Go for Innovation in Distribution! A Story about Costco’s Innovation in Distribution.
There is a store that admits only those with annual membership. Customers must pay with cash while just one brand of credit card is accepted. The description of the store makes it sound like anything but a successful business, but it has built the largest distributor in the world. That’s Costco. Today, we’re going to talk about the distribution innovation achieved by Costco.
1. No more than a 2% margin ― Costco’s golden rule for its operating income
Costco is racking up annual sales of 88.9 billion dollars with 64 million members served by 128,000 employees managing or working in 627 stores located in 9 countries including the United States. Compared to 1992 when it was first listed at New York Stock Exchange, the company’s stock price has hiked 800% and sales has risen 700%. The formula that specifies an operating income to sales ratio of 2% lies behind the success that Costco has achieved in distribution, one of the oldest business models. An operating income to sales ratio of 2% has nothing special about it in the distribution industry. But, combining operating income to sales ratio of 2% with paid membership, the key feature of its business model, came up with interesting results.
We have observed trends in the operating income and membership fee revenue for Walmart, a rival of Costco. While Walmart’s operating income shows unrelated to its membership fee revenue, Costco’s operating income nearly shadows its membership fee revenue. If we compare the two companies in the 2017 figures, Costco had up to 74% of its operating income from its membership fee revenue. Altogether, the figures lead us to think that the business model of Costco is perhaps distribution not based on fees but based on paid membership. Specifically, the business structure of Costco is designed to make sure that the company gains profits by increasing the number of paid members while providing greater benefits for customers by minimizing its sales margin.
2. The alpha and omega of Costco ― paid membership
As we said earlier, paid membership is ensconced in the kernel of Costco business model. But from the perspective of customers, insisting on paid membership only causes discomfort in their shopping experience. Customers’ membership cards are checked not only on their entry but also for payment. And as a customer exits a store, his or her receipt issued for payment must be shown to staff. If over 90% of its first-time members get their membership renewed despite such inconveniences, it would be because of the unique membership model of Costco that ensures that ‘the more products customers buy, the greater benefit they collect’.
3. Absolutely cheap ― customer trust in prices
Costco can keep prices low with its cheap fee, small number of SKUs (stock keeping units), and private-label products. Its small number of SKUs adds to Costco’s big advantages. Costco runs 4,000 or so SKUs, which accounts for about 3% of the number for Walmart. A smaller number of SKUs means that the company takes advantage of its great bargaining power in negotiating with manufacturers to obtain benefits, which it delivers to its customers.
This leads to enhanced customer recognition. And it amounts to the branding to the effect that people won’t fail to find stuffs cheap at Costco. In fact, if competing distributors like Walmart sell them at the same price, Costco makes sure to offer at a lower price products like Levi’s jeans through negotiations with the supplier. Although such a strategy may generate noises through supply chain, it works to get Costco’s business model robust. Thus, customers can trustfully get their fill of buying. Even if they get into overspending, it’s OK since it should be cheaper than from any other outlets. You can cope by just stocking up in your own storage. It goes without saying that it is a paradise for wholesalers.
Moreover, the company maximizes customer satisfaction with Kirkland Signature, its private label that keeps prices as low as possible through a contract for great quantities of excellent products that arrive through strict quality control.
Since it started business, Costco has stuck to its fee of 15%. By comparing it with the fees charged by other distributors, you can see that a 15% fee is actually pretty modest. Discount stores charge 25 to 35% and department stores charge 30 to 40%, while online malls without offline stores charge about 15% fee, which Costco charges. Thus, Costco makes sure that greater benefits are enjoyed by its customers by reducing selling fees for products.
‘A 15% margin is appropriate as it ensures that we make money while our customers are satisfied. If we make more profit, corporate discipline will get lost and we will get lost in greed. Moreover, customers will leave and the company will fall behind. (Jim Sinegal, Costco founder)
‘Traditional distributors like Walmart try to figure out how they can increase their profits by keeping prices as high as possible. But Costco has succeeded by thinking backwards, that is, how it can minimize its profits by further lowering prices.’ (John Mullins, London Business School)
4. We accept only one ― one credit card for a country
At Costco, payment can be made in cash or with just one brand of card. This represents Costco’s policy to lower product prices by reducing credit card processing fee. The company holds a bidding where credit card companies compete in lowering their processing fees. We will accept only one brand of card. And we will give all our sales to you. Only under one condition: you give us a credit card processing fee so low that you can never imagine.
Coming into this year, American Express Card failed to renew its 16-year exclusive contract while Costco concluded an exclusive credit card program agreement with Citi and Visa. The agreement was so extraordinary that Citigroup’s stock price rose 2.04% and Visa’s rose 2.57% at New York Stock Exchange on the day they reported the two companies’ partnership with Costco.
5. Jim Sinegal, founder of Costco
Behind all this stands Jim Sinegal, the founder of Costco, who has taken 33 years to raise his company to 24th place among Fortune 500 companies. He is usually called Steve Jobs in the distribution industry. However, Steve Jobs started Apple from his father’s garage when he was 18, whereas Jim Sinegal began his career as a part-time worker downloading mattresses at a discount store when he was 18. For some 30 years, Jim Sinegal had worked in the distribution industry and served as an executive vice president for Price Club. He was 47 when he started Costco with an investor in downtown Seattle. So, we should say that he is a veteran sailor more than a pirate like Steve Jobs.
Today, we have checked on the innovation that has transpired with Costco, the global distributor. Its innovation can be summarized as a product of thinking out of box. The company identified their source of profit in membership sales instead of product sales. Therefore, its pricing strategy is designed to give big benefits to its members instead of setting consumer prices solely to increase margin as emphasized by existing distributors and conventional practice in business management. Hence its profit margin smaller than with its competitors and the policy for signing with one credit card company in a country.
We often witness such out-of-box thinking in shipping or logistics industry. It is practiced by those companies that establish their strategy through transferring their profit source for their transport service from transport charges to the price for space available for sale from transport equipment such as ships and trucks. Likewise, we frequently find the same basis for innovation not only within an industry but also in related or entirely unrelated industries. In our next piece, we will
check the idea of IKEA, another company that has staged innovation in logistics.