Amazon’s Razor Thin Margins – Poor Performance or Business Strategy?

Amazon is a fascinating company to study from the point of understanding a business model, for it is continually evolving. Regardless of whichever business the firm has entered however, it’s customer value proposition has remained consistent to delivering price, convenience & variety. The question however is whether we believe it has delivered on this value proposition effectively. Financial performance has been consistently poor with Amazon reporting razor thin margins YOY. Is this however the right metric to evaluate the company's business model? Or are it's operations and strategy tied to something else entirely?

Amazon is a fascinating company to study from the point of understanding a business model, for it is continually evolving. From being an online book retailer to an auction platform, a marketplace and now with it’s focus on logistics, Amazon has consistently reinvented itself to stay ahead of competition. Regardless of whichever business the firm has entered however, it’s customer value proposition has remained consistent to delivering price, convenience & variety.

To deliver on it’s customer value proposition, Amazon’s business model has two overarching objectives – to maximize revenue through diverse business streams, given the commoditized nature of the retail industry, and to minimize costs through an efficient cost structure.

Amazon’s objective of revenue maximization is executed through a focus on:

  • Customer relationships : Customers are well-served by automated and self-service options that enable the low price point the firm strives for and relationships are further strengthened as Amazon focuses on service & customization
  • Customer segmentation : Though largely a mass market retailer, Amazon caters to different types of consumers – shoppers, sellers, traders, developers – with platforms catering to the needs of each segment
  • Channels : By implementing different platforms – websites, apps, physical delivery points – Amazon delivers on it’s promise of convenience to each of the customer segments described above

An efficient cost structure is enabled by it’s:

  • Partner network: A large ecosystem of suppliers, developers, logistics companies and third party service providers that enable Amazon to negotiate for low costs
  • Investment in key activities: Optimizing order fulfillment, product development, promotions etc. helps increase efficiency
  • Access to key resources: Investment in latest technology systems and infrastructure results in streamlined operations

Given the two objectives, we would naturally conclude that the firm’s effectiveness in executing it’s business model should be measured by it’s financial performance, namely margins. Based on this, we would conclude that Amazon with it’s razor thin margins (0.3% last quarter[6], the lowest among it’s peers) has been doing a poor job however, Amazon says that this is in fact a strategic decision. By ensuring it reports low margins, the firm believes it keeps competition at bay and instead, focuses on investing it’s earnings into new avenues for growth. Take a look at how Jeff Bezos, the founder of Amazon, describes the firm’s business strategy in Exhibit 1. There is no mention of profits.

So then what is the right metric to evaluate performance then? Amazon says we should look at growth (the very center of Bezos’ diagram) and with a ~20% YOY growth rate (industry average is ~13%)[3], I would say they are performing extremely well. Growth implies continuous investment and Amazon seems to use it’s cash to invest in capex rather than report earnings (see Exhibit 2 for capex as a % of sales). Investors seem to buy this rationale too, with the stock moving up despite the company reporting losses.

To summarize Amazon’s business strategy, I will borrow an analogy I found apt : “A profitless business model is one in which it costs you $2 to make a glass of lemonade but you have to sell it for $1 a glass at your lemonade stand. But if you sell a glass of lemonade for $2 and it only costs you $1 to make it, and you decide business is so great you’re going to build a lemonade stand on every street corner in the world so you can eventually afford to move humanity into outer space or buy a newspaper in your spare time, and that requires you to invest all your profits in buying up some lemon fields and timber to set up lemonade franchises on every street corner, that sounds like many things, but it doesn’t sound like a charitable organization.” [2]

If we therefore accept that Amazon is profitable and it is the focus of Amazon’s business model to keep margins (artificially) low, it implies that Amazon’s operating model must deliver on this strategy effectively. It does in fact do so in many ways, as can be gauged from the examples below:

  • Infrastructure:
    • Amazon has seemingly optimized the ratio of workers to machines in it’s warehouses
    • Warehouse locations are chosen after much deliberation to optimize cost of logistics vs rental
  • Processes:
    • Amazon has emulated Toyota’s Kaizen Continuous Improvement program, which significantly contributes to cost-effective, fast product handling
    • No individual picks specific, whole orders, but instead picks parts of orders located in his or her work area to maximize speed & accuracy
  • People:
    • Amazon focuses on training and a strong work ethic. There are multiple orientations and even on-site universities.
    • Amazon workers aren’t allowed to bring anything with them to the warehouse floor, including cell phones to avoid distraction
    • KPIs for workers are defined on an order fulfillment basis i.e. rate of correct fulfilled
  • Technology:
    • Every order funneled from Amazon’s website to the fulfillment center is relayed to a handheld scanner carried by all workers in the library or pick modules. The scanner directs the associates to the cubbies where the ordered items are stored.
    • Amazon’s database knows where there’s empty shelf space and fills it as quickly as possible to maximize efficiency – there’s more efficient use of shelf space because products are shelved at random rather than categorically
    • Amazon machines are programmed to tell whether the order is incorrect e.g. scales weigh each package, and if the weight is off, the box gets pulled and a “problem solver” is called over to inspect it

Going forward, as Amazon looks to expand, the challenge will be in sustaining this competitive advantage as a low margin player by continuing to perfectly align it’s operating model and business objective.

Exhibit 1 : Amazon’s Business Strategy

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Exhibit 2: Amazon TTM Capex/Sales

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Image(s) source: Amazon

Document sources :

  1. http://www.digitalbusinessmodelguru.com/2013/07/analysis-of-amazon-business-model.html
  2. http://www.businessinsider.com/amazons-profits-what-people-dont-understand-2013-10
  3. http://csimarket.com/stocks/growthrates.php?code=AMZN
  4. http://www.businessinsider.com/the-secret-to-amazons-efficiency-robots-2014-6
  5. http://www.eugenewei.com/blog/2012/11/28/amazon-and-margins
  6. http://www.wikinvest.com/stock/Amazon.com_(AMZN)/Data/Net_Margin
  7. http://www.joc.com/international-logistics/distribution-centers/amazon%E2%80%99s-competitive-advantage-tied-fulfillment-operations_20151116.html
  8. http://mentalfloss.com/article/61249/13-secrets-amazon-warehouse-employees

 

 

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2 thoughts on “Amazon’s Razor Thin Margins – Poor Performance or Business Strategy?

  1. Thanks Aparajita. This is a good summary of Amazon’s strategy! What’s interesting about Amazon is the company is trying to beat real retail stores by keeping offering lower prices. The company launched a new functionality of reading barcodes and showing Amazon’s price. This makes showrooming much easier. I regarded this move as a message that Amazon keeps offering lower prices for a while to shift consumers’ real store purchases to online shopping.

  2. Thanks, Aparajita – this is great. I’ve always found one of the most interesting aspects of Amazon’s model is its ability to sell products at such low prices (that they sometimes even lose money) and still be such a successful company, so it’s fascinating to learn how it’s able to do that effectively and base metrics on other aspects of the business that make them competitive. Their move into digital (books, movies, and their own TV shows) will also be interesting to watch going forward.

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