Friday, July 20, 2012

Costco and Paradox of Choice vs. the Growth Levers

Tweet About Growth Levers Post

After tweeting about my post The Growth Levers in Retail: Price, Selection, Convenience, I received the following reply:

Tweet Reply
I'm pretty sure Mike is referring to the CNBC special, The Costco Craze (it originally aired in late-April) in which a marketing expert explains to host Carl Quintanilla the concept of "paradox of choice." It was popularized several years ago by psychologist Barry Schwartz who authored a book with the same name. The idea is this: while people tend to believe that options are great (and the more you have the better), the reality is that we tend to be overwhelmed by too many. It creates stress. In many cases we would prefer not to have a choice; that our decisions be made for us. In the shopping environment, that stress can lead to indecision and consumers walking away from a purchase altogether. Mike is absolutely right about that.

Marketing Experts Like New Marketing Ideas

Retail dogma has long held that the more selection you can make available to customers, the better. Schwartz's research encouraged us to revisit that concept from the shopper's perspective. 

Now marketing experts love a novel concept, and when they find a new theory they tend to go looking for places to either a.) apply it, or b.) prove it. That has certainly been the case with the paradox of choice. Many an expert has sought out retail examples to prove the point that limited selection leads to a better shopping experience and more sales.  Their favorite cases to cite are Costco, Trader Joe's and Aldi's.

Costco carries about 3,800 individual stock keeping units (SKUs) per store, Trader Joe's carries about 3,000, and Aldi carries 1,400.* 

By contrast, Walmart Supercenters carry upwards of 150,000 and the average large-chain grocery store, like Kroger, carries 30,000 to 52,000 SKUs.

Average sales per SKU (calculated by dividing number of SKUs into gross sales and a good signal for efficiency and how quickly they sell their stuff), are $18.4 million for Costco, nearly $3 million for Trader Joe's, and $5 million for Aldi.  

For Kroger it's around $2.6 million, and for Walmart it's about $2.5 million.** 

Marketing experts see those numbers and are quick to give credit to the paradox of choice, their theory du jour, for the low-selection retailers racking up such high sales per item. Especially with Costco. Less selection, they argue, leads to a more pleasant shopping experience that drives higher sales. But I think they're too quick to go with the sexy theory when the numbers - and the rational for these retailers opting for a low-selection strategy - are adequately explained by the concept of the growth levers (the retail dogma). And especially by the importance of price.

Retailers Must Decide Which Levers Get Their Investment Resources

More About Lower Price Than Beating the Paradox of Choice

Consider the following quote from recently retired Costco CEO James Sinegal:* 

We carry a 325 bottle of Advil for $15.25. Lots of customers don't want to buy 325. If you had ten customers come in to buy Advil, how many are not going to buy any because you just have one size? Maybe one or two. We refer to that as the intelligent loss of sales. We are prepared to give up that one customer. But if we had four or five sizes of Advil, as grocery stores do, it would make our business more difficult to manage. Our business can only succeed if we are efficient. You can't go on selling at these margins if you are not.
Those margins to which he refers are 11 percent gross and three percent net, meaning operating expenses account for only eight percent of revenue. That's insanely low.  (Yes, Costco's profit margin is only three percent!) Contrast that to Walmart's 24 percent gross margin and 19 percent operating expenses.

The only way Costco can survive on those margins is if it buys in bulk. And it can only buy in bulk if it can sell in bulk. And it can only sell in bulk if it limits its selection to a handful of items. This allows Costco to offer the absolute cheapest prices on its items.

But because it relies on a narrow selection, Costco will never be the place you go for everyday shopping.  That's the trade-off in investing in one growth lever over the others. This is not a critique of its business. They embrace this fact, even if they're constantly priming their selection to find ways to get you in the door more. My family makes one Costco run a month, grabbing some things in bulk to save a few bucks on our weekly Trader Joe's runs. Costco can't replace Trader Joe's for us because Trader Joe's offers a wider food selection. They both serve their role. They co-exist quite well. And they're both excellent businesses. 

Walmart serves its role too, with the objective to be the place for one-stop shopping. It will not be able to compete with Costco on price for the same items because its selection is so much wider, its purchasing volume per SKU so much lower, and therefore its costs per item higher. But because it has so much more selection, it's more likely to get you in the door on a more frequent basis than Costco. 

(I should disclose that we've found no overall cost-savings in our grocery bill since adding Costco to our rotation about a year ago. Indeed, we spend just as much at Trader Joe's, so Costco has just made our bill go up 20 percent a month. Oh well. We like their almond butter.)

Concluding Thoughts

Mike's objection is an important one to raise. Let's challenge the dogma of retail's traditional growth levers.   But in this case, I think the marketing expert's enthusiasm for the paradox of choice is being applied ex post facto in an attempt to explain why Costco offers a lower selection. The reduced selection is not the reason for their success. The success stems from the low prices they're able to offer by virtue of having less inventory to buy, handle and store.

But paradox of choice remains a very cool theory, and I'm certain the marketing experts will find many more scenarios upon which they can graft it.

* Information provided by Barry Berman's Competing in Tough Times.

**These are 2008 or 2009 numbers (also gleaned from Berman's book) but I'm sure they hold approximately true today, too. A more important note is what a rough calculation this represents. SKUs are calculated on a per store basis, but most retail chains will offer items at certain stores but not others. This probably has much more impact for Walmart and Kroger than it does for Costco, Trader Joe's and Aldi. Still, I think the illustration has merit.)