The second post in the Free Shipping Series focuses on the simple math calculation that you should do to make sure you are profitable when running free shipping deals. We know that free shipping is important to customers, but the key is to leverage this tactic without losing money. As an ecommerce site your fundamental goal is to be profitable, right?
The calculation that you want to perform is a breakeven analysis. I've adopted this analysis based on the excellent post and spreadsheet model provided by Troy Brown of Timberland. As Troy says:
A. How much does it cost me to give free shipping to everyone (including those that would have purchased anyway without the free shipping offer)?
B. What percent of my orders have to be truly incremental to drive to break-even on a bottomline VARIABLE PROFIT basis (after COGS and volume-driven, variable OPEX for shipping expense, fulfillment, other marketing, technology, payment processing, customer service, etc. is removed).
Or to translate... Does running a free shipping offer lead to incrementally more profits than if no free shipping promotion was run?
Gather Your Metrics
Here are the key numbers that you are going to plug into the breakeven model:
- Number of Orders - How many unique orders do estimate you will receive for the given promotion or period of time?
- Average Order Size - What is the average dollars spent in an individual order for just the product/service (excluding shipping and handling, taxes, extended warranties, etc.)?
- Gross Margin - Estimate the % profit contribution of an order after paying for fixed Cost of Goods Sold. Here's the math...
(Revenue-Cost of Goods Sold)/Revenue.
- Operating Expense - Estimate the variable expense component of the order, like shipping, fulfillment, marketing and media costs, and technology costs of hosting and bandwidth. This metric is also a % of order revenue or...
- Free Shipping Promotion Cost - What would you normally charge for shipping for this order?
I highly recommend that you also play with several alternative values (high, medium, low) for each factor. This allows you to develop several different scenarios and take into account seasonality, length of the promotion, product categories, customer segments, and any other variable factor that would influence your estimates.
Crunch the Numbers
I have attached a spreadsheet so that you do not have to build your own. Again, thanks to Troy Brown whose spreadsheet was the foundation for this model.
When you plug in the key metrics, the model calculates the variable contribution of an order, the number of orders to just breakeven, and the percentage of customers that need to be incremental. Use these numbers to make the decision whether you should run a free shipping deal.
For example, if the model says you need 30% incremental customers to breakeven (the line you have to cross to for this promotion to make financial sense), ask yourself... will more than 3 out of 10 customers simply walk away from your site because of a lack of free shipping? If the answer is a confident "Yes!", then go for it.
Now, time to crunch the numbers. Plug in the metrics for your online business. Develop several different scenarios. Then develop some free shipping offers that will boost your profitability, not give it away.
Did you like this post on the math behind profitable free shipping offers? Check out the other posts in the Free Shipping Series:
Free Shipping #1: Consumers Love Free Shipping, do online retailers?
Free Shipping #2: Do the Math for Profitable Free Shipping