Rafi Mohammed

COSTCO: Cost Plus or Value Pricing?

Posted on December 9th, 2006 (0 Comments)

Costco is great! After every Costco shopping visit, I marvel at how much money I saved on high quality products. No trip to the warehouse club would be complete without enjoying their tasty $1.50 jumbo hot dog and soda special as well as picking up a delicious $4.99 roast chicken for dinner (they sell almost 25 million roast chickens a year!). The company pays its workers well and has a virtually unlimited return policy. So, what’s not to love about Costco?

A friend of mine, Larry, sent me a recent Fortune article on Costco and with a twinkle in his eye, intoned that Costco followed a pricing policy that contradicted my notion of pricing to capture value. Larry has a great question, do retailers that focus on offering the “lowest prices” follow a value pricing strategy?

A few facts on Costco. Costco pledges not to mark up any product by more than 14%. Each store stocks approximately 4,000 SKUs (compared to rival retailers that stock between 40,000 to 50,000 SKUs) with products ranging from 36 roll packs of toilet paper to Dom Perignon champagne (of which it is the largest retailer in the U.S.). To shop at Costco, you have to buy a membership (ranging from $50 - $100 annually). The benefits of membership allow you to enjoy low prices on high quality products. As I discuss in my book, this two part pricing strategy has great psychological benefits. The delight I experience after each Costco shopping trip builds up a lot of goodwill. When it comes time to renew my membership, the $50 seems well worth it! A lot of other members must share this satisfaction as Costco has a phenomenal 86% renewal rate.

In 2005, Costco had total revenues of close to $53 billion and net profits of $1.063 billion – thus achieving a 2% profit margin. Here’s what is interesting, revenues from Costco’s membership fees (which are pure profit) were $1.073 billion. Thus, membership revenues entirely make up Costco’s profits.

So, are retailers that promote a “lowest price” brand using value or cost plus pricing? I believe the answer is value pricing (you knew that I’d say that!). Let’s not forget that Costco is in an extremely competitive market. In addition to grocery superstores, Wal Mart’s low price warehouse retailer Sam’s Club is a direct competitor. In Denver, a Sam’s Club is located right across the street from Costco. With Sam’s Club offering low prices, Costco has little choice but to promote low prices. Sure, Costco is doing a good job of differentiating itself by also offering upscale products (e.g., a $50,000 diamond ring). But, let’s face it, a primary reason why we all shop at wholesale clubs is for low prices. Given that the next best alternative is to shop at a Sam’s Club or local super market, value pricing in competitive markets often translates into low prices. Remember, the notion of value pricing does not always mean a high price, it focuses on capturing your product’s value relative to your next best competitor.

Further evidence that Costco incorporates value into its pricing includes the fact that it does not have a fixed markup on its products (e.g., 10% on everything). Instead, its markup ranges up to 14%. The fact that its markup differs by product indicates that some notion of capturing value is being incorporated into its pricing. My bet is there is room to improve Costco’s value pricing by reexamining these markups. Should a gallon jar of pickles be marked up by 5% instead of 3%? Similarly, where did the maximum markup of 14% come from? Why not make it 15%? Finally, Costco should consider adjusting its prices according to the degree of local competition. While prices have to be rock bottom when a Sam’s Club is situated across the street, there may be more pricing latitude when its closest competitor is 5 miles away.

A 1% increase in price would translate into a 50% increase in Costco’s net profits…a jumbo hot dog and soda for $1.52 is still a great deal!

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