – storage. Under the fulfillment model, the provider needs to build out a lot of warehouses to store the products before they are sold. So the natural question to ask is whether this cost is worth the additional control that you get pre-transaction. And the answer is actually a very resounding yes!
Although storage costs are higher, you get additional cost benefits that you wouldn’t get otherwise under a dropshipping model (and, again, the cost benefits I list below come on top of the tighter control that you would have over delivery timelines).
One of the cost benefits come from the ability to group items. Let’s consider a hypothetical scenario of 5 sellers selling collectively 5 items (or one item each). We will call them A / B / C / D / E. These 5 sellers sell their items to 3 buyers that we will call X / Y / Z. Buyer X purchases an item from A and B. Buyer Y purchases an item from C and D. Z purchases the item from E.
- Under our baseline example where the seller handles the shipping, the 5 sellers make a combined 5 shipments. A needs to send their item to X. B also needs to send to X. C and D needs to send to Y. While E needs to send to Z. 5 different shipments.
- Under a dropshipping model, we still have 5 shipments, but there will likely be a volume discount since the dropshipping partner will handle the shipping.
- Under a fulfillment model, you only have 3 shipments! Since the fulfillment partner has control of the inventory pre- and post-transaction, the fulfillment partner (with an efficient enough process) can group together the items from A and B and put it into a single shipping package before sending it off to X. Same with the packages for Y. The cost advantage of this grouping is low when volumes are low, but likely significantly exceeds the cost of storage when your customers are purchasing with high frequency.
So not only do you have greater control of inventory under a fulfillment model vs other models, you also get the benefits of volume discounts and a more efficient shipping process through package grouping.
Storage Cost Arbitrage
FBA is not free of charge. The cost of using FBA covers not only shipping costs but also storage costs. Although I don’t have concrete numbers to back-up, I believe the storage costs for Amazon are likely lower than that for their merchants because Amazon Warehouses are likely located in non-prime real estate locations and obviously negotiated on a much larger scale. FBA likely embeds a cost arbitrage on the storage side whereby it is cheaper for a merchant to store and ship items via FBA than to store items in-house and then use a dropshipping partner. I don’t have concrete numbers to back this up, but intuitively this makes sense to me and will be a project for some other time in the future.
But it Gets Better – Inventory Commingling
Whereas all the items I listed above are probably still likely fairly well understood, inventory commingling is probably more arcane, but an incredible advantage and this advantage only accrues to the fulfillment model.
What inventory commingling refers to, is the ability to mix ownership of items in storage. For example, you have two sellers that are both selling the same trinket and they both have 10 items each in storage under the fulfillment model. With effective control of the inventory, the platform essentially has 20 trinkets to handle as it wish until it is sold.
Why does this matter?
Because it also magically leads to lower costs! And this is possible because geography comes into play.
Let’s consider the two sellers with 10 trinkets each and consider their geographic distribution. Let’s assume one is located in California and another is located in New York. Under the fulfillment model, the trinkets are pre-shipped for storage at the local fulfillment warehouse. For the Californian seller, this is in California. And for the New York seller, it is in New York.
Now let’s assume there is a buyer in California that happens to buy the trinket but buys it from the New York seller because the price is better (buyers don’t consciously consider where the seller is located as long as it gets to them in the expected timeframe, e.g. 2 days).
Under the seller direct shipping model and dropshipping model, the trinket essentially needs to go from New York to California in a very short period of time. That is costly. A bit cheaper with volume discount under the dropshipping model but still costly. Under the fulfillment model, inventory is commingled. The fulfillment partner can send the trinket from California instead! The shorter distance means not only lower cost, but the time to do that delivery is also shorter. I believe this is a key reason why Amazon Fulfillment is starting to gain enough scale to do same-day delivery.
Of course, over time this process will lead to a geographic imbalance of inventory, but that is easily remedied by shipping the excess inventory from New York to California in our above example. But wouldn’t that negate the cost benefit eventually? No, because this rebalancing process can be done over time on a longer timeframe. Shipping and item from New York to California by train over a week is much cheaper than having to airfreight it overnight to stick to a 2 day delivery promise.
The Competitive Advantage that is Hard to Copy – It’s All Because of Working Capital
Given all of the advantages I listed above, it’s shocking (to me) that fulfillment isn’t more of a priority for both traditional retailers like Walmart as well as other global ecommerce platforms. JD does this in China, but Alibaba is barely starting to explore this angle. Same with Mercadolibre in Latin America.
Competitors like Walmart and other retailers that don’t offer fulfillment likely don’t realize that fulfillment has a massive first mover advantage on the supply side, not just the goodwill that you accrue with buyers on the demand side. And this is all because of working capital.
Retailers generally have low margins and managing cash flows are a particular challenge because inventory days are quite high and business is seasonal. A retailer like Macy’s or JC Penney has to turn cash into inventory months in advance and then will have to spend months to turn that back into cash. In short, working capital is high, and working capital can both be life blood and poison.
In a world without fulfillment, ecommerce is a fantastic channel for managing working capital. It brings additional customers without much additional working capital. For example, consider a small local merchant with a physical store in San Francisco. The store already has inventory. That inventory can be listed on Ebay or a Shopify page, and when it sells, you just ship whatever inventory you already have in the store.
We can also consider another example where the merchant is purely online. One set of inventory, but that one set of inventory can be listed across Ebay, Shopify, Alibaba, Mercadolibre, Amazon, etc. One set of inventory, many sales channel. Effectively, we can create shadow/duplicate inventory in an online world. Of course, the merchant would have an issue if all of the items sold at once, but that doesn’t usually happen.
But the whole equation changes when fulfillment comes into play. Because that inventory is now under a non-neutral platform’s control (and not necessarily the seller’s control). With that inventory sitting in a specific non-seller-controlled warehouse, it becomes much harder to duplicate inventory online across a number of websites. In effect, the inventory held in storage becomes captive to that specific platform. And since working capital is a very hard problem for retailers, it limits their ability to sell across a large number of online channels. This creates incredible lock-in, and I think this advantage is largely glossed over by the mainstream media and investor crowd that assume that a well-funded competitor like Walmart can just walk in and fulfillment. Walmart may be able to build out a fulfillment network, but good luck convincing merchants to hold inventory in both a Walmart warehouse as well as an Amazon warehouse. 2x more inventory = 2x bigger inventory management problem and more cash required.
Fulfillment is clearly beneficial on the demand side, but has a lot of supply side advantages as well. It all comes from the ability to control the inventory. That control helps reduce shipping times, which is what consumers are most focused on, but also significantly reduces costs for the entire system.
More importantly, I believe fulfillment has first mover advantages and creates lock-in because merchants have limited ability to fund working capital. The first player to offer fulfillment effectively ups the working capital requirement on subsequent fulfillment competitors. The bar goes up and becomes that much higher.