Amazon Raises Prime Costs: Big Mistake or Smart Move?

Source: Amazon.com.

Amazon.com (NASDAQ: AMZN  ) has recently announced that it will be raising the price of its Prime membership program from $79 to $99 per year, a considerable increase of 25%. Prime is a crucial strategic initiative for Amazon, so the company could be materially hurt if the move backfires. On the other hand, the value proposition is still quite convenient, and Amazon will most likely come out stronger than ever from this decision.

Cost vs. value
Amazon Prime provides free two-day shipping, access to the Kindle Owners' Lending Library including more than 500,000 Kindle titles, and more than 40,000 movies and TV episodes available for streaming via its Prime Instant online video.

The price has remained the same since the service was launched nine years ago, even as the company has materially broadened the selection of items included in the program from 1 million back then to more than 20 million currently.

Digital content, rising fuel and transportation costs, and increased use by members mean materially rising costs for Amazon, and the company had in fact anticipated to investors during its latest earnings press conference that it was considering a price increase of between $20 and $40, so the decision should not come as a big surprise.

Building customer loyalty
Seen as a stand-alone operation, Amazon Prime does not look like a brilliant business model. Even if Amazon is well-known for generating amazing cost efficiencies, it sounds almost impossible to recoup the costs by charging only $99 per year.

However, that's not what Amazon Prime is about -- the program is about building customer loyalty and increasing both the frequency and the amount of purchases. And it's working fantastically well, according to some studies.

A report from Consumer Intelligence Research Partners last year estimated that Prime members buy from Amazon at double the frequency of non-Prime customers. Besides, the study claims that Prime members spend twice as much, with an average purchase amount of $1,340 per year versus $650 per year for non-Prime customers.

In a sense, Prime works in a similar way to Costco's membership-based business model. Once customers pay an up-front fee to use the service, they feel more compelled to maximize the benefits, so they tend to choose Costco or Amazon over other retailers. In the savagely competitive retail environment, customer loyalty is of enormous value.

There is one important difference, though. Costco only sells to members, and the company makes most of its profits from those fees, so this allows Costco to charge razor-thin profit margins on its products and reward its customers with competitively low prices.

Amazon, on the other hand, sells all its products for the same minuscule profit margins to both Prime and non-Prime shoppers. Amazon customers don't need the Prime membership to buy from the company at convenient prices, and the company still offers free shipping for purchases of more than $35.

Will free two-day shipping and other services justify the price increase, or is Amazon making a serious mistake that will cost the company many of its valuable Prime members?

Cost vs. benefits
Amazon says it has "tens of millions" Prime members, so a $20 increase in price per member could probably alleviate margin pressure to some degree, but it will not be a big game changer from a financial point of view for a company that produced almost $61 billion in revenue during 2013.

The good news for investors is that the company will likely be able to implement the hike without losing many customers. Amazon has recently raised prices for Prime members in the U.K. and Germany while adding video content with the acquisition of streaming company Lovefilm. Management must have received an encouraging response from members in those countries if the company has decided to also raise the price in its main U.S. market.

Amazon does not disclose precise membership numbers, but the service has been growing at remarkable speed over the years, and it even had to limit new Prime membership signups during peak periods in December due to capacity constraints. Considering demand strength, it looks like Amazon could have some room for price increases without hurting growth too much.

Bottom line
Investors need to closely monitor Amazon's decision to raise Prime prices, since the program is crucial for the company in terms of customer loyalty and competitive strength. But Amazon looks strong enough to implement the initiative without suffering much damage, so Amazon will likely see some margin improvements while still generating healthy growth in the future.

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