Tiered Pricing Is the Better Option for Amazon Prime

Amazon should charge different prices for the various components of Amazon Prime instead of charging a flat fee for the whole package so that its customers will only pay for what they need.

Mar 29, 2014 at 11:00AM

Amazon (NASDAQ:AMZN) has finally shown that it will play hardball by hiking the price of Amazon Prime from $79 to $99. Amazon Prime will now provide its members with unlimited free two-day delivery on eligible products for $99 a year, plus extras such as Kindle book borrowing and movie/television streaming.

Amazon reasoned that although hiking the price of Prime may lead to the loss of a few of its members, the extra cash would fatten its razor-thin margins. In a way, the company had a point since according to a Forrester Research analyst it loses $1 billion-$2 billion on the program every year.Its gross profit margin has also thinned dramatically even as its revenue growth has spiked. The $20 price increase represents a 25% hike, meaning that the company would still break even from this decision in the highly unlikely scenario that 25% of its Amazon Prime members, or 5 million of its members, jumped ship.

Mark Miller, a William and Blair analyst, talked to an Amazon investor relations official prior to the price hike. The official pointed out that Amazon had taken some encouraging lessons from Costco (NASDAQ:COST), as the company had cranked up its membership fee several times in the past few years and yet it never saw any material attrition in its membership base, which in fact continued to grow at around 9% per annum. 

Well, Costco's example certainly provides a refreshing real-life case study that Amazon can learn from. However, Costco's membership program and Amazon Prime's program fundamentally differ in a few respects, and this might negate Amazon's logic when it compares itself to Costco. First off, Costco's membership program operates on an all-or-none principle; you either have a Costco membership or you do not, there's no middle ground. To shop at Costco stores, you must either hold a regular membership, or an executive one, period.

You can still shop at Amazon's online stores even without being an Amazon Prime member. Although Amazon Prime has a huge user base of 20 million, Prime members account for just 36% of Amazon's $74 billion in annual revenue. That means that a full 64% of the company's revenue comes from non-Prime members, although according to Consumer Research Intelligence, Prime members spend 2.5 times as much as non-Prime members ($1,340 for Prime members vs. $529 for non-Prime members). 

Amazon Prime certainly looks like a great bargain for high-volume shoppers because of the huge savings they get on shipping costs. However, for low-volume shoppers who purchase less than $100 per month of goods from the retail giant, the cross-subsidy might evaporate with the higher prices and these shoppers might opt to stay out of the program.

Second, Costco actually has a tiered membership program; you can choose to become a regular member and pay a membership fee of $55 per year, or you can opt for an executive membership for $110 per year. Executive members get 2% back on their annual purchases, capped at $750. 

This incentive must look pretty attractive to Costco's members, since the company's executive membership base has been growing at a faster clip than the regular membership base (1.4% growth for executive members in the first-quarter of fiscal 2014 vs.1% for regular members). Executive members account for nearly two thirds of Costco's annual revenue, although they only make up 38% of total membership.

The membership fee is also highly lucrative for Costco, since the company makes close to $3 billion every year in membership fees. This provides a great boost to its bottom line. In contrast, Amazon loses a considerable amount of money on its Prime program.

The key components of Amazon Prime include shipping, video streaming, and the Kindle library,  seemingly unrelated. No doubt, the vast majority of Prime customers enjoy the merits of free shipping. Video streaming might be OK if the phenomenal growth of Netflix's subscriber base is anything to go by. However, the real value of something like the Kindle library is perhaps questionable, and it adds unnecessary expense to an already-overburdened program.

Amazon cited increased fuel and shipping costs as the major reason for the price hike, but a peek into the company's shipping costs as a percentage of its total costs reveals that its shipping costs have actually stabilized in recent times.

Source: Amazon Company Filings

The simplest solution for Amazon would be to unbundle the whole Amazon Prime program and introduce tiered pricing for the different components of the program. This way, customers can choose what suits them best without having to contend with a 'take everything or leave it' kind of package that doesn't work very well for them, or the company for that matter.

Amazon could even go a step further and introduce a minimum purchase threshold, of say $25, before customers become eligible for free shipping. Another viable option would be to introduce a fixed/variable price program for free shipping with a fixed price component and a variable pricing component that depends on the shipping needs of the customer.

Netflix plans to introduce tiered pricing
Other than free shipping and two-day delivery, video streaming perhaps serves as the next biggest attraction for Amazon Prime members. Amazon should probably borrow a page from Netflix, which plans to introduce a three-tiered pricing structure on its video streaming program for new members. CEO Reed Hastings said that the tiered pricing program is ''designed to be 3 simple options that suit everyone's needs.'' 

Foolish bottom line
Amazon has stuck with a one-size-fits-all pricing structure for its Amazon Prime program for a long time since it has worked quite well for the company -- at least where its top-line is concerned. However, going forward the company will have to become more responsive to the specific needs of its customers, and introducing tiered pricing for Amazon Prime would be a great way to do this.

Although Amazon currently looks well insulated from any major losses because of the 25% fee hike, simple price increases might not work well for the company in the future.

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Joseph Gacinga has no position in any stocks mentioned. The Motley Fool recommends Amazon.com, Costco Wholesale, and Netflix. The Motley Fool owns shares of Amazon.com, Costco Wholesale, and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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