Costco: Becoming the Second Biggest Global Retailer
Costco is now the second biggest retailer in the world even though Costco is not really a retailer. Compared to other big retailers, Costco is relatively young. So how did this relatively young pretend retailer rise to become the second biggest retailer in the world? What can other retailers learn from Costco rapid success?
Costco has the audacity to charge shoppers for the privilege of shopping in their store. Why are shoppers willing to pay to shop at Costco? What is it about Costco that attracts shoppers willing to pay for the privilege of shopping there?
Costco founders understood what many retailers are struggling to grasp. Shoppers do not visit retail stores to buy the merchandise but the experience of buying the merchandise. They understand that it is about breaking shoppers threshold resistance…The invisible barrier that stands between shoppers and merchandise.
This article aims to show retailers how to create those experiences that removes those invisible barriers that stands between shoppers and their merchandise.
The Costco Vision
Imagine you are a professor at Harvard, Wharton, London School of Economics or one of the prestigious business schools in 1976.
Brothers Sol and Robert Price were your students.
At the end of the academic year, the project they submitted stated that they wanted to open a retail store that will charge shoppers for the privilege of shopping at their store.
Imagine what you would think of their idea?
You might probably give them an ‘F’ and recommend they underwent psychiatric evaluation.
Well, Costco business model rested on the premise that shoppers will pay for the privilege of shopping at their store.
In return, shoppers receive wholesale or “bulk” products at the lowest possible price.
So how did the Price brothers pull off their dazzling fate enabling Jeff and James to pick up the baton in 1983?
Costco’s rise to glory like all successful retailers was based upon the three retail success fundamentals:
- Your market: Who you are selling to
- Your message: What you are selling to them
Your Media: How you are going to sell to them
Your market: Who you are selling to
As Sol Price strolled down the streets of San Diego chatting with grocery store owners, restaurateurs, newspaper vendors and candy stands, he discovered a gap in the market he felt he could fill.
At that time, those small business owners purchased their stock from four to five different vendors or cash-and-carry with limited stock.
Instinctively, he knew that if he had a warehouse like retail operation that carried all of the stock those businesses needed at reasonable price, his business was going to succeed.
So with his brother, they came up with the concept of the ‘Price Club’ using funding from families and friends.
The ‘Price Club’ was established to cater to the needs of small business owners.
However, as the operation grew, they realized that targeting small businesses exclusively was an unsustainable business model.
So they decided to extend membership to high-end consumers that included: licensed professionals, public sector, utilities, hospitals or banks workers.
Basically, those workers whose cheque was unlikely to bounce.
This is a very important lesson every retail organization need to learn.
The Price brothers first identified their target audience before deciding on what they were going to sell to them.
The clarity and leaser targeting of their preferred audience made it easy for Costco to structure its offering to appeal directly to those types of people.
Their strategy was in sharp contrast to the conventional way of establishing a retail venture, where the retailer stock the store and hope shoppers will show up.
Paying for Membership
The most ingenious of all target market selection the Price brothers pulled off was asking prospective members to pay for the privilege of shopping at Costco.
This is how Sol Price described the thinking behind the membership model:
“The membership concept is very important to us. First, membership provides a way f or us to pre-select the demographics of our customer base without having to do all the extensive research that would otherwise be requires. Business owners and managers, licensed professionals, and people who work for governments, utilities, hospitals or banks tend to be more stable than many other. We take less risk in accepting their checks.
Second, dealing exclusively with selected groups makes it possible to communicate with your customers effectively. Instead of communicating with the whole world, you communicate one-on-one with the people you want to reach.
Finally, someone who pays for a membership in an organization makes a form of commitment. They have a built-in reason to come back.”
Sol Price, founder, Price Club, November 1990”.
Costco membership renewal rate is 97% amongst active business users.
That is a massive renewal rate by any standard.
Even the Vatican is yet to figure out a way of achieving 50% membership retention let alone 97%.
What that means is at the beginning of the trading year Costco already has half of its operating profit because membership accounts for 50-55% of its operating profit.
First identifying their target market and asking them to self-select by paying membership fees is one of the cornerstones of Costco success.
Paying for Membership
Target market identification on its own is not enough to catapult a retail organization to the second biggest retailer in the world.
The second key to Costco success was knowing what it was going to sell to its target market.
Sol had already identified the pains of small business owners: purchasing from multiple vendors or from cash-and-carry with limited stock.
The solution he came up with was having a place they could purchase all of their stock at a reasonable price.
In order to achieve that, Costco had to clearly articulate what it really sold.
So what is it that Costco really sells?
Here is the answer from Sol Price himself:
“My ‘secret’ is so simple that I’m reluctant to speak openly about it for fear of appearing stupid. I sell things as cheaply as I can.” Sol Price, founder, Price Club, March 1985 ”.
What Does Costco Sells?
I need you to analyse the statement carefully.
He did not say I sell cheap things or I sell things cheaply.
He said “I sell things as cheaply as I can”.
This brings us to the points I have made in the previous ‘Lessons from Masters” article series.
Successful retailers build their pricing promise into their operations.
However, before getting into the pricing structure of Costco, let’s answer the question: what is it that Costco really sell?
Many retailers like to believe that shoppers visit their stores to buy their crappy made in China merchandise.
Let me be the one to break this bad news to you.
Shoppers do not visit your store to buy your crappy made in China merchandise.
They visit your store to buy the experience of buying the merchandise.
If they were really buying the merchandise, they would stay home and order from the comfort of their living rooms.
They don’t just want the merchandise, they also want the experience of buying the merchandise.
That is exactly what Costco provide them.
The experience of buying the merchandise.
Costco sells bulky merchandise.
Costco customers enjoy the thrill of hauling out ten pound bags of stuff into their car.
Pulling into their drive way and their neighbours seeing them dragging the large bags or boxes of stuff into their homes.
Costco sells them the bragging right of belonging to the middle class.
In case you need reminding, Costco do not sell to poor and unemployed people.
This is how Super Marketing describe Costco’s strategy:
“The Costco trick is to lure people in with the promise of bargains and, when they see what’s on offer, persuade them to spend more than they intended. Its membership criteria concentrates on those with a pocket deep enough for impulse buying. The poor and unemployed are not invited to this party.” Super Marketing, November 1993”.
So shopping at Costco automatically provide customers the feeling of belonging to a different class.
Costco Make Shopping Fun
In addition to the staples, Costco customers could strike gold in their shopping expedition.
Costco has relationships with a number of big brand manufacturers who supply the retailer branded merchandise at reasonable price.
Therefore, some weeks, shoppers could find merchandise from big brands as Ralph Lauren or Levi’s.
But the trick is, it is not in the store for more than a week.
The British Monarch could be going out of business and lucky shopper could find the queen’s crown for sale.
The following week, the Vatican could be declaring bankruptcy and the Pope’s ring might be up for sale.
Or the week after that it could be Al Capone’s favourite gun on sale.
This atmosphere of treasure hunting keeps customers coming every week for fear of losing out on something.
Building Cost into Operational Expenses
While the average supermarket operates a 30% gross margin, warehouse clubs like Costco operates only 9% gross margin.
As a result, warehouse clubs constantly needs to find creative ways of remaining solvent.
Charging for membership is one way Costco generates revenue to compete against established players.
Another way is having an efficient supply chain system.
Compared to its competitors, Costco has a highly efficient supply chain system.
Firstly, Costco has far less inventory (SKUs’) than is main competitors.
The average supermarket has over 25,000 SKUs while Costco has about four thousand.
Secondly, Costco inventory turnaround time is faster than its competitors.
Compared to the average retailer with four to five times inventory turnaround per year, Costco’s inventory turnaround is 15 to 18 times on average per year.
Here is Forbes explanation for Costco’s need for quick inventory turnaround:
“With old and new members flocking to the stores, and no slow-moving items on its shelves, Costco turns its inventory over 14 times1 a year on average–once every 26 days. Home improvement stores turn inventory 4 to 6 times, supermarkets somewhat less than Costco. That high-inventory turn answers another question about Costco, namely, how can a $22 billion company operate on what was barely $110 million in working capital at the end of 1996? Home Depot has about the same revenues as Costco, but requires over $2 billion in working capital–and Home Depot is no sluggard. With its goods moving so quickly off the trucks and out its doors, Costco doesn’t need much working capital. It is largely financed by its vendors. Note this: Costco’s accounts payable currently equal 80% of its inventory. At Wal-Mart the ratio is about 48%.” Forbes August 1997”
Building Cost into Operational Expenses
This is Business Week’s take on it:
“But the limited selection creates efficiency. Successful stores turn over inventory 15 to 18 times a year, compared with four times a year for the average retailer. Less capital is tied up in inventory, and fixed costs are spread over greater sales. That, coupled with the low overhead and membership fees that run about $25 a year, allows the clubs to operate on 10% gross margins, compared with 30% for the average discount store.” Business Week, March 1985″
Quick inventory turnaround limits markdowns considerably and above all, reduces shrinkage.
In the article about Tesco path to greatness, I mention the supermarket giant selling fruit and veg for pennies.
Can you imagine what this is doing to Tesco’s profit margin?
Thirdly, having a warehouse model enables Costco to eliminate cost relating to transportation of merchandise from manufacturer to store.
Costco ships almost all of it stock directly from the manufacturer into its stores.
This direct link between manufacturer and store eliminates costs associated with distributors, central receiving, storing, distributing warehouses and in-store warehouse.
Like all successful retailers, Costco do not sell low prices to the detriment of its customer.
Costco builds its pricing promise into its operations.
Building Cost into Operational Expenses
Even though Costco executives boast of not spending on advertising, the retailer understands that having a sales process is a critical step in the process of retail success.
Therefore, it has several sales processes built into its operations.
The first of its sales strategies is the ‘Treasure Hunt’ policy of having certain merchandise on a weekly basis to entice customers to keep returning.
Secondly, customers are not confused with lots of SKU’s.
Having limited SKUs focus instead of confuse shoppers when they are in the stores.
Here is how New York Times explains the benefit of limited SKUs:
“To keep the warehouses running efficiently and to promote quick sellouts, operators typically stock only about 3,500 products, compared with more than 25,000 in the typical supermarket. That means only one or a few brands of each product are carried, usually in one large size, like five-gallon jars of mayonnaise and packages of five dozen eggs. The bigger sizes are a better deal for those who need or can use them, like restaurant operators.” New York Times, Dec 1990
This is Sol Price’s own summation of Costco’s merchandising strategy:
““Six Rights of Merchandising:
The Right Merchandise: High quality, brand name and private label merchandise augmented with key locally sourced products.
The Right Time: Maximize technology throughout the distribution and sales process to maintain in-stock and avoid over-stock conditions.
The Right Price: A purchasing strategy to assure low price through volume buying.
The Right Place: Strategy, systems and standards for the placement of merchandise on the sales floor.
The Right Quantity: Implement and use a just-in-time flow of product concept when ordering and purchasing to maintain on-hand merchandise.
The Right Condition: Merchandise is pre-marked in the appropriate language and prepared for handling at the selling locations”. “.
It is not enough to identify your target market and decide on what you are going to sell to them.
You also need to create a strategy for reaching them.
Key Lessons from the Making of Costco
Costco rise to becoming the second biggest retailer in the world is not an accident.
It was engineered into the business from the start.
The retailer followed the three fundamental retail success principles:
- Your market: Who you are selling to?
- Your message: What you are selling to them?
- Your Media: How you are going to sell to them?
At the start, Sol Price identified his target market to be small business owners who wanted to buy stock in a single store at reasonable price.
With time he included public sector workers, bankers and other professionals he knew could afford Costco merchandise.
He introduced membership fees to be able to weed out those who were unsuitable for Costco business model.
What Costco sells to its customers is high quality products at reasonable price.
They also enjoy the prestige of membership into an elite club.
To ensure its customers keeps returning, Costco sales process is based around limited SKUs but bulky, high-end brands at reasonable price and the mystic of treasure hunting.
On a good week, customers could find the crown of Her Majesty the Queen, the ring of the Pope or Al Capone’s favourite gun.
The strategy of treasure hunting is what keeps customers returning week after week and renewing their membership in droves.
Next Action Steps
I do not expect you to be able to implement everything you have learnt in this article today in your store.
But you can implement one or two of them without spending a single red penny to receive an instant result.
Take a walk around your store right now and remove every single slow moving merchandise from your shelves
This is money been left to rot plus they are occupying space that could be used to display fast moving products.
This simple action alone can start making a huge difference to your profit margin today
Step outside of your store and look inside to see what a passing shopper would see.
Stop someone passing by and ask if they could describe in detail what they see.
You would be surprise what they tell you.
You do not need to hire me or any other retail consultant.
Simply making a few changes in your store can make a huge difference to your profit margin.
Meanwhile, if you want a complimentary checklist of how to implement the Costco three step strategy in your business, please click on the ‘Next Actions Steps’ red button.
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About the author
Romeo Richards is an experienced retail trainer and consultant with knowledge of retail marketing, store performance and retail loss prevention.
He has the ability to choreograph the customer journey, boost store conversion and enhance in-store experience using store design and visual merchandising.
Specialises in increasing retail profit through shrinkage reduction.
He is the author of 23 retail and marketing books including:
• How to Increase Retail Sales
• How to Make Profit In Retail
• Store Design Blueprint
• Visual Merchandising Display
He is the creator of five retail home study courses.
Frequently presents webinars on shoplifting prevention and boosting retail sales.
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