Costco & Buying Scale per SKU | In Practise

Costco & Buying Scale per SKU

In Practise Weekly Analysis

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In Practise reflects on some of the key lessons and major questions explored in one or more interviews each week

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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.

Buyers manage fewer SKU’s in more detail relative to other retailers and often know the unit product costs better than the supplier. This deep category knowledge means Costco can work closely with suppliers to reduce unit costs to pass back to the customer:

“Companies love doing business with Costco, even though they are a tough negotiator and expect the best price in the market. Costco is always fair with suppliers. They try to extract the best from it, but still want to keep suppliers happy and profitable. There is a perpetual conversation around product development and specification of private labels to allow us to sell more while reducing the cost. Continual product development keeps you on your toes.

This is the correct way to reduce costs for customers. Unlike Boohoo’s recent strategy of squeezing factory owners so much that they pay employees and then ask for part of the salary back in cash.

Costco’s genius lies in simplicity. Everything is invested into the price to increase sales. The company fixes the maximum gross margin at 14% and, unlike other retailers, has no listing fees or trade marketing budgets. This simplicity saves the supplier time and money serving Costco relative to a traditional retail account:

Costco is about cost efficiency and saving and their suppliers also need to do that. They benefit because selling to Costco is easy. Most of the time you have one key account manager with almost no team behind them because they can manage it on their own. When selling to other retailers, full time marketing and logistics staff are required due to the complexity.  Reducing the complexity reduces the cost to a supplier who passes that saving to Costco who get a better price. It is a ripple effect; the simpler the business and the people managing it, the cheaper the cost. Both Costco and the supplier know that, whereas 20 years ago, the concept was difficult to explain.

There is no big secret to Costco’s success. It’s the combination of hundreds of small details across the culture, range, org structure, supply chain, warehouse layout, and pricing. Employees are paid over 50% more than competitors. Over 75% of the SG&A cost is labour. An increase in employee churn would increase SG&A costs that would eventually lead to higher prices for customers.

The supply chain is carefully constructed to minimise cost. Over 90% of goods are cross-docked. This means the supplier ships pallets to Costco’s depots or directly to the warehouses. Pallets are placed on the store floor to optimise handling efficiencies. However, herein lies part of the challenge for Costco moving online. If you’re offering goods at 14% gross margin, there is no room to offer delivery or pick-up.

In Q1 21, Costco’s e-commerce penetration was ~8%. Pre-covid, in-store and online average order values were $140 and $350 respectively. The higher online AOV was because most online orders were larger, white-goods that were either shipped directly from the supplier or cross-docked and shipped DTC. The challenge with shipping non-bulky items DTC at a 14% gross margin is obvious. It would require larger depot space to centralise and hold inventory and large last-mile delivery costs. Warehousing and delivery costs would decrease turns and will eventually be reflected in prices to customers.

Ordering online to pick up in the store seems a better solution for Costco. However, cross-docking is in pallets and large case quantities which doesn't suit individual online orders. Stock availability is also difficult to manage because in-store shopping makes it hard to forecast the total inventory available for online shoppers. Also, Costco turns inventory over 12x per year. If products are sold but not collected, this consumes highly valuable shop floor space which hurts asset efficiency.

Costco’s warehouse model is one of the most resilient physical retail businesses globally. We wonder how resilient this may be if 50%+ of retail is online in 20 years. E-commerce is very different. It’s less about ‘treasure-hunts’ and more about convenience and delivery speed.

The company hasn't released much about the future e-commerce strategy. In 2020, they acquired Innovel, a 3P-logistics provider focused on bulky products. However, this still leaves questions over how they can sell the other 85%+ of the range online. Today, it’s unlikely Costco would be a price leader online for non-bulky products. However, what should bring shareholders comfort is the fact that retailers with the largest volume per SKU will have buying advantages over rational competitors. Whether Costco can replicate this online is yet to be seen. After all, Sinegal could begin competing with the very man who reinvented part of Costco's own strategy online: Bezos.

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