How to Use Free Shipping as a Competitive Weapon

 
 
Free shipping is an increasingly important tool in the online retailer's marketing arsenal, but profit is lost when not done right, says Donald Ngwe.
 
 
by Kristen Senz
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Free shipping is an increasingly important tool in the online retailer's marketing arsenal, but few sellers understand the intricacies of the strategy and are leaving significant profits on the table, new research suggests.

"Retailers need to be careful with free shipping promotions, given that they're exchanging what they hope is a boost in demand for sure losses on the logistics side," says Harvard Business School Assistant Professor Donald Ngwe.

Shipping Fees and Product Assortment in Online Retail explores the implications of various shipping fee policies for online retailer profitability, and the impact of each policy on customer decisions about the size of their shopping carts and whether to purchase from particular product categories. It was written by Ngwe and Chaoqun Chen, assistant professor at Southern Methodist University's Cox School of Business.

Although price remains a primary determinant of whether a consumer will buy a product, free shipping provides an added enhancement for online merchants to consider. Shoppers are only one-tenth as sensitive to increases in shipping fees as they are to product price increases, according to the researchers, so there is room available for merchants to experiment with different value combinations.

"Contingent free shipping magnifies the effectiveness of a promotion"

To help online sellers understand the complex relationship between shipping fees and product pricing, and the effect it has on consumer behavior, Ngwe and Chen analyzed sales data from Southeast Asian fashion retailer Zalora in the Philippines. Because the data included the company's startup period, encompassing more than two million orders from 2012 to 2016, the researchers could track customers across multiple purchases on the site as the company experimented with different shipping policies, including free shipping and "contingent free shipping," which requires shoppers to meet a minimum purchase total to qualify for complimentary mailing.

The analysis revealed the contingent free shipping policy to be the most profitable. "Not only are merchandise profits higher under contingent free shipping than under free shipping, but our estimates imply that the firm could derive even higher merchandise profits by increasing both its flat shipping fee and its minimum order size for free shipping," the authors wrote.

Additionally, the researchers found that under a contingent free shipping policy, a promotional discount in a particular product category becomes more attractive to shoppers. The reason: the product discount might further encourage the buyer since that would help them meet the free shipping threshold.

"The motivation to buy a dress, given that there's a promotion, is amplified because not just is the price lower for dresses," says Ngwe, "but a dress is more likely to be that top-up item that gets the shopper past the free shipping threshold. Contingent free shipping magnifies the effectiveness of a promotion."

Shoppers, fill your baskets

The study showed that shoppers spent 9.4 percent more when they need to meet a free-shipping minimum. However, there were 6.4 percent fewer purchases overall when the company moved from free shipping to a contingent free shipping model, according to Ngwe.

Ngwe attributes the higher purchase totals to customers overshooting the minimum balance needed to qualify for free shipping, due to the extra time and effort required to hit it exactly.

"Shoppers have limited time, and they would have devoted the bulk of their shopping time to finding the items that they wanted," says Ngwe. "The objective of filling their purchase basket up to reach that threshold is an additional effort from their perspective. As a result, we find a substantial amount of overshooting, and obviously, that is good for the seller."

Shoppers who come closest to the free-shipping threshold generally represent the lowest margin orders for the seller. "It's particularly damaging," says Ngwe, "when you realize shoppers are filling their baskets up with lower-margin items, but the company is also losing revenue from the shipping fees because these are orders that qualify for free shipping."

As one might expect, customers who visited the seller's website more frequently, as well as more recently, exhibited the highest demand and purchase totals. However, another finding related to loyal shoppers was more counterintuitive, says Ngwe. According to his research, VIP shoppers were less sensitive to paying a higher shipping fee, presumably because their desire for the products was stronger.

"Whereas online sellers might think of a shipping incentive as a reward for frequent shoppers and VIP shoppers, these online sellers might actually be losing out by being so generous with this, given that our estimates imply that frequent shoppers might be more, rather than less, willing to pay a shipping fee," Ngwe says.

Instead of free shipping, retailers like Zalora that sell products in multiple categories would be better served by offering online product discounts to their most frequent customers. "Our results suggest that that's a safer and in the end more profitable way for the firm to reward loyal shoppers."

Ngwe and Chen also used the data to simulate a subscription service through which Zalora customers could purchase an annual membership to receive free shipping, similar to the Amazon Prime model. "Our research implies that it is very difficult for the average online seller to make a program like Amazon Prime work," he says. "This retailer would have to charge a very high membership, and at that price, the number of people who would sign up is very low."

Despite the trend toward online shopping, some previously online-only sellers are now establishing a physical presence, says Ngwe, citing the Google Store, Amazon Go, and Bonobos showrooms.

"I think a large part of what this work is about is displaying how costly it is, underscoring the importance of setting your shipping fees"

As growth in online retail has outpaced expansion in traditional retail stores, the higher cost of doing business online often gets lost in the discussion, says Ngwe.

"Having a physical store is a much more cost-efficient distribution strategy than having to ship everything directly to consumers," he says. "I think a large part of what this work is about is displaying how costly it is, underscoring the importance of setting your shipping fees."

Many multichannel strategies to consider

Retailers have a number of options when deciding how to fulfill customer orders while attempting to maximize profit and customer satisfaction, says Ngwe. To help them, Ngwe tries to get a sense of where customers find value in deciding between online convenience or seeing something up close in the store.

"Fulfillment is in a lot of flux these days, and I'm interested in seeing in the end what the predominant fulfillment strategy will be for online sellers, and retailers more broadly."

Kristen Senz is a freelance writer and social media content creator.

Related Reading:

Should Retailers Match Their Own Prices Online and in Stores?
Behavioral Economists Can Make You a Healthier Consumer and Smarter Marketer
Research Paper: The Effects of Store Openings on Sales through Direct Channels

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