Commerce, at its core, is a game of arbitrage. Buy something for one price, sell it to someone else for more money, repeat. Failing to do this will result in losses—and eventually, bankruptcy.

At each step in the process, the upsell contains the margin that allows the company to make money. Brand A pays a factory $20 to make a shirt and sells it to a consumer for $40. The $20 difference is a 50% margin, which the brand charges the consumer. Most companies function like this and we call it front-end inflationary margin.

Amazon, however, has an entirely different view of margin than most other companies. One of CEO Jeff Bezos’ most well-known quotes is, “Your margin is my opportunity,” signaling the company’s intention to use its scale to significantly drive down prices for consumers.

Amazon has two basic ways it runs its retail business:

  1. It buys products from brands wholesale and sells them at retail, earning a possible margin on the difference. Here, Amazon controls pricing.
  2. It gives brands digital (Amazon.com) and physical (Amazon Fulfillment Centers, often called FBA) shelfspace to sell their goods through a program called Amazon Marketplace. This allows Amazon to take a range of percentage-based fees from sellers. In this scenario, brands control pricing.

There are many different mutations of these two setups, but they are similar at a high level. Like many platforms, Amazon takes what is called a rake from its suppliers—the amount differs depending on what Amazon services a company uses to sell its products on the platform.

In the wholesale scenario, to use the same example as above, Amazon might buy the shirt for $20, keeping the cost of goods a constant, and sell it for a mere $22, earning a 9% margin. While most brands would be disgusted with these numbers, the benefit is that this approach allows for increased price elasticity. Amazon plans to sell many more shirts than Brand A—which sells them for $40—further driving Amazon’s scale feedback loop, which allows it to offer lower and lower prices. With its strategy largely driven by algorithms that look at competitive pricing and adjust it accordingly, sometimes Amazon will set the price so low that it might make no money or even lose money. This margin seems paltry in comparison to Brand A, but Amazon will surely earn more raw dollars, creating more free cash flow than Brand A.  

In the Marketplace scenario—carrying on with the same example—a brand might sell the shirt for $40, and if it is using Amazon’s fulfillment service (FBA), Amazon would take the following fees:

  • A $39 annual professional seller fee that Brand A pays for the right to sell on the platform
  • A 15% referral fee ($6) for the sale that Brand A pays Amazon for finding the customer
  • A fulfillment and storage fee ($3.60) that Brand A pays Amazon for storing the inventory and shipping the order  
  • The cost for Brand A to ship the products to the warehouse for storage ($0.50)

This adds another $10 in expenses, bringing the 50% gross margin down to a 25% net margin. The cost could even increase for Brand A if it buys Amazon search ads or uses other seller services that the company offers.

Importantly, in this scenario, Amazon is not marking up anything for the consumer—all of its profit is coming from the supplier. We call this back-end deflationary margin. This is a stark contrast to a platform like Airbnb, which charges hosts a 3% fee plus tax, and charges guests between 5-15% for their stay, with the percentage dropping as the stay grows more expensive. Airbnb uses significant front-end inflationary margin.

This sets up an interesting contrast that one can see and feel when interacting with each of these services. Amazon is structurally built for consumers, and puts them first. That’s why people buy so much stuff from Amazon, but it is also why it has created very negative commoditization effects for sellers as they race to the bottom on price and Amazon accelerates the outcome.

Airbnb, conversely, is structurally built for hosts, charging them small fees compared to guests, while also prioritizing the hosts in customer service issues and a range of other policies. The simplest manifestation of this is asking for the opinion of someone who has had a problem with both companies. She will likely respond that Amazon was much more helpful than Airbnb.  

The aggressive stance that Amazon takes on pricing and margin has been mostly positive for consumers as prices keep decreasing. But there are plenty of valid concerns. For one, as Amazon continues to starve suppliers of their margin—since it refuses to make its margin on the front-end—the long-term effects will be anything but healthy for the ecosystem overall. This creates a trap for suppliers—they can’t really raise prices because another company will simply undercut them and take their sales. It also leads to a downstream effect: Suppliers go to their factories and demand cheaper prices, which likely means cheaper labor or more automation, further exacerbating the price pressure on the lowest levels of the supply chain.

It’s unclear if there is any one solution. Maybe businesses need to sell more on Amazon Marketplace as opposed to wholesaling their products to Amazon, which would allow brands to control pricing. Maybe the answer is making fewer commodity products in favor of more unique items that are less sensitive to price and have fewer competitors. Either way, it will be an uphill battle for sellers. But understanding Amazon’s unique position on margin is the first step to figuring out the answer.