Costco - A Case Study - Strategy With RS

To successfully implement this business model Costco has changed the ‘Rules of Retailing’ on the following dimensions:

1. Frame the right question: Most retailers would frame a question on how to increase the price of merchandise – ‘what can we do to increase the price of merchandise which is currently priced at $10 to $10.50 or better still at $ 11? But Costco poses a question which gets them to focus on driving down cost – ‘what strategic initiatives can we take so that we can bring down the cost of the merchandise from $9 to $8.50? Or better still to $8, so that we can reduce cost & pass on the benefit to our customers through lower price & create better value for our customers’.

2. Keep a check on margin: At Costco there is an unwritten rule that the margin on branded merchandise cannot be hiked more than 14%; and for Private Label by more than 15%. In contrast Supermarkets mark up merchandise by 25% & Department Stores by upward of 50%.

3. Limited merchandise: Costco has merely 4000 types of items & if you take toothpaste then they stock merely 4 top selling toothpaste brands. In contrast Walmart has 1,00,000 + items & when it comes to toothpaste it may have as many as 60 different brands of toothpaste. Why does Costco stock less items & less number of brands? For the following reasons:
A. To leverage the behavioural sciences principle of ‘Paradox of Choice’. It is observed that if there are too many choices before customers it tends to confuse & disorient them & they end up postponing the buying decision. But if they have up to 7 or fewer choices they ends up making a buying decisions. By reducing the number of choices for its members, Costco reduces their anxiety– and when that happens its members end up buying more. Reducing the number of choices, also has an indirect benefit - more of a particular brand get sold – which leads to increase in its volume & which in turn gives Costco better bargaining power to negotiate better rate with the owner of that brand & pass on the benefit to its members.
B. It positions its range of offerings as ’best selection’ – this means that they only stock best selling brand in each category. In short, they take the responsibility for selecting - on behalf of customers what they feel are the best toothpaste brands in the market for its members.

4. Absence of signage to guide customers: This strategy is deployed to make customers ‘hunt’ for what they want. In the process of hunting they end up ‘discovering’ many more items they had no intention of buying but end up buying upon discovering them.

5. Better pay & benefit for its workers as compared to its rivals: Costco pays better & provides better benefits to its employees than its rivals. This results in lower attrition rate & higher satisfaction among employees. And when employees are happy they make their customers happy, who in turn come back & give more business to Costco. Also the customers feel good that the ‘attractive’ price is not delivered by cutting employee’s salary. This make them feel just a bit better.

6. Eco system of service: Costco offers a range of services to its members. For example - tailor made financial loans. It does not restrict its service offering to those which generate revenue for them. It offers its members help to improve their business. For example it offers them service so that they can create an impactful presence on the Web. It also offers them ‘QuickBook Online’ which provides the business people flexibility to run their business from anywhere they have on line connectivity.
This kicks in 2 additional behavioral sciences principle – Reciprocal Principle – when some one does good to you, you are inclined to return the favor & Likability Principle – you tend to do business with somebody you like!

7. Membership fees: Costco restrict entry to only its members & its membership fees starts at $55 per annum. There are several benefits of pursuing the membership strategy:
A. Source of additional revenue that helps it to offset some of its operational cost so that it can bring down its cost & hence offer lower prices.
B. Sunk Cost fallacy -: Most members fall victim to this behavioural science principle - once they pay the annual member ship fee they perceive it as a sunk cost – and they strive to recover it. This quest gets them to shop more at Costco in a bid to recover the ‘sunk’ cost. This results in generating more volume for Costco giving them power to negotiate lower cost.

8. Membership pyramid: Depending upon the value of shopping done over a period of time the members climb the membership pyramid – which entitles them to more ‘extra’ saving – this prompts the members to shop even more giving more volume to Costco which in turn gives them power to negotiate better price, which they pass on to their members.

Business Lesson for us:
1. Be customers focused. Build your business around serving them.
2. Attempt to change the ‘Rules of your industry’ on 'determinant benefit' - benefits which customers want , competition is not giving & you give. 2. Learn to frame the right questions. That will lead you to right answer.
3. Embed principles of ‘Behaviour Sciences’ into your business model. This will compel your customers to behave the way you desire, effortlessly. But please do not manipulate them.
4. Respect your employees. If they are happy they will make your customers happy who in turn will give you repeat business.

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In this series, Rajesh Srivastava, Business Strategist and Visiting Faculty at IIM Indore gives you a regular dose of strategy case studies to help you think and keep you one step ahead as a professional as compared to your peers. Rajesh is an alumnus of IIM Bangalore and IIT Kanpur and has over 2 decades of experience in the FMCG industry. All previous Strategy with RS posts can be found here