Costco and the power of cheap thrills

Last week I saw that Costco celebrated its one-year anniversary in New Zealand, with its first huge store out in West Auckland.  And what a year it has had.  Apparently...

Last week I saw that Costco celebrated its one-year anniversary in New Zealand, with its first huge store out in West Auckland.  And what a year it has had.  Apparently 150,000 members have signed-up, shopping up a storm and experiencing the benefit of bulk-buying on a scale not previously seen in this country.

For those readers who don’t know, Costco is a bulk retailer that makes its money from a membership model allowing it to sell items at prices that we are led to believe are not too far above cost.  Not only has this model been successfully employed by Costco, but by many other companies such as Ford, Walmart, Amazon and Tesla to name a few.

I wouldn’t put them in the same class as Costco, but local retailers Pak-n Save and Chemist Warehouse would probably be considered the closest thing, notwithstanding they don’t require an annual membership.  Maybe it’s a scale thing as we have a small population which is relatively dispersed but in spite of its proven power overseas, this model remains uncommon Down Under.  Famed UK-based investor, Nick Sleep, calls this model “scale economies shared (SES)”.  This model is when a business shares with customers the efficiencies it gains from scale by increasing the value proposition, often in the form of lower prices.  It runs counter-intuitive to the theory that businesses enjoy larger profits when efficiencies are made.  SES businesses instead take these cost savings and use them to lower prices but still maintain their profitability.

Lower prices drive more sales, leading to growth, more scale benefits, and then even lower prices.  The increased sales volume means the SES business buys more volume from suppliers, so suppliers increasingly want their products in these stores, giving the SES business bargaining power to obtain wholesale products cheaper than the levels of their competitors.  As the cost base is lowered, prices can be lowered further.  This becomes a powerful cycle that allows a SES business to continue to operate profitably while offering their products at super low prices which is a major competitive advantage.

It is commonly believed that as a business grows, high profits attract competition which in turn lowers profits.  However, businesses which successfully apply the SES model have almost always grown stronger with size.  Here is a sketch from Amazon CEO, Jeff Bezos, apparently originally and literally on the back of a napkin that shows the powerful flywheel effect of the SES business model:


Figure: A sketch from Jeff Bezos on the SES business model

In New Zealand, supermarkets have long been criticized for being too expensive, especially in the middle of the current cost-of-living crisis.   Supermarkets often discount certain essential items, with the goal of attracting consumers looking for a bargain. While in-store, these bargain hunters buy other non-sale items which is how the store stays profitable. Grocery stores often lure shoppers in with low prices on a staple good, but raise the prices of other goods to even things out.  The problem with this model is that because of their higher cost bases, these businesses can even lose money on the discounted items, and must make that back on other, potentially overpriced items.  And this is one reason why New Zealand consumers are angry as they feel prices are too high.  This “high-low model” encourages customers to bargain hunt but they might be disloyal if they see better bargains at a competitor.

In contrast, SES businesses operate with a low-cost base and low margins.  Investors often look at low margin businesses and consider them “bad businesses”, as they overlook the powerful long-term advantages of low prices.  It is common to raise margins to earn increased profits.  The problem is that by driving prices higher, the businesses oftentimes become less competitive, volumes will likely decrease and the business may fall into decline.

SES businesses are uncommon, and very hard to create as they require a thrift-like culture embedded from inception in the company’s DNA, with the willingness to forego short-term profits in favour of long-term market share.  Look how many, many years it took Amazon to turn a profit.  Such businesses are able to undercut the competition on price while remaining profitable, and therefore may be valuable in the long-run.  In New Zealand, we simply don’t have the scale and population needed and therefore don’t often see the benefits of such a business model.

All this writing about low prices, cost savings and great selection makes me want to go out and buy something.   I did purchase a Costco membership online last year soon after the store opened its doors, but when I went to collect my members card, the line of people doing the same thing was out the door, up the travelator and winding its way around the rooftop carpark.  I hear the queues have died down these days so I may chance it and shoot out there on the weekend to experience the SES model firsthand!