Because most philosophies that frown on reproduction don't survive.

Wednesday, February 26, 2014

Pricing and Amazon Prime

We first got an Amazon prime membership on a trial basis, and because I was buying something that the shipping would have been absurd on: a weight bench that wasn't stocked at any of my local sporting good stores. However, it quickly became so addictive to be able to get any thing sold by Amazon shipped second day without any fee for shipping, that we've kept it for the last six years or so.

I'm sure that we're some of the reason that Amazon loses over a billion dollars on Prime every year. For instance, the cheap earphones I'd passed down to the kids so that they could listen to audiobooks on my old iPod finally broke, so rather than go out to the store I got on Amazon, picked out a nice pair for $15 (which would have cost me much more in store) and they showed up two days later to the kids great delight. The fact that it's a pain for us to get out the door to go shopping, especially for something that we'd have to drive down into Columbus to buy, means that free second day shipping is a huge value for us. (And we even end up using the discounted overnight shipping a lot for last minute birthday presents and such.)

As such, I was rather chagrined to read that Amazon is thinking of raising the price on Prime by $20-$40 in the near future. The feedback has been overwhelmingly negative, and I myself have wondered if we should cancel if it happens. However, reading Rafi Mohammad's piece on pricing Prime in Harverd Business Review, I think I probably disagree with his alternative suggestion.

The solution to Amazon’s pricing dilemma is straightforward: unbundle the components of Prime. By unbundle, I mean instead of making a “take everything in the package or leave it” price hike, allow customers to purchase what works best for them.

Much like cell phone carriers serve customers with varying usage needs, Prime should provide different shipping options. The premium option can be the current unlimited service, albeit at a steeper price. A lower-priced option could require a purchase minimum of, say $25, to get free two-day shipping. This will curb shipping losses from irksome small dollar orders such as $5 scissors. Another variant is to offer a classic two-part fixed/variable pricing strategy. For instance, there could be a $50 annual Prime membership that gives members the right to receive two-day shipping at a variable price of $1 – $2 a package.

Given that streaming and the Kindle library have little to do with shipping, there’s no clear reason to include them in the Prime bundle except to elicit a “wait, there’s more” urge to buy. Why not simply offer streaming and the Kindle library a la carte or as an extra option to those who purchase a shipping option?

Unbundling Prime and providing choices better serves customers, which increases the popularity of this critical growth program. Amazon’s challenge provides two key pricing lessons to all managers. First, understand and respect that customers have different needs. One price does not fit all – provide pricing options to serve the diverse needs of customers. Just as importantly, when implementing a significant pricing increase, it’s critical to offer customers lower priced options. No one likes “take or leave it” ultimatums.

The reason, from Amazon's point of view, for keeping Prime bundled is that it allows them to get people used to extra value. Take the instant video streaming service. We already subscribe to Netflix, and the things available overlap to a great extent, so I don't think I would have ever tried Amazon streaming if it hadn't been included in Prime. As it is, though, they selection is slightly different. (For instance, the had the BBC production of Emma on streaming while Netflix did not.) And so we've gradually fallen into using it more. Now I'd be more inclined to drop the Netflix streaming and pay for Amazon if they split it off into a separate service from Prime, but the key is: I never would have got to that point if they hadn't offered it as a free service to Prime members for quite a while.

Offering free add-on services to Prime rewards Amazon's most loyal and profitable customers, and it encourages those customers to broaden the number of services they turn to Amazon for. Splitting Prime into a set of a la carte options would probably significantly slow adoption of new services which Amazon would like to launch.

The one split out that would potentially work would be if there are a small number of users who are having a massively disproportionate effect on the cost of Prime by shipping huge numbers of items. (For instance, people who are doing ordering for some kind of small business.) If 10% or less of Prime members are accounting for a huge percentage of the shipping costs, and if it's possible to come up with a way to charge for for "unlimited two day shipping" versus some sort of more modest plan like "50 free second day shipments a year, with additional shipments at $2.99 each" or "unlimited free 5-6 day shipping and 25 free 2nd day shipping credits per year" I think that could potentially work as a segmentation. However, while as a consumer I'd happily not have have to pay for the Kindle lending library (I don't own a Kindle), I think that in general Amazon would probably not be well served by segmenting their Prime offering.

As for the size of the increase: They're going to face major backlash when they increase Prime pricing regardless, so it's probably a good bet for them to make a price increase such that they won't have to do it again for another 5-7 years. In that sense, it's probably smart to do a single $20-40 increase and deal with whatever percentage of people actually cancel (probably much smaller than the number who say they'd cancel), than to set themselves up for having to do smaller price increases every 2-3 years and deal with the backlash each time.


Jenny said...

We took the plunge with Amazon Prime in December. It's a dangerous thing especially with Discover money attached to it. What pushed us over the edge to try it is that we are exploring how to lower our TV bill. Soon and very soon, the cable will be turned off. Without streaming attached to Prime, I doubt we ever would have paid for it.

"Unbundling Prime and providing choices better serves customers"

Says who? I hate many unbundled services although unbundled cable would be nice. I know I am a cheapskate. I generally will not pay for anything extra unless there is no way around it. When I do have to pay extra, I feel like my vulnerability is being exploited. When I don't pay extra, I grouch about what used to be included in the service.

Unbundling makes cheap people cranky. :)

Paul Zummo said...

Your last point is intriguing to me, because in a sense it is the opposite of what those in my field deem best practices. I work in the electric utility industry, and in particular with those who set electric rates, and most analysts would suggest that you raise rates just a bit year-to-year rather than one big rate spike every few years. Customers don't tend to notice if you raise their rates about 5%, but once you start going over that magic number the complaints roll in.

I suppose it's not exactly an apples-to-apples comparison, but as a Prime member myself I'd probably be more inclined towards smaller increases every year rather than one big jump, but I might be an anomaly.

On a barely tangentially related note, when it comes to unbundling and cable in particular, I think WWE's foray into a paid internet channel is going to be fascinating to watch. Whatever you think of wrestling, this is truly a potentially revolutionary venture as I suspect many people would prefer a model where you pay for certain stations instead of all of cable.

Darwin said...

Your last point is intriguing to me, because in a sense it is the opposite of what those in my field deem best practices. I work in the electric utility industry, and in particular with those who set electric rates, and most analysts would suggest that you raise rates just a bit year-to-year rather than one big rate spike every few years. Customers don't tend to notice if you raise their rates about 5%, but once you start going over that magic number the complaints roll in.

This is the kind of thing that varies a lot by industry and customer set. In the consumer packaged goods products that I price, we stick with the small incremental price changes approach as well, and consumers generally absorb them as part of inflation.

My theory in this case is that they key to the Prime business is that it's a once-a-year charge which you have to take action to prevent from renewing. The tendency is for people to forget it's there. They don't want to cancel right after it charges, because they might as well get a year's use out if it. But then, if they may forget to cancel during the month or two before it expires, and there they are again.

If they're going to increase the rate, I believe they're going to be legally required to notify all the members via email, and that gives people an obvious chance to exit. My guess is that the defection rate would be a function of the size of the increase and the frequency of the increases. I could be wrong (and given the size of the risk, they'd want to come up with a way to do some fairly rigorous testing) but my suspicion is that the frequency would end up being a bigger factor, so they'd probably be better off going from $79 to $99 once and staying for 5 years, than doing four five dollar increases over the next four years.

Paul Zummo said...

That makes sense, and I thought that it might not exactly compare to utilities. After all, I can't (or wouldn't want) to ditch electric service.

Even at $99 I'd likely stick with Amazon. Even though I don't tend to purchase that much, I probably order enough that the subscription more than pays for itself within a few months.

Tom Davis said...

The HBR guy is trying to make sense of retail pricing.... good luck. Retail pricing is insanity. If you want to read a book that might help you understand Prime better, read Priceless: The Myth of Fair Value (and How to Take Advantage of It).

Logic and pricing just do not mix. Ask Ron Johnson, former CEO of Penney's. I liked his idea of everyday pricing. I hate feeling like what I buy today will be half price tomorrow. But apparently people like me don't buy a lot of clothes.