Costco & Buying Scale per SKU

Although we are all interested in margin, it must never be done at the expense of our philosophy. Increasing the retail prices and justifying it on the basis that we are still “competitive” could lead to a rude awakening as it has with so many. Let us concentrate on how cheap we can bring things to the people, rather than how much the traffic will bear, and when the race is over Fed-Mart will be there - Sol Price, Founder of Fed-Mart, Price Club (merged with Costco), 1967

Sol Price’s quote perfectly describes Costco’s philosophy: to provide high-quality products at the lowest possible prices. Every little detail of Costco’s business leads to reducing prices to add more value to customers. Sol Price realised early on that the durability of a franchise is based on the persistence of value added to customers. The lower the prices, the more value Costco is giving back to customers. But, more importantly, the lower the prices, the harder it is to compete with Costco.

Another pretty impressive leader recently discovered just how powerful it is to continually reduce prices:

We have made a decision to continuously and significantly lower prices for customers year after year as our efficiency and scale make it possible. Our judgment is that relentlessly returning efficiency improvements and scale economies to customers in the form of lower prices creates a virtuous cycle that leads over the long-term to a much larger dollar amount of free cash flow, and thereby to a much more valuable Amazon.com. - Jeff Bezos, Amazon, 2005 Annual Letter

It’s remarkable how similar the quotes from Price and Bezos really are. Continually reducing prices drives higher sales volume over a fixed asset base. The incremental cost savings are passed back to customers which again fuels higher sales volumes and so goes the ‘virtuous cycle’. This strategy has created a unique level of trust and customer retention for Costco and Amazon. This also partly explains why both companies have near-zero marketing budgets. Everything is reinvested in price. The alternative is the easy option for retailers: increase the retail price or slotting fees to increase gross margin. This destroys trust and, as Sol suggested, ‘could lead to a rude awakening’.

Amazon and Costco approached the ‘everyday low price’ strategy from opposite angles: Amazon maximised selection and Costco minimised selection. Bezos extended the range to any willing third-party seller and created an online auction-like framework where suppliers competed in the ‘buy box’ to offer the lowest prices to customers. On the other hand, Costco limited selection to 4,000 SKU’s and is often the largest buyer of any individual SKU from suppliers. By limiting the SKU count, Costco created its own type of auction where suppliers compete to provide products at the cheapest price to millions of Costco members.

We interviewed a Costco buyer of 20 years to understand how Costco procures products and negotiates with suppliers. One principle that shines through when speaking to Costco executives is how Sinegal created a culture where reducing price to drive sales volume is the sole focus. There are also side-effects of this strategy that give Costco an advantage. For example, limiting the selection to 4,000 SKU’s changes the structure of the buying team:

Buying less SKUs means you can dedicate more time to the details. A typical supermarket buyer manages 1,000 to 2,000 SKUs, whereas Costco buyers manage less than 200. Their buying team is also much smaller because they do not need 10 buyers for each category. Having one who buys 50 SKUs is more efficient. The typical philosophy of Costco is managed mainly on sales which is king. Other retailers put profitability first, then sales, whereas Costco does the opposite.