COSTCO: Big Bad Amazon can’t blow this brick and mortar house down.

COST SAVING, Costco's business and operating models' singular focus.

With almost 700 warehouses worldwide and over $100 billion in revenue last year, Costco has shown that it can survive in a retail industry overcome by e-commerce. Costco is able to continue to draw its 40+ million household memberships back to its store for the promise of steep discounts. The business model and operating model of Costco are singularly focus on one theme, cost savings.

Costco v Amazon

Membership

A subscription business model is not unique to Costco. However, this type of business model allows Costco to pass on cost savings to its members. Costco charges it’s members $55 a year to have access to the incredible savings that lie inside the warehouse-like stores and at their gas pumps. This subscription fee accounted for $785 million in sales for the fourth quarter and flows directly to the bottom line of the company’s profitability. Because of membership revenues, Costco does not have to make a large margin on the products it sells. Costco’s average gross margin is about 10%, while Walmart’s is around 25%. This cost savings is given directly to its customers which they believe more than compensates for the price of membership. Renewal rates for membership are roughly 85%.[5]

Economies of Scale 

Costco buys products in bulk orders from suppliers at low prices because suppliers are able to spread their fixed costs over more units. Prices are pushed down even further due to competition between suppliers. Costco has a limited number of stock keeping units, which limits the amount of brand competition in the aisle. Therefore, suppliers bid down their prices to obtain the coveted space within Costco.[1] Customers, attracted by the extremely low prices, purchase their items in bulk quantities as well moving massive volumes of products through Costco. Furthermore, Gasoline is a very unique product that Costco provides which also benefits from economies of scale. Traditional gas stations have limited storage capacity and can not purchase in wholesale quantities. Costco, on the other hand, can buy enough gas in bulk at wholesale prices for its network of self-service stations in the US and Canada and sell it to customers at a discount.[2]

Employees

Another cost saving measure of Costco is to invest in its employees. Employee turnover is costly for a business due to lost productivity and finding, hiring, and training new employees. Costco pays high wages, $43,000/year average, almost twice the industry average.[4] They also provide comprehensive benefits, health insurance, retirement programs, and gym memberships.[3] In 2014, employee turnover was only 5%.[4] Costco can afford this high compensation because employees are so productive with 3x the revenue per employee as Walmart.[5] Employee productivity is also increased due to the limited SKU’s in their spartan-like warehouses. [1]

Rev:employee

Conclusion

Costco’s business model is clearly in line with the operating model. Both are focused on utilizing economies of scale for their suppliers and consumers. The subscriber model allows Costco to keep its margin razor thing, so customers can benefit from the cost savings. Furthermore, Costco’s emphasis on employee retention demonstrates the value of human capital in an organization while still keeping costs low and productivity high.

 

[1] http://www.investopedia.com/articles/investing/070715/costcos-business-model-smarter-you-think.asp

[2] http://www.wsj.com/articles/costco-is-still-holding-its-own-1449520516

[3] https://www.costcobenefits.com/cms/what-you-need-to-know-about-costco-benefits/

[4] http://www.businessinsider.com/costco-pays-retail-employees-20-an-hour-2014-10

[5] http://www.investopedia.com/stock-analysis/040915/3-reasons-costco-great-company-cost.aspx?header_alt=c

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6 thoughts on “COSTCO: Big Bad Amazon can’t blow this brick and mortar house down.

  1. This is a very interesting blogpost, you did a splendid job!

    The “Closing In” chart is very interesting as the revenue gap between Costco and Amazon has been closing at a rate slower than I had anticipated. Costco’s subscription business model is unique in the retail landscape that it operates in, and I think this model is key driver of Costco having the largest membership club among competitors. However, I also think this is a key risk for Costco going forward as the $55 per year membership fee is often a deterrent to new customers, especially younger customers who often prefer instant and free access to shopping opportunities – which is offered by the rapid growth of e-commerce. One could argue that Costco targets customers with large basket sizes and thus would benefit from the bulk purchase discounts, but as the customer segments evolve, the stability and share of Costco’s core customer base may change against its favor.

    It is also interesting to think about the future of Costco’s subscription business model from a competitor’s perspective. Walmart and Target have not yet shown any interest in adopting a subscription business model, but their club memberships are also growing strongly. It would be worthwhile to further investigate whether Costco conducts any analysis on the value offered to each individual customer, let’s say measured by discounts received relative to the $55 per year membership fee. If the trend is decreasing for certain customer segments, it would pose the important question of whether Costco should charge different membership price points for different customers.

    1. Hi Lee.

      Great Comments. I wanted to get back to you on membership, and on how this constitues a sustainable competitive advantage.

      Costco’s membership provides a strong sense of community (as it allows customers to access Costco). I am not so sure membership at Amazon, or Walmart does the same. As such, the Membership remains to me not only a key asset to leverage on lower costs and higher customer value proposition, but also on a genuine customer community that may be leveraged online, in due time.

      Another issue lies in ecommerce. Given the high cost of transportation (24% of item costs) and issues on fresh items, it is extremely hard (not to say impossible) to offer sustainably low prices on shipped fresh products, which protects Costco against a rival ecommerce rival on price, while also being promising should Costco opt for an Omnichannel strategy.

      Finally, a main operating asset of Costco is its employees, its frontline employees. Neither Walmart not Amazon have invested as much on their frontline teams. Solid employee basis is another sustainable competitive advantage in retail, as empowered and involved employees actually steer and evolve the operating model of the firm toward customer needs.

  2. I really enjoyed your post! You clearly laid out the distinctive features of Costco’s customer value proposition (low cost goods) and the operating model the retailer has put in place to support its business strategy.

    There are a few components of Costco’s business model that I was curious about after reading your post:
    1) As you noted, Costco’s $55 membership fee is a key component of its operating model and allows it to command lower margins than competitors. I can appreciate that a subscription model is compelling for a middle-aged consumer that can anticipate future needs, but how is Costco going to make this an attractive investment for a younger generation? It is hard for me to imagine a younger demographic foreseeing the need for a Costco subscription, so I imagine the retailer either needs to rethink its targeting to millennials or limit itself to an older demographic? I envision there are some limitations of this strategy.
    2) Costco’s business model is somewhat tied to its superior in-store shopping experience (fewer SKUs, easy checkout, famous food sampling). How is the retailer responding to “Big Box” online retailers such as Big-Box, Soap.com, etc that are now similarly offering bulk items at low cost with no membership needs or need for in-store shopping? Is it reasonable for Costco to waive its membership fee requirement for online purchasing?
    3) Is Costco affected by the resurgence of urban living? Cities across the United States have seen a flurry of high-end commercial and residential real estate activity and an influx of a professional demographic (ie a potential Costco consumer). Does this trend towards apartment/city living shift the value proposition that Costco is offering to consumers with more limited storage space? The bulk items are attractive to rural and suburban customers, but unrealistic for most urban dwellers. Costco will have to rethink this as such trends challenge a basic tenet of its business model

  3. I think this was a great analysis of how Costco’s operating model appropriately achieves the goals laid out in its business model. I agree that the limited SKU count and ability to buy in bulk are two of the keys to keeping costs low compared to competitors. Moreover, I would add that limiting SKUs contributes to higher sales because of the paradox of choice. Customers are less likely to become overwhelmed by having too many options while shopping at Costco. By only offering a few (if any) choices for each type of product, customers are more likely to just buy whatever brand or package size is offered at Costco because they feel like they are getting the best deal. For most products where customers do not care about brand, color, or size, Costco can win. I think the company has done a great job of choosing the categories where they can be successful.

    I was also very impressed with their employee compensation and benefits. I had no idea that their wages were that much higher than competitors. At first glance, I wouldn’t think that this would be in-line with their cost-cutting business model, but I see how by managing turnover it can be an overall win. I agree that Costco is and will continue to be well-positioned for the future.

  4. Thank you for an interesting post on Costco.

    I was surprised to learn that Costco’s margin’s were that much lower than that of Walmart’s. With that being said, I’m not sure how sustainable the business model would be in to the future. Similar to the other commentaries, my concern is that Costco has not yet addressed the younger generation and the move of millennial into urban areas. Given competitors like Amazon and Big Box as mentioned above, I would be curious to learn if Costco is developing an e-commerce strategy. Do you think this would be a viable option to address the younger and urban consumers?

  5. Great post. I am pretty interested in further understanding the operating model here. There are several cultural aspects that are important (Focus on frugality, employee congeniality and longevity, service orientation) but I think the real magic is SKU and product curation, supply chain design and a focus on a premium private label in Kirkland.

    On the SKU and product curation front, it sounds like they spend a significant amount of time identifying only one or two suppliers per consumation area, culling suppliers for quality and then guaranteeing large volumes over time to help those partners scale to the filling needs of Costco. On the Supply Chain design part, they have a global sourcing operation that is supported by centralized analytics (faciltiated by membership cards) that can predict and help time product needs and ensure that volume needs are addressed at the individual warehouse level. On Kirkland, the investment and focus on branding Kirkland as a quality private label with a separate team to help build that product line creates for a unique value proposition to customers.

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