Strategy in action: Costco's consistent outperformance of Walmart

Costco and Walmart rank among the largest retailers globally. In 2024, Costco ran over 800 stores worldwide, generating $254 billion in revenue. Meanwhile, Walmart operated more than 10,000 stores across the globe, with revenue of $648 billion in the same year. However, the key question is - which company boasts a higher ROIC? Given Walmart's size and scale, one might assume they have a higher ROIC than Costco.

But what if I told you Costco's ROIC is nearly double that of Walmart's? Over the past 3 years (2022-2024), Costco's ROIC has averaged 20%, while Walmart's has averaged just 11%.

Why is this? At a high level, it is due to differences in how each company executes its strategy. As we've previously discussed, there are three generic competitive strategies:

1. Cost: you can compete to be the lowest cost provider in the industry (typically only room for one of these in each industry).

2. Differentiation: you can compete by being differentiated (room for several firms in the industry to pursue this strategy, since there are many dimensions on which to differentiate).

3. Focus: you can focus on one or two segments in a market, and by maintaining stringent focus, you can become both the lowest cost and most differentiated provider.

In my opinion, both Costco and Walmart are pursuing the "Cost" strategy. That is, they are both aiming to offer the lowest possible prices to consumers in the retail industry. However, as we'll see, Costco has done a phenomenally better job executing this strategy. Walmart has made a series of decisions that have prevented it from becoming the cost leader.

To examine what Costco is doing so well, let's explore Costco's value chain. As I mentioned in my last post, "A firm achieves its chosen strategy through its "value chain," which is the set of choices or trade-offs a firm makes." In other words, Costco has made a series of tradeoffs in how it performs each of its activities that has allowed it to deliver superior returns on capital. Let's go through a few examples of the tradeoffs Costco has made in its value chain to achieve these extraordinary returns.

Michael Porter's illustration of a company's value chain. While on the surface it seems like this framework only applies to asset-heavy companies, it can be applied to asset-light companies as well (e.g., technology firms, service businesses, etc.).

Procurement

Let's start by comparing Costco's procurement activities to those of Walmart. Let's specifically compare each company's SKU (stock-keeping unit) count. It's estimated that Walmart has ~140,000 SKUs in a typical store. That is in stark contrast to Costco, which only carries about 4,000 SKUs (35x fewer SKUs than Walmart)!

Maintaining a SKU count significantly below the retail industry average offers Costco several benefits. It enables Costco to:

1. Become the largest purchaser of a given SKU and secure the lowest prices from suppliers. Due to Costco's limited SKU count, it often becomes the largest buyer of any stocked item. Take paper towels as an example. While Walmart might offer 5-6 different types, Costco typically stocks only 1-2. This allows Costco to place larger orders and obtain lower prices for each SKU. In fact, Costco's average revenue per product is about ten times that of Walmart's. This is why items at Costco are usually cheaper than those at Walmart or Amazon.

2. Hold suppliers more accountable, further reducing and controlling prices. With significantly fewer SKUs, Costco's purchasers have a better understanding of each product's supply chain dynamics. This enables them to hold suppliers accountable. For example, if cacao prices drop, a Costco purchaser might contact their chocolate suppliers to negotiate lower prices for chocolate SKUs. This scenario is less likely at Walmart, where there are many more SKUs to manage and oversee.

3. Turn over inventory and generate cash more rapidly than Walmart and other major retailers. For example, if only one brand of paper towels is carried, that inventory will turn over faster than if five different brands were stocked. This positively impacts Costco's working capital.

Operations

We've identified that a key distinction between Costco and Walmart is the number of SKUs, which provides Costco with several financial advantages.

Another significant difference that gives Costco an additional cost advantage is how it handles inventory reception and distribution. Both companies have suppliers send inventory to warehouses, from which it is then distributed to individual stores. However, their warehouse operations differ. At Costco, approximately 90% of SKUs are "cross-docked", whereas at Walmart, this figure is only about 10%.

What is "cross-docking", and why is it advantageous? In cross-docking, a warehouse has two sides: one for supplier trucks and the other for the company's delivery trucks (such as Costco's or Walmart's trucks). When supplier trucks arrive, goods are moved by the pallet directly across the warehouse to the company's receiving trucks. This allows inventory to transfer from supplier trucks to company delivery trucks in just minutes or hours.

Cross-docking results in various cost savings. Inventory moves swiftly through Costco's warehouses, reducing the need for working capital. Moreover, moving inventory by the pallet instead of unpacking each pallet to distribute some inventory to Store A, some to Store B, etc., reduces labor costs. All of this is essential to Costco's cost advantage over Walmart.

What's more intriguing is that Costco's ability to cross-dock so much of its merchandise is due to its low SKU count. Therefore, Costco's low SKU count, which alone provides a cost advantage, also enables it to cross-dock its merchandise, further reducing costs. This concept is what Michael Porter calls "interlocking activities," and the more interlocking activities a firm achieves, the harder it is for any competitor to replicate its value chain.

Outbound Logistics

Let's next examine how Costco manages its inventory. At Walmart, inventory is taken off warehouse pallets, unpacked, and neatly arranged on store shelves. In contrast, Costco wheels the pallets directly from the warehouse onto the store floor, where customers remove items from the pallets themselves.

This method is another way Costco reduces its costs. While Walmart incurs labor costs for unpacking and stocking inventory, Costco minimizes labor expenses in this area.

This is another instance of an "interlocking activity." Costco's limited SKU count facilitates cross-docking, which in turn permits the distribution of goods to stores by the pallet. This then allows stores to place inventory directly on the store floor for customers to pick up off the pallet.

Human Resource Management

Another interesting aspect of Costco's value chain is that it compensates its workers about 30% more than the retail industry average and provides outstanding healthcare and benefits. Costco can afford to pay its employees well because it reallocates some of the money saved from cross-docking and merchandising inventory directly from pallets back into its workforce.

By paying its employees above the industry average, Costco in return gets reduced inventory shrinkage (theft) from employees and also lower recruiting costs (due to less employee turnover). This is yet another example of an "interlocking activity" that reduces overall costs and is enabled by Costco's other value chain activities.

Technology Development

Another factor contributing to Costco's cost advantage is its minimal investment in online distribution (e-commerce). While Amazon has invested significantly in this area and Walmart has recently expanded its efforts in this space as well, Costco has kept investment to a minimum.

Developing a comprehensive logistics network for online shopping and delivery requires substantial capital. Costco has intentionally opted not to heavily invest in online merchandising, which has kept its cost base lower than that of Walmart and Amazon. This decision enables Costco to transfer these cost savings to customers through lower prices.

Conclusion

Costco has effectively implemented a series of "interlocking activities" throughout its value chain, enabling it to offer the lowest possible prices to its customers and establish itself as the cost leader in the retail industry. In return, it has consistently earned superior returns on invested capital (ROIC).

So why doesn't Walmart simply replicate Costco's strategy? Due to the numerous interlocking activities Costco has, Walmart cannot just imitate one or two of Costco's value chain activities; it would need to replicate each of them. For example, Walmart can't just reduce its SKU count to match Costco's cost structure; it would also need to adopt cross-docking, pay its employees well, abandon its investment in e-commerce, etc. It is highly unlikely that Walmart's management would agree to undertake all these changes.

Although this article demonstrates the challenges of effectively implementing and maintaining a business strategy, it also emphasizes the substantial financial advantages of executing a strategy correctly.

Sources:

1. Acquired (Costco): https://www.acquired.fm/episodes/costco

2. Acquired (Walmart): https://www.acquired.fm/episodes/walmart

3. HBS Institute for Strategy & Competitiveness: https://www.isc.hbs.edu/strategy/business-strategy/Pages/the-value-chain.aspx

4. Morningstar

5. Individual analysis