Business Model: Creating & Capturing Value
Costco’s operational execution and value capture strategy enable differentiation from competitors like Wal-Mart who also provide value through low price consumer goods. Rather than cost markups, Costco employs an alternative profit model through membership subscription. Consumer’s pay an upfront fee to access products priced with minimal to nonexistent margins. Competitors in the discount retail space are forever at a disadvantage relative to Costco because no matter how efficient their processes, they must price products above their procurement cost. Armed with this competitive advantage, Costco executes several operational tactics to enhance consumer value.
Operating Model: Processes that transform assets into valuable actions
Limited Product Assortment & Bulk Purchasing
Costco makes two strategic trade-offs when designing the consumer experience. Compared to other retailers Costco severely limits the number of products available for purchase. While Costco sacrifices the convenience of carrying products for all consumer needs, it gains significant bargaining power as consumer purchases are split between less items. This power is magnified further because Costco typically sells items in bulk format. Although the sticker price of multipack items can deter some shoppers, bulk product offerings often result in a larger overall purchase versus stores that sell individual units. The effect of these actions translates to manufacturer willingness to compress margins. In my experience at General Mills, manufacturers begrudgingly conform to Costco’s price requirements in order to access the highly incremental sales volume attributed to the bulk product format. Costco’s business model allows them to plow these savings directly into price.
Loss leader pricing & low markups
Price is leadership and the awareness of said leadership are the key driver of Costco’s business and the willingness of consumers to purchase memberships. Loss leader pricing is a familiar tactic used by discount retailers, but Costco takes the practice to a whole new level. Retailers typically place select items, during specified time windows, at prices at or below their costs in order to drive traffic to the store and subsequent purchases of other higher margin goods. Costco is able to double down on this strategy because they don’t rely on the second part of that equation to drive profits. Memberships account for roughly 75% of Costco’s profits so pricing items at a loss or just above product cost is common at Costco. Items like fresh fruit, rotisserie chicken, hot dogs, and gas are always available at or below cost. Costco doesn’t need to advertise these deals because unlike loss leaders at other retailers they are always offered.
Supply Chain & Labor Efficiencies
With the sole focus on price Costco is able to cut costs in other areas like store design, shipping, and labor. Costco essentially sells directly from its warehousing space and therefore avoids the cost of separate selling & storing locations. Through stringent rules on manufacturer packaging and shipping Costco is able to sell product that comes directly from the manufacturer, thereby eliminating expensive distributor middlemen. Costco also eliminates much of the expensive stock keeping costs other retailers must endure by placing bulk goods in palletized format directly on the warehouse/sales floor. Shoppers navigate the warehouse and help themselves to product without much assistance because Costco maintains a lean workforce. Contrary to initial intuition, Costco actually invests heavily in the workers it does employ. Through low turnover and higher worker productivity, Costco finds yet another way to lower its costs and pass the savings on to consumers.
As Costco continues to grow, the efficiencies of its’ business model will scale and create a reinforcing cycle of lower prices and increased consumer value. The primary impediments to growth will be market saturation and improved performance of competitors like Sam’s Club, but existing stores should continue generating cash. As Costco expands internationally it will look to duplicate the proven success of translating operational efficiencies into consumer value through its membership model.