Costco Must Overcome Three Challenges to Break into the Chinese Market

In October, 2014, Costco opened up an overseas flagship store on TMall International to give e-commerce in China a shot.

On January 23^rd, 2016, Costco opened a franchised store in Wuhan to give offline retail a try.

On September 8^th, 2017, Costco announced the opening of its first store in Shanghai, and confirmed the store opening hours at the same time.

On September 13^th, 2017, Costco opened its first local flagship store in China via TMall.

Costco’s business development may seem like a natural passage to embark on eventually, however, the problems and challenges that the company has been facing for 18 whole years (1996-2014) have still not been solved completely. Besides the massive consumer market and spending power that the foreign Chinese market offers, there are simply too many uncertainties looming across multiple areas of the business that are not visible at a glance. And to add on, the natural difference and giant gap between China and the US is the deadliest threat to Costco throughout its conquest of the Chinese market. Acclimatization has been a problem shared by all foreign brands since ancient times. Just take KFC China for example. It was considered as a successful example of a foreign business that has localized in China. But unfortunately, KFC was still unable to escape the fate of its operating company—Yum China—being acquired by Alibaba.

To break into the Chinese market, Costco must overcome three mountain-sized challenges

I.

The members of a blogging team named Zhu Si Ma Ji on Baijia Baidu (a Chinese blogging platform) had the chance of visiting the US Arizona Costco in Tucson’s recently. The warehouse is located 155 kilometers away from Phoenix and more than 30 kilometers away from the province’s second largest city, Tucson. Other locations in North America, and even the headquarters in Asia—located in the Neihu District of Taipei—all follow without exception the general principle of being located away from the city center, and either close to the highway or near the airport. Rumors are that Shanghai’s first Costco branch will be located in the Chuansha Area next to Pudong International Airport and where the Shanghai Disneyland is. It will be about a one hour drive from the city center, which seems to be in line with Costco’s above mentioned strategy for warehouse locations.

What sort of considerations went into these location selections?

Costco is not your average retailer. The company’s business model can be summarized with two core keywords: warehousing and wholesale, meaning that the type of business is geared towards high-paying middle-class families who do bulk purchases in low-frequency. The advantages of being away from the urban center, and near highways, ports, or airports are the low costs of rent and the enhanced efficiency of logistics. Another quick example that comes to mind with this sort of business model is IKEA.

What sort of problems will arise with this sort of location selection in China?

Throughout the vast majority of cities in China’s Mainland, medium- to large-sized commercial buildings are located in the downtown area and about 3-5 km away from residential areas. And to spread out the coverage of commercial sites, the final 1-km-wide area is scattered with convenience and community stores. The CBD and residential areas aren’t exactly clearly divided up. Thus, what this brings about along with densely populated cities, is a consumption behavior of high-frequency shopping at local supermarkets and convenience stores that are close in proximity, throughout Chinese cities everywhere.

The consumption habit of low-frequency bulk purchases aren’t exactly what the majority of Chinese consumers are used to. For the vast majority of Chinese middle-class consumers, the problem isn’t transport; it’s really the great reduction of storage space resulted from making bulk purchases. An average Chinese family has about 2 to 4 members. An apartment unit that houses a small family like this simply isn’t suitable for storing bulk purchases compared to the independent houses that most families live in across North America. The same goes to the fridge and freezers of Chinese families: there is simply not enough space to store the packages of products sold by Costco.

If low-frequency bulk purchases can’t be maintained locally, consumption patterns will only revert back to the good old habit of buying in small quantities and in high frequency.

So what is the problem with this business model?

• Chinese consumers and their low-quantity purchases in high frequency are largely shaped by e-commerce. To add on, Costco’s challenge is exacerbated by the disadvantages of traffic and time costs brought about by the far-off locations of the warehouses.
• If a warehouse-styled wholesale supermarket like Costco can’t dish out periodic shipments and achieve an acceptable product turnover rate, it will be definitely result in blazing high deficits for the company, especially from the loss of its cold and chilled food products.
• If Chinese consumers solved the problem of storage space by buying a bigger house, and magically conformed to Costco’s membership program that’s renewed on an annual basis, Costco would still need a few absolutely necessary conditions to be met before things can work out. Costco would have to educate Chinese consumers and redefine consumption behaviors in China shaped since birth by the already advanced e-commerce through the company’s service of offering unprecedented low-cost and high-quality products; an approach similar to the practice of Taobao back in the days. But the myriad of differences in public transport, e-commerce, logistics, and population base in North America compared to China is just too great for Costco to address all at once. Thus, the probability of achieving this result by educating the market is close to zero.

II.

Can Costco really offer the lowest prices through wholesale?

In North America and other parts of the world, Costco’s prices are indeed the lowest and of the highest quality among the same products offered at other local markets. This is because the main source of profit for Costco is made from its membership fees only. And the rest are from products sold, which are in turn used for maintaining daily operations. The 14% gross margin that Costco has maintained throughout other parts of the world is the company’s secret to keeping up high quality products at a reduced price.

Furthermore, Costco can effectively bring down the offered wholesale prices by using exclusive sales agreements and offering the most irresistible large orders as bargaining chips to global suppliers and co-branding companies. But until today, Costco is still an import-based supermarket in China.

When Costco opened up a flagship store on TMall on September 12^th, 2017, we can quickly notice the warehouse center for shipping out products has been switched from Taiwan—TMall International’s logistics center in Asia—to Ningbo FTZ. Furthermore, while we couldn’t find a single product with a SPUs (Standard Product Unit) that’s labeled “Made in China”, we found goods made from the company’s official Taiwanese suppliers labeled “Made in Taiwan”.

Being an import-based company selling foreign products, the difference between Costco and TMall International is the slightly lower logistics costs and being slightly more time-efficient. A quick example of a contrasting company to Costco is IKEA. Before opening up its first store in China, IKEA had begun loads of early OEM preparation work with multiple factories across the country.

What if Costco didn’t localize?

Naturally, refusal of localization would lead to tariff issues. The price difference would be comparable to the ratio and prices of BMW Brilliances and imported BMWs in the domestic market; meaning that Costco would have to sell at a much higher price like the latter. Tariffs and all sorts of industries that are involved with imported products are under national protection. In addition, agricultural products carry various pests and diseases from around the world, and the constantly updated health quarantine standards would also bring about uncertainties for Costco such as Japan’s nuclear radiation food products, beef produced from epidemic areas of infectious diseases, and GMOs and so on. If Costco elects against localization, all of the above mentioned factors would hinder its business greatly in China.

Next is inventory problems. Purely imported goods cannot hope to pull ahead in its competition with the same products offered by retail stores in local areas and keep up its wholesaler’s low-price advantage. Thus, the North American low-frequency bulk purchases and its 29.3-day inventory turnover rate advantage would be rendered non-existent. Inventory problems would persist and in fact be exacerbated.

The only happy company throughout all this is in fact Walmart. Having been in business in China for over 21 years, Walmart is clearly way ahead down the line. Sam’s Club isn’t short of exclusive products that are in cooperation with Chinese suppliers. We can even find products similar to the Wenger Swiss army knife. Wenger is an affiliate company of Shanghai UTC (Urban Traveler).

Assuming Costco does move ahead with localization, what sort of challenges would Costco encounter then?

It would be time costs. As a result of the late arrival in China, finding the right suppliers willing to cooperate would require time-consuming labour and material resources. Furthermore, Costco would have to guarantee that quality standards are up to par with the company’s requirements, be in control of its retail stores in the industry, and also make sure that their prices are truly below those listed through e-commerce. This is definitely not an easy path.

Next is the competition from Walmart. Walmart has been in business in China for over 21 years now, and has a large number of supplier resources. The company is also one of JD’s shareholders. And now, Chinese companies that are capable of independent purchases and e-commerce are coincidentally on the same team. Although Alibaba is fully equipped with the same potential, and can really help out Costco in theory with its LST platform of retail products as a partner of Costco, Costco would still be presented with great pressure from the joint alliance of Walmart and JD.

And finally, it would bring about more competition. If Costco’s were to successfully integrate into China and localize, the rapid rise of Chinese middle class consumers, medium and large-sized domestic and foreign investment companies, joint ventures and local businesses would all join in and dish out the greatest challenge for Costco. Tencent and Alibaba’s e-commerce platforms would also undoubtedly join in on this unprecedented market war.

III.

The membership-free business model that TMall is testing out would also serve as a stimulant to Costco’s Chinese consumers. As we all know, wholesale supermarkets that employ a membership system to offer exclusive products at a bargain price would need to lay down high membership fees. And the membership fees at Costco are almost the highest among all other competitors in the industry. At TMall however, consumers don’t need to pay a cent.

According to the latest Costco membership fee details on June 1^st, 2017, the basic membership fee is $60 USD (equivalent to about 39.1.8 yuan). And next up, there is the Gold Star Executive membership that offers an annual 2% reward on eligible Costco purchases and travel packages and a maximum return of 750 USD at $120 USD (equivalent to about 783.6 yuan).

The latest financial reports have shown that Costco’s profits fell by 5.7%, indirectly resulting to this year’s global upward membership fee adjustment.

In other words, if you’re looking to really make a bargain at Costco, you’d need to subscribe to a membership and make loads of bulk purchases before this can be achieved. According to the latest financial reports, Costco’s 2016 annual revenue of 29.86 billion USD are mostly from the membership fees. If Costco were to follow in the footsteps of TMall and offer a lower threshold to access its services, or better yet remove the membership system altogether, it would definitely impact the company in a negative way, and force the company to run a deficit; a scene that no listed company and consumers in other parts of the world want to see. But if Costco were to reduce discounts at the cost of sacrificing its low-price advantage, and still unable to keep up a high brand loyalty with e-commerce platforms and traditional shopping malls, nothing would work out still. Thus, this problem will likely remain a giant headache for Costco.

Data have shown that North American customers renew their annual memberships at a rate as high as 91%.

On the topic of membership fees, a bigger problem Costco’s facing is from the previously granted access to the e-commerce platform. The Zhu Si Ma Ji Team visited Costco’s official Taiwanese site and was informed by a relevant person in charge that before Costco entered TMall, Alibaba has already released relevant data—sales volumes and profit values—on their products that are bought from Costco in Taiwan and sold on Taobao.

However, with the opening of an actual store in China this time, Taobao’s e-commerce products of Costco goods will truly become an obstruction to Costco’s membership fee system. When IKEA haven’t quite expanded in China’s domestic stores during the early stages, purchase agents and stores across Taobao that bought IKEA goods for Chinese consumers dominated the TOP category. But IKEA is, after all, a membership-free store. Thus, based on the relatively higher logistics costs and the growing number of stores across the country, IKEA really needn’t worry about the impact and challenges brought along by its Taobao competitors. And when Costco’s high membership fees cannot meet the comprehensive demands of its consumers, perhaps it will give rise to a new emerging wave of competitors buying Costco goods at a lower price than Costco’s in-store items on Taobao all over again.

In fact, there are still huge ongoing market differences between China and the United States. If one were to force the North American experience and habits upon Chinese consumers, failure is bound to take place eventually. It is really only a matter of time. The same thing can be said for Chinese enterprises looking to invest or expand overseas. They must get a clear picture of the local market first, find out the layout of the city and the mainstream consumption habits to say the least. And similarly, other retail examples that are relatable to Costco’s cause should also make their judgments more rationally. They can try to learn from Costco’s example, but definitely not copy from head-to-toe or boast about success for no reason at all. After all, even the good old American gramps who once set up shop in front of Tiananmen Square has changed his last name to Ma today. (This is a reference to KFC China being bought by Ant Financial, an affiliate of Alibaba, and to Jack Ma, the executive chairman of Alibaba)

This article originally appeared in Huxiu and was translated by Pandaily.

Click here to read the original Chinese article.