Costco: Saving you Money

This discount retail giant outperforms competitors through cost-cutting and operational efficiency.

Costco is a warehouse retail store that consistently outperforms reputable competitors such as Walmart and Target in the discount retail landscape. They currently have over 81 million members and operate 697 warehouse stores across nine countries.[i] Costco takes advantage of a strategic operating model that enables them to utilize economies of scale and a no-frills retail approach to provide incredibly low prices to their members. Their business model of providing value to customers through high-quality goods at industry-low prices is a direct result of their cost-cutting operations strategy. For this reason, I believe Costco is a clear TOM winner and is highly effective at driving alignment between their business and operating models.
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Figure 1-Costco Stock Performance compared to Target, Walmart.[ii]

 

Business Model

CostcoStorefrontThe Costco business model is centered around offering the “best possible prices on quality brand-name products” to consumers.[iii] With a commitment to only stocking quality brands, they offer customers an exclusive membership to grocery prices that are substantially lower than traditional supermarkets. Costco captures value in two ways: product margins and membership fees. While other grocery retails offer margins consistently in the 25-30% range, Costco has kept their margins low at around 10.6% for the past five years. In fact, Costco has permanently capped its margins to further share the value they create with their customers. The smaller revenue from lower margins is made up for in membership fees. Costco utilizes a subscription business model where customers purchase an annual membership ($55 in the U.S.)[iv] to shop in their stores and take advantage of their low prices. While other warehouse competitors, such as Walmart, also offer low prices due to their large purchasing power, Costco is able to leverage their membership fees to actually increase sales from their members. Since customers have to pay capital upfront, they are motivated to shop at Costco more frequently in order to capture more value from access to the low prices. Costco has seen a membership renewal rate of 91% in the U.S. and Canada, indicating that their business model is driving a high degree of customer loyalty.[v]

 

Operating Model

Costco is able to offer its customers incredibly low prices due to their strategic operating model that focuses on minimal overhead costs. First and foremost, they take advantage of economies of scale by buying and selling products in bulk. Costco is able to leverage its vast network of stores and 40-year market leadership to negotiate lower prices with suppliers. Their efficient supply chain is then designed to limit the number of touch points on products. They accomplish this by purchasing in bulk directly from manufacturers and bringing products to their own distribution centers. Full truck loads are then coordinated to deliver products to individual Costco warehouses.

Costco offers significantly fewer SKUs than the average supermarket (3,700 Costco SKUs compared to 30,000 in a typical supermarket), enabling them to further simplify their supply chain logistics.[vi] In addition to their condensed product variety, Costco offers their own private brand label, Kirkland Signature, which accounts for 25% of their global sales and allows for higher margins at competitively low prices.[vii]

Kirkland

The Costco retail layout is a simplified and efficient warehouse. By eliminating unnecessary sales staff and traditional aesthetic displays, Costco significantly limits store overhead costs. Additionally, they choose not to advertise. By investing back into their operations, the value they provide stands on its own and encourages word-of-mouth marketing.

Costco also mitigates SG&A expenses by reducing employee turnover which is high in the retail sector. The average Costco worker makes $21/hour, receives health benefits, vacation time, and a 401(k) match.[viii] By providing above average salary and benefits, Costco attracts and retains talented employees, minimizing costs of employee turnover.

 

Outlook

Overall, the money and value that Costco creates through their efficient and cost-cutting operating strategy is passed onto the consumer in the form of low prices. Their business strategy is reflected at every level of their operations and enables them to run a lean, profitable business. Despite formidable competitors in the marketplace, Costco continues to outperform and look for future growth.

 

Endnotes:

[i] “Investor Relations: Corporate Profile.” http://phx.corporate-ir.net/phoenix.zhtml?c=83830&p=irol-homeprofile.

[ii] http://finance.yahoo.com/

[iii] http://www.costco.com/about.html

[iv] http://www.costco.com/join-costco.html

[v] “FY 2014 Annual Report.” http://phx.corporate-ir.net/phoenix.zhtml?c=83830&p=irol-reportsannual

[vi] “FY 2014 Annual Report.” http://phx.corporate-ir.net/phoenix.zhtml?c=83830&p=irol-reportsannual

[vii] “FY 2014 Annual Report.” http://phx.corporate-ir.net/phoenix.zhtml?c=83830&p=irol-reportsannual

[viii] http://www.investopedia.com/articles/investing/070715/costcos-business-model-smarter-you-think.asp?layout=orig

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3 thoughts on “Costco: Saving you Money

  1. I had my first experience in this giant warehouse store a few months ago and I loved it! Mainly in the cities that I’ve visited in the US, Costco tends to be located at least a 30-min drive from the city center, therefore, customers are focused on price and volume, since no one is going to drive for miles just to buy one unit or two. Costco’s business and operating models understand the customers needs, providing them access to high quality product at affordable prices and in large quantities, reducing the need to do groceries on a weekly basis. Costco also targets the right consumer, focusing on families, since its business model might not be very attractive to young couples or people who live alone, given the fact that products are sold in bulk. In a industry that margins tend to be tight, Costco’s focus on reducing the number of SKUs and on high volume allows the company to increase its purchasing power with distributors and manufacturing companies.

  2. Great post Heather. Costco’s membership model is the standout here for me – that return subscriber rate is impressive, but it seems the data they collect from 100% of their customer base would be incredibly valuable to Costco in helping them plan their inventory levels (and more). I’d also be interested to know what proportion of their revenue is derived from their membership fees, because I wonder if that lets them loss-lead across more product lines to get customers into their stores.

  3. Heather – Great post. Costco’s operations are clearly spectacular, and its operating model is very well aligned with its business model. However, in terms of outlook for the company, do you know what Costco is doing to get in front of online retail? It would be interesting to know what Costco is planning to do from an operations standpoint to support the growth of online retail as this would allow Costco to continue to provide the best possible prices, but Costco would be able to do it in a way that is more convenient for its customers. Also, since it would be more convenient, this would potentially result in customers shopping Costco even more frequently than they do now. I mentioned this in a post for Erik’s article as well, but Target and Walmart are currently developing the capability to fulfill online orders from their stores – even with a same day delivery option. Based on Costco’s already superior supply chain, I would have to imagine that Costco is working on something similar at this point as well. With Costco’s 3,700 SKUs (This is SO LOW – Target has 5,000 SKUs in Cosmetics alone), it seems that this would allow them to execute an online fulfillment operation even more efficiently than Walmart or Target, giving them an even larger supply chain advantage over both of them.

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