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

Costco's Artful Discounts

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Bonita "had us, it thought, over a barrel," Lyons says. "We have to make the right decision for our members." Bonita's North America distributor, Pacific Fruit, did not respond to requests for comment.

Battling persistent food price hikes has forced more creative solutions. Costco typically buys 70% of all the premium macadamia nuts from Mauna Loa, a unit of Hershey (HSY). Costco is so big, says Costco's head of packaged food and sundries buying Tim Rose, "I'll drive my own price up if I only want the cream of the crop." He's now working with Hershey to use smaller nuts in a new chocolate-nut cluster that will be sold at Costco. Because Hershey won't have to risk unloading those smaller nuts at a steep discount, it can afford to ease its prices on the premium nuts. Everybody wins.

To hedge against price increases, the giant retailer is even taking the unusual step of commissioning its own pumpkin patches. For years, Costco has offered customers a pumpkin pie for $5.99, selling more than a million of the store-baked pies in the three days before Thanksgiving. Despite margins getting whacked by higher prices on canned pumpkin prices, Costco has opted to maintain its price. So this year, Lyons began testing a way to get around the food processing companies' high prices, asking some of the farms that grow its melons to cultivate pumpkins. It will experiment with using the pumpkin in some of next year's pies. "It's not beyond us to figure this out," Lyons says. "We won't be held hostage."

Minor Tweaks Save Millions

Meanwhile, in Costco's distribution centers, even minor tweaks to the supply chain can save millions. One simple change, which Costco is rolling out to all of its 16 depots this year and is expected to save Costco around $7 million in annual labor costs, involves adopting the buzzers that chain restaurants give customers to let them know when their table is ready. In the past, drivers parked their trucks on the side of the depot and walked to receiving windows at the front of the vast buildings to drop off and pick up paperwork, a process that took about 25 minutes. Now, when they pull up to the guard gate, drivers trade their inventory lists for a buzzer and back up to the loading door without ever getting out of their cab. When the buzzer goes off, they know the truck has been unloaded, and can drive away. The new system is shaving hours off each depot's operations.

Costco has even gotten vendors to redesign product packages to fit more items on a pallet, the wooden platforms it uses to ship and display its goods. Putting cashews into square containers instead of round ones will decrease the number of pallets shipped by 24,000 this year, cutting the number of trucks by 600. By reshaping everything from laundry detergent buckets to milk jugs, Costco has needed 200,000 fewer pallets a year overall.

Sinegal acknowledges that he can't hold back the cost increases forever. Indeed, within the past six months Costco has twice raised the price of its popular rotisserie chickens, by a total of 20%, to $5.99. But he isn't giving in to higher costs without a fight. "The biggest concern to me is that we lose our way and start thinking it doesn't matter if you charge another dime or another dollar or another hundred dollars," he says. "Without those disciplines, we don't have anything."

For more on Costco's money-saving strategies, watch a video report at www.businessweek.com/go/tv/costco

McGregor is BusinessWeek's management editor.