The most underrated part of Costco’s business model

Not long ago, I had my very first Costco visit. The friend who took me was a massive Costco fan, and referred me to this 3 hour podcast by Acquired about the history and strategy of Costco.

Why do people love Costco in a way that they don’t Walmart? And I mean love. Since moving here, multiple people have offered to take me to Costco. Not one person has made the same offer for Walmart.

When people talk about Costco’s business model, you’ll probably hear about the $1.50 hot dogs, the cheap rotisserie chickens, and the loyalty inspired by making people pay for memberships.

But few discuss their savvy decision to limit their product selection.

Note: this post is not going to be a full podcast summary — it’s more of a blog post that focuses on some of the more underrated aspects of Costco’s business model.

Limited selection makes shopping at Costco more pleasant

One reason why so many people seem to like Costco is that shopping at Costco is quite pleasant, because you don’t have to make too many decisions. (You may argue that shopping at Costco is not all that pleasant because it gets so busy, especially on weekends. But that’s an unrelated factor.)

Costco’s product selection is pretty limited. They only have about 4,000 SKUs (Stock-Keeping Units or product codes), while Walmart has around 100,000 to 250,000 different SKUs. Basically this means you’re far more likely to find exactly what you want at a Walmart than a Costco.

But within those 4,000 SKUs, Costco ensures a certain level of quality so you don’t have to compare lots of different brands of the same products and decide what quality-price trade-off you’re happy with. Whereas at Walmart, you’ll have to make a range of such trade-offs. Faced with a dazzling array of peanut butters, you’ll have to decide which one is worth your hard-earned cash. If you don’t already have a favourite brand, you’ll rely on indicators such as packaging (some packaging looks more premium than others) or price (more expensive is usually better, but weekly discounts may disrupt that). You may also have to spend precious time reading the labels (how much sugar is in this? How much of this is actually peanuts?).

But at Costco, you know you’re going to get something that’s at least “pretty good”. There’ll be a few brands to choose from, and they’ll all be decent. If you’re not particularly picky about your peanut butter, you’ll likely be fine with any of them.

You even know that you’re going to get a decent price for it, because that’s kind of Costco’s thing. They’ve committed to fixed markups of no more than 15%, so you don’t have to weigh up whether to buy something now or wait until it goes “on special”.

Put another way, it’s easy to be a satisficer at Costco because the gains from maximising are reduced.

Limited selection supercharges economies of scale

Costco doesn’t stock the full range of sizes, which helps them maintain low SKUs, and removes another decision for you to make. If you’re going to Costco, you need to be prepared to buy in bulk.

Obviously, the large sizes means there are economies of scale. We all know that the per unit cost goes down when buying in bulk. That’s true at other retailers too, (usually—fluctuating specials will sometimes alter that).

But because Costco only has around 4,000 SKUs, they can leverage greater economies of scale for each product. Walmart’s overall turnover is much higher than Costco’s—around 3x in the US. Yet Costco’s average revenue per product is around 10x Walmart’s, because their inventory turnover is much higher. Costco turns over their inventory more than 12x per year, compared to Walmart at just 8x. Faster inventory turnover means lower holding costs (shrinkage, spoilage, obsolescence, etc) and increased profits. It’s like a restaurant that can turn over its tables 3 times per evening compared to an eatery that only averages one sitting—the former will find it easier to maintain fresher ingredients and can spread its fixed costs over a larger volume of sales.

Another benefit of having higher turnover for each product is that it gives Costco considerable negotiating power with its suppliers. When it does choose to stock a particular product, its supplier knows that they will be able to sell a lot to Costco.

Why can’t all businesses be like this?

There are many other attractive things about the way Costco operates. It pays its workers pretty well, with an average wage of almost $21/hour compared to Walmart’s $11.83/hr. Their employee turnover is correspondingly low—7% attrition vs 20% average for the retail industry—while customer retention is high.

With all those advantages, it’s tempting to think, “Why can’t all businesses be like this?” That’s where my mind immediately went.

An easy answer is that the model doesn’t work for perishable goods, which can’t be purchased in bulk. After all, few people visit Costco more than once a month—they’ll still visit another grocery store each week for their regular supplies. (Going once a month makes the trip more special, which also contributes to why people like Costco so much.)

That answer is true, but it’s incomplete. Lest you start thinking that this post is just a Costco ad (I wish), I must point out the downsides from lack of choice, too.

Costco’s business model makes potent use of a selection effect. In particular, various aspects of Costco’s model only work for relatively well-off customers. The typical household income for a Costco customer is US$125,000 per year, compared to US$80,000 for Walmart.

Not all customers are equally lucrative. There are lots of benefits to having higher income or wealth, and Costco is able to leverage some of their customers’ privileges:

  • Storage space. Wealthier households tend to be bigger and have larger fridges and freezers. So some of the cost savings you get are because you’re willing to store goods in your home until they’re needed (i.e. you bear the inventory costs and risks).
  • Cash flow. Even though the per unit cost is typically cheaper when buying in bulk, poorer households may find it difficult to get the cash needed to take advantage of these savings.
  • Quality-price trade-offs. The “pretty good” level of quality that Costco aims for is not suitable for everyone. Some people may want the absolute cheapest item, even it means a sacrifice in quality. Costco doesn’t bother to cater to those people—they’d rather cater to the wealthier crowd who like nice things—and this narrower (but still quite large) segment will self-select into being customers.
  • Credit cards. There’s a Costco-branded credit card in partnership with Citi and Visa. While it’s mostly speculation, the Acquired podcast hosts suspect that Costco is getting the better end of that bargain because they’re able to bring over a bunch of high-income customers with good credit. Although this partnership is not a big part of Costco’s business model, it’s another illustration of how beneficial it is to have wealthy customers.

The paradox of choice on multiple levels

One thing that Costco’s business model demonstrates is the paradox of choice: more choice is not always better.

From the consumer’s point of view, the full range of options may not be needed. Some people will be happy with, or even prefer, a limited choice set, provided it includes a “good enough” option.

From the business’s point of view, offering fewer choices allows you to turn over inventory faster, lowering your costs. And if you don’t try to be everything to everyone, you can concentrate on serving the customers that generate the most value for your business.

From a broader, societal point of view, I think Costco’s model highlights the limits to limited choice. We don’t want a world where every business is like Costco. Even the most fervent Costco fan will occasionally want something they don’t sell. In those cases, it’s much easier to search for it in a megastore with 250,000 SKUs than across dozens of smaller boutiques. Moreover, many people also need the smaller size options for various reasons ranging from perishability to lack of cash flow.

Costco’s business model works so well because it caters to richer customers and leverages the benefits associated with their wealth. But not all businesses can, or should, do that.

What do you think of Costco’s business model? Share your thoughts in the comments below!

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