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Costco Wholesale - untapped pricing power

Updated: Jun 7, 2019

Costco is a successful retailer in the sense that it sells a growing stream of goods directly to consumers. Unlike a retailer, the company maintains the cost structure of a wholesaler. Costco’s inimitable cost advantage means that the company has significant untapped pricing power relative to the next best operator in that field. This is not Costco’s only advantage but it is the advantage that is most easily measured.


Industry economics

A retailer can sell merchandise from a physical shop at a convenient location or from a website served up by a computer on the Internet. Either way, it requires labor to process the orders and marketing to attract the attention of customers. These costs vary from one retail format to another. Starbucks might seek to exploit the benefits of having shops in a convenient location while O’Reilly might emphasize the instant availability of a large and well-catalogued inventory of unordinary parts.


Regardless of the retail format, costs must come out of gross profit and should be low enough to leave the retailer with some net profit. A retailer that can put the same goods in the hands of consumers at lower cost has superior earnings power. The cost can be calculated by subtracting net margin from gross margin and dividing the result by revenue.


The retailer with the lowest cost has a choice. That retailer can charge the same as its competitors and generate superior profits or it can pass on the lower costs to consumers to gain market share. For every dollar of merchandise that Costco shifts to its customers, the company spends eleven cents on costs. Walmart and Amazon have costs that are twice as high! PriceSmart has the second-best cost structure but still spends 6 cents more than Costco per dollar of revenue.


Assuming Costco acquires its merchandise at the same price as its competitors, the company could raise prices by five percent and still offer lower prices than the next-best alternative. This would increase Costco's net margin by roughly four percent to six percent. In other words, Costco's earnings would triple.

Costco's net margin is not higher though. Instead of boosting its margin, the company passes on its lower cost to consumers by charging lower prices. Unsurprisingly, Costco has a growing number of loyal customers. At Costco, they are called members.


Unit economics

Some have argued that Costco pays higher wages which makes its employees more productive. While this does explain a few things, it does not explain the magnitude of the advantage. Costco’s cashiers do not scan twice as fast and its truck drivers do not drive twice as fast because they are paid more. There is another way to increase per-dollar efficiency and that is by increasing per-unit revenue.

As of May 2019, you can find the Fujifilm XP140 at Costco.com. That is a $200 camera. While the price isn’t listed online, it sells for $149 at the warehouse. That's obviously a good deal. Interestingly, Costco doesn’t sell any cameras that cost less. They sell 14 other models but all are higher-priced.


Meanwhile at Amazon and Walmart they’re selling hundreds of different cameras. One low-priced camera they both carry is the Bell+Howell DC5-R at $35. That may or may not be a better deal but it is certainly less money per unit. Walmart and Amazon have to process four pallets of DC5-Rs to generate the same revenue as Costco with its XP140. That it is typical for merchandise sold at Costco. You will observe the same effect for handbags or headphones. Of course, Walmart and Amazon also offer the XP140. At Walmart it sells for $199 and at Amazon it sells for $179 (new). The effect is less pronounced for low-priced high-volume grocery items.


In short, Costco doesn’t fill its floors or burden its employees with low-priced merchandise. Instead they shift high-priced merchandise at a discount. Costco’s truck drivers may not drive twice as fast but the dollar value of their truckload is much higher and that is what drives Costco's superior per-dollar efficiency.


Are the advantages sustainable?

Costco’s format is not unique to the company. In the US there are BJs and Sam’s club. Other clubs operating in North America are PriceSmart and Wholesale Club. All focus on a relatively small number of Stock Keeping Units (SKUs) in an attempt to increase efficiency. So why is Costco better?

In the final analysis, a wholesale club is not a retailer with superior efficiency. A wholesale club is a group of consumers combining their purchasing power to negotiate better prices from suppliers. It helps if members want the same things and the club knows what those things are.


At Costco, the average dollar volume per SKU is an order of magnitude higher than at its competitors. Only Sam’s club comes within hailing distance. For an average SKU, the purchasing power of Costco exceeds the combined purchasing power of Walmart, PriceSmart and BJs.


It is safe to assume that the CEOs of Nestle or Nikon know exactly when their sales representative has an appointment with one of Costco’s procurement managers. That manager has one simple demand and that is that Cotsco gets the lowest price. If Costco finds out a supplier has been selling that item to someone else at a lower price, that supplier will be ruthlessly eliminated. The decision to kick-out Coca-Cola probably didn’t cost Costco many members but everyone is aware of it a decade after the fact. Think about the effect this has on a sales representative from Nutella negotiating with Costco.


Of course, Costco’s procurement department has to have an idea of what members want and when they want it. Liquidating billions of dollars worth of unsold cameras at a loss is not a low-cost strategy. That is why Costco has a loyalty program. The company knows a lot about the spending habits of its members. Many have been members for a decade or longer. Costco knows exactly when they come into the store and what they tend to buy. Costco’s largest advantage is probably the low churn of its members. A metric that is not fully appreciated by those casually parsing Costco’s annual report.


Ask any American for a profile of a typical Costco member and they will paint a fairly uniform picture. They have families and busy jobs. Many own small businesses. They wish to be seen as being able to afford the best. They would not want to throw a party with wine bought at Walmart but will readily brag about how they bought a great Cabernet at Costco on the cheap. They will happily present Costco merchandise as gifts to their friends explaining that it is on-par with anything sold at Macy’s, just cheaper. Some might aspire to buy a Rolex day-date at $35 000 that would ordinarily cost $45 000 at a jewelry.


Now what is the profile of a typical Sam's club member?


Having a fairly uniform group of consumers and being able to track their purchasing habits over many years is a huge and irreplicable advantage. This is at the heart of Costco’s superior purchasing power and it is only partly reflected in Costco’s aforementioned superior operational efficiency.


Measuring the moat

The superior operational efficiency of Costco relative to PriceSmart is a reasonable proxy for Costco’s moat. If anything it understates the untapped pricing power because it does not reflect the negotiating power of Costco’s procurement managers.


Based on this superior efficiency alone, Costco’s moat is worth 5 percent of revenue. In retail that is an insurmountable advantage.


First published 22 May 2019 by batbeer.


Sources and further reading:

https://www.ou.edu/russell/UGcomp/Cascio.pdf


https://20somethingfinance.com/sams-club-vs-costco


http://www.clubintelligencecenter.com/hhc/documents/wcf_501_20180629.pdf

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