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Cover Story October 9, 2008, 5:00PM EST

Costco's Artful Discounts

With costs of everything on the rise, the big box retailer gets creative

By Jena McGregor

Sinegal: Trying to preserve the Costco way amid rising costs Brian Smale

Editor's note: This is an extended version of a story published in the Oct. 20, 2008, issue of BusinessWeek magazine.

In Costco Wholesale's New Jersey distribution center, some 2 million rolls of paper towels recently sat stacked in a mountain of green and orange plastic. Nearby, row upon row of jumbo tissue rolls formed a wall of cushiony toilet paper.

A year ago, the space was virtually empty.

Costco's customers have not, of course, suddenly stopped buying paper products. The 258 truckloads of Bounty and Charmin are the result of a "buy-in," just one strategy Costco (COST) has been using to hold prices down amid rising costs. After Procter & Gamble (PG) announced a 6% price increase in August, Costco bought as much as it could stuff into its depots at the old rate. As a result, says Senior Vice-President Tim Rose, "we'll have a six-week supply when everyone else is going up in price."

Famously Frugal CEO

At Costco, where more than 29 million households pay $50 to $100 a year to shop, low prices aren't just a nice-to-have. They're a way of life. Not only does Costco's famously frugal CEO James D. Sinegal cap margins at a sacrosanct 14% on branded goods, he's constantly pushing his buyers to find creative ways to lower prices and add value while getting his managers to crank up their efficiency efforts. Besides the buy-in strategy, Costco has been redesigning product packaging to squeeze more bulky goods onto trucks and revamping processes for moving goods through its depots. Even small tweaks to its well-oiled operations can have a big impact. "If that stuff doesn't really turn you on," says Sinegal, "then you're in the wrong business."

Such tactics are keeping customers' shopping carts full—the $72 billion retailer's sales have been one of the only bright spots in today's brutal retail economy. But they've also been pinching profits. As commodities surged over the summer, Sinegal's call to hold the line on pricing helped prompt Costco to warn in July that its fourth-quarter earnings would be "well below" expectations. On Oct. 8, it announced quarterly net income of $398 million, slightly lower than Wall Street's revised expectations.

But to Sinegal, the short-term earnings pain is worth the potential for long-term market share gain. For one, holding prices low is the best way to protect profits: About 75% of Costco's operating earnings come directly from membership fees, and if prices rose too quickly, some members could flee. In addition, the 72-year-old warehouse club veteran knows that in this environment, Costco's reputation for bargain prices and surprise designer goods could inspire a new crop of warehouse chic devotees. "We should shine at a time like this," he says. "We have always believed that great companies build market share in really tough times."

Fostering Impulse Buys

What Sinegal isn't doing is wavering from the basic model that helped him and co-founder Jeffrey Brotman build Costco into a retail phenomenon. The Issaquah (Wash.)-based company's warehouse model relies on selling core items at rock-bottom prices while scooping up excess inventory from high-end brands. The here-today, gone-tomorrow nature of Costco products tends to foster carts full of impulse buys. The average store does $137 million in annual sales, a volume so high that Costco turns its inventory 11.9 times a year, meaning it often sells goods before it technically has to pay its suppliers. Combine that with high-income customers—the average Costco household makes upwards of $75,000—and "what they're doing is really high velocity retailing," says Boston Consulting Group Managing Director Michael Silverstein, who has studied Costco.

It's a retail recipe that inspires cocktail party chatter and boardroom word-of-mouth.

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