#163 – Amazon’s Double Flywheel

How Cutting Cost-To-Serve Increases Selection and Deepens Wallet Share

Oct 06, 2024

Hi 👋 – Amazon’s redesigned fulfillment network has unlocked a lollapalooza effect, where lower costs and faster delivery fuel greater selection and customer loyalty. As costs drop, Amazon can economically offer more lower-priced items, expanding its selection and becoming relevant on more purchase occasions. Faster delivery drives purchase frequency, basket size, customer satisfaction, and ultimately LTV. Below, a look at Amazon’s new fulfillment flywheel. As always, thanks for reading.

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Building UPS Overnight

With e-commerce demand surging, Amazon doubled the size of its fulfillment infrastructure during the pandemic, constructing a last-mile transportation network the size of UPS in 18 months. (UPS has been building out its network since 1907.)

When you get big fast, stuff slips through the cracks. As the network swelled, so did the number of nodes and connections. As e-commerce demand normalized from the pandemic sugar-high, Amazon began untangling the Gordian knot. To do so, it challenged closely held beliefs about fulfillment. Here’s CEO Andy Jassy reflecting on that process1:

In many ways, it was very useful for us to go through what was a pretty significant change we went through during the pandemic where we doubled the size of our fulfillment center network…It was disruptive to get that optimized. But one of the things that was very useful was it really caused us to relook at everything we were doing with the fulfillment network. And we looked at it with really a beginner's eye, and we have found so many areas that we believe that we can evolve that I think will both help our cost-to-serve and, even more importantly, deliver faster delivery speeds for customers.

Stress-testing resulted in a major overhaul. Inspired by its European operations, Amazon re-architected its fulfillment network, moving from one national system to eight smaller regions. It also redesigned processes to enhance productivity2. Though optimization will take years, these changes are already generating returns.

Heads I Win, Tails You Lose – The Benefits of Regionalization

Regionalization produced two major direct benefits – lower costs and faster delivery speeds – and a host of positive second order effects. Combined, they reinforce Amazon’s dominant position with customers, shift key variables of the LTV equation upwards, and deepen its moat.

Lowering Costs

Simplicity is often the most elegant design. Bringing inventory closer to customers meant that packages traveled shorter distances. Fewer miles equals fewer dollars. Elegant simplicity. Additionally, by refining inventory placement algorithms, Amazon improved local in-stock levels which increased the number of units shipped per box, reducing deliveries3.

The results are impressive. Regionalization trimmed the number of touches required to deliver a package by 20%, cut miles traveled by 19%, and increased the number of deliveries fulfilled in-region to 76% from 66%4. This yielded massive cost savings. In 2023, Amazon slashed cost-to-serve5 on a per unit basis for the first time since 20186. In the US, cost-per-serve fell by $0.45 per unit. Pennies matter, especially when you’re operating on Amazon’s scale. The company shipped 5.2 billion packages in 2022 and anticipated shipping roughly 5.9 billion in 20237. It turned over the couch cushions and found $2.7 billion. Truly mind-boggling.

Faster Delivery

In addition to lower costs, shorter distances fueled faster delivery. In the fourth quarter of 2023, same- or next-day deliveries increased 65% year-over-year8. In the first quarter of 2024, nearly 60% of Prime orders arrived the same- or next-day9. This trend should continue as Amazon has committed to doubling the number of same-day delivery facilities10.

Customers love speedy delivery. When delivery speeds up, they turn to Amazon on more purchase occasions. And the kicker is that it’s both cheaper and faster, according to Andy Jassy11:

A lot of people have made the assumption over the last few years that faster speeds are going to mean higher cost, and that is not the case if you build the infrastructure with the right building blocks the way we have over the last couple of years. And our same-day facilities are our least expensive facilities in the network.

Good luck competing with that.

Second Order Effects – Higher Consideration and Increased Selection

Things get spicy when you combine lower costs and faster delivery. It’s a classic example of what Charlie Munger called a lollapalooza effect. That is, multiple dynamics commingling can produce outsized results.

Selection is a good case study. As Amazon decreases its cost-to-serve, it can economically sell lower average selling price items. Expanded selection allows it to fulfill more of a customer's shopping needs from its arsenal of over 300 million SKUs12. Need diaper wipes delivered by 8am tomorrow? No problem. Growing supply spurs demand, as Andy Jassy noted earlier this year13:

We see this time in and time out that when we add more selection, customers actually consider us for more of their purchases and spend more with us down the line.

The alchemy here is combining lower costs and faster delivery speeds, revving Amazon’s flywheel. Here’s Andy Jassy addressing the cost component14:

Lowering cost-to-serve allows us not only to invest in speed improvements but also afford adding more selection at lower average selling prices, or ASPs, and profitably. We have a saying that it's not hard to lower prices, it's hard to be able to afford lowering prices. The same is true with adding selection. It's not hard to add lower ASP selection, it's hard to be able to afford offering lower ASP selection and still like the economics. Like improving speed, adding selection puts us in the consideration set for more purchases.

And here’s CFO Brian Olsavsky on the benefits of faster delivery15:

When you [provide] faster delivery to customers, they actually start to consider you for a lot more items than they otherwise would. I think it's part of what – if you look at our very significant growth rates right now in everyday essentials and consumables, a lot of it is when you – if you're going to order something which you need in the same day or next day, you're not going to consider it if it's coming in three or four days. But when you're consistently getting it on same-day or the next-day, it just changes what you're willing to do.

Over the past year, Amazon has seen outsized growth in everyday essentials and consumables – things like tubes of toothpaste, bars of soap, and cans of soup. With spending on discretionary and big-ticket items under pressure, essentials are helping it soak up market share, as evidenced by recent the acceleration in unit growth.

Additionally, expanded selection and faster delivery drive bigger basket sizes, higher purchase frequency, and increased customer satisfaction16, important drivers of LTV. Here’s Andy Jassy addressing that dynamic earlier this year17:

As we get items to customers this fast, customers choose Amazon to fulfill their shopping needs more frequently, and we can see the results in various areas, including how fast our everyday essentials business is growing and the continued increase in Prime member purchase frequency and total spend with us.

Faster delivery fuels “meaningfully higher”18 spending. That’s a lollapalooza.

Relentless

Amazon isn’t sitting still. Despite realizing better-than-anticipated benefits from regionalization, lowering the cost-to-serve remains an obsession as Andy Jassy stated in August19:

One of the great things about regionalization was it not only took our cost-to-serve down, but it meaningfully changed the speed with which we're able to get items to customers. And so we have a number of those other opportunities. Another example of that is regionalizing our inbound network, which is also going to lower our cost-to-serve and get items more close to end users and diminish the amount of time it takes to get them to customers. We have a number of things that we're working on that allow us to combine more units per box, which lowers our costs as well and a lot of customers like that better because it's better for the environment, having more units per box.

Increasing delivery speeds and expanding selection while cutting costs is quite the jujitsu move. In doing so, Amazon bulldozes the price, convenience, selection pick-two conventional wisdom. It’s a good reminder about the benefit of stress-testing assumptions. Who knows what’s hiding under your couch cushions.