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Most people who have Amazon (NASDAQ:AMZN) Prime love it and regard it as one of the main reasons they shop at Amazon. It is no question that Amazon Prime offers excellent value to its customers. It charges $79 annually for the following services:

  1. Unlimited 2-day free shipping.
  2. Free streaming
  3. Privilege to borrow e-book from Amazon library

Some analysts equated Amazon "Prime" to Costco's (NASDAQ:COST) membership. They argue that both of the programs bring customer loyalty. There is no question that Prime enhances loyalty. There is a key difference, however, between Amazon's Prime and Costco's membership. Costco's membership is a profit center for the company. The membership costs nothing for Costco and the fees generated are pure profits. On the other hand, Prime has a huge cost for Amazon. From my analysis below, you will see how Prime can kill Amazon's profit margin.

Amazon didn't break down the revenue and expenses for Prime. I will try to analyze each component cost for Prime and look for ways to improve profit margin.

1. Cost of Streaming

The cost of steaming includes content cost and technology cost (both hardware and software). Content cost is the most significant cost. Amazon did not provide the detail expenses, so I will use Netflix' (NASDAQ:NFLX) number to do an estimate. Netflix has about 27 million subscribers in the U.S. and charges $8/month ($96/year). Up to now, Netflix is still losing money. In comparison, Amazon has anywhere between 7 million to 13 million Prime users. Since most costs are fixed, it is reasonable to assume that the breakeven point for Amazon streaming should not be lower than Netflix, given Netflix has more subscribers. Therefore, $79 can't even cover the streaming cost at the moment.

2. Cost of 2-day free shipping

On the UPS website, the cost of shipping a regular sized package (5lb) in two days is between $15-30, depending on the need for air transportation. I will assume ground transfer will be good for majority of the package, and therefore, I put average cost at $18/package. Amazon probably can get a 50% discount form UPS which will reduce the cost to $9/package.

Some may argue that over the longer term, given the build-out of fulfillment centers, Amazon may start its own delivery business to cut cost. It is quite possible and I have done an estimate on the cost. Assume one truck can deliver 5 packages in one hour (10 minutes driving and 2 minutes delivering per package), the average cost per package will be over $6. (Driver costs $20/hour, gas costs $5/hour, and maintenance/depreciation of the truck costs $5/hour). All my assumptions are conservative. The cost probably is higher than $6.

According to Amazon's latest earnings report, the gross margin before fulfillment cost is 24%. In order to cover $9 shipping cost, the minimum purchase has to be $37.50 (higher if sales tax applies). If Amazon can reduce the shipping cost to $6, then, the minimum purchase will be $25. For anything less than the minimum, Amazon is losing money on the sale. If consumers start to treat Amazon as a local convenient store, it will spell trouble for the company. I do have people tell me how convenient it is to buy a $1.99 tooth paste or $5.99 toilet paper on Amazon. Unfortunately, unlimited free shipping encourages this kind of behavior.

3. Cost to maintain a digital library

After the initial cost of establishing the library, the operating expenses should be small. The problem for Amazon is how many new books to put into a library and the impact on e-book sales.

4. Possibility for price increase

Can Amazon increase the annual fee to $99? It is possible but very difficult. Netflix tried once but failed miserably. Amazon has set the bar very high for its service and perceived value. It will be a shock for many Prime members if the fee increases to $99. Also competition will prevent Amazon from increasing the fee. Google (NASDAQ:GOOG) just announced a same-day delivery service

5. Minimum purchase

For Prime members, there is no requirement for minimum purchase. Small and high frequent purchases, however, will be a nightmare for the company and shareholders. In order to encourage a minimum purchase, Amazon should consider some reward system to change people's behavior.

In summary, the annual fee of $79 for Prime can hardly cover the cost of streaming at the present time. The shipping costs are paid for by Amazon and customers are getting a free lunch. In order for Amazon to make money, the minimum purchase has to be $37. It could drop to $25 if Amazon starts its own delivery service. Small and high frequent purchases will kill profit margins.

Source: What Is The True Cost For Amazon Prime?