Over a year and a half ago, I expressed concern that Amazon (AMZN 0.58%) could face debilitating costs linked to its then-expanding Prime program. Sure, free next-day shipping on millions of items was bound to draw a crowd of spenders. If Amazon's delivery costs for an item are as much or more than the item's gross profit, though, what's the point? Never even mind the added costs of picking and boxing lower-cost goods eligible for speedy, no-cost delivery.

Looking at the latest earnings results, my concern was clearly unmerited. The offer isn't costing too much at all.

Granted, the COVID-19 pandemic helped, supplying Amazon with a much-needed scale that kept relative costs down. Efficiency ramps up when employees can focus on one task or when a piece of equipment is always in use. Nevertheless, Amazon's costly free-shipping endeavor is paying for itself, widening profit margins as a result.

Delivered package left at front door of a home.

Image source: Getty Images.

Self-funded growth

One has to dig deep into Amazon's quarterly reports to find it, but it's there. In its "Supplemental Financial Information and Business Metrics" table, the e-commerce giant notes that it spent $17.1 billion on shipping last quarter, up 57% year over year. That outpaces the 44% improvement in revenue growth though it trails Amazon's operating cash flow growth of 69%. All in all, not a bad trade-off.

Delivery charges or costs associated with handling its own deliveries aren't the only expenses an expanded Amazon Prime shipping offer adds. Selling more items means more people are needed to get goods off of warehouse shelves and into delivery trucks. These costs are categorized as "fulfillment" on the company's income statements. Amazon spent $16.5 billion on fulfillment during the first quarter, up 44% year over year, growing in sync with revenue growth.

There's considerable overlap between the two cost categories. Fulfillment costs reflect "costs incurred in operating and staffing our North America and International fulfillment centers, physical stores, and customer service centers and payment processing costs," while shipping costs include "sortation and delivery centers and transportation costs."

Any additional expense that could be linked to Amazon's free next-day shipping offer is helping more than it hurts.

The chart below tells the tale, comparing the company's major expense items to one another as a percentage of total revenue. As a percentage of sales, fulfillment and shipping costs are stabilizing near where they were a year and a half ago when next-day shipping became Prime's new norm.

Amazon's fulfillment costs as a percentage of revenue are holding steady despite Prime's free one-day shipping promise, while shipping costs are leveling off.

Data source: Amazon Inc. Chart by author.

In simplest terms, the added expenses aren't a problem.

Better profitability

This isn't the end of the story, however. Free next-day shipping on millions of Prime-eligible products is producing another fiscal benefit. By selling considerably more goods than it has in the past, Amazon's relative cost of sales (or cost of goods sold) is sinking, translating into wider profit margin percentages.

Some of Amazon's costs of sales reflect sortation, delivery, and even digital media costs in addition to the raw costs of its own inventory sold to online shoppers. Amazon's product revenue also reflects sales made on behalf of third-party sellers, which technically don't cost Amazon anything to purchase yet still incur a fulfillment cost.

The organization's cost of sales is still a reflection of combined net-product costs or related expenses, and it's still largely linked to the expanded Prime program. While these inventory and servicing costs aren't moving relatively lower, greater scale is lowering the company's relative spending linked to serving as a retailer. The end result is larger profit margins.

Amazon's profitability rises as its total costs linked to free next-day deliveries falls relative to revenue.

Data source: Thomson Reuters. Chart by author.

Note that analysts expect even greater scale to produce wider margin rates.

Probably permanent

It remains to be seen if all the manpower and fulfillment capacity will still be paying for itself in a more normal environment. Not all expenses are as easy to cut as they are to add.

On the other hand, it's a concern that may simply not matter.

While 2020's incredible sales growth is a tough act to follow, the pandemic also arguably pushed the retailing industry past a key tipping point by making online shopping for non-perishable goods completely normal. That's not to say most retail spending now happens online, because it doesn't. Digital Commerce 360 estimates only a little more than 20% of last year's retail spending in the U.S. -- Amazon's biggest market -- happened online despite 44% growth for the industry. That leaves almost 80% of the country's retail industry up for grabs, and to this end, the National Retail Federation forecasts between 18% and 23% growth for the country's e-commerce industry in 2021. Analysts believe Amazon will win more than its fair share of that growth, modeling a sales increase of more than 26% for the year now underway. 

The big takeaway for investors: Amazon can afford this expansion. Indeed, the company's shipping and fulfillment apparatus is so efficient at its current scale that it's supplying more real cash flow than investors could have even dreamed of just a couple of years ago. This cash can pretty much fund whatever initiative Amazon wants to take on next.

This is the scenario that shareholders have been waiting years to see take shape.