By Fang Er

Recently, Costco unveiled its first Chinese warehouse store in Shanghai. The US members-only wholesaler believes that retail should be service-driven, and that its own role is to serve the customer. Nevertheless, the company’s opening day in China was a scene of chaos – shelves were emptied within an hour, cars had to wait 3 hours to find a parking place, and customers had to queue for two hours at checkouts. But, how exactly did Costco end up going viral in China? What are the brand’s chances of success in the Chinese market? And what can Chinese brands learn from Costco?

Why did Costco go viral in China?

Costco is the world’s second biggest retailer after Walmart (which was founded 20 years earlier). So, what is Costco’s secret to success? Recent media reports have misrepresented the Costco brand. Fundamentally, Costco is driven by two basic principles. First, Costco believes that retail should be service driven. The brand makes service its main priority and strives to deliver product choice to customers. And, second, Costco feels that it has a duty to serve consumers over brands. Costco has traditionally catered to middle-class shoppers, and its latest foray in Shanghai is a bid to tap into China’s growing middle-class market.

So what is Costco’s value proposition for middle-class consumers? Generally speaking, there are four ways that retailers deliver value to customers: choice, speed, quality, and price. Walmart, for example, is known for offering a wide range of choices at low prices. High-end, US-based retailer Whole Foods Market has a dual focus on choice and quality. By comparison, Costco emphasises good quality at lower prices. Simply put, the value proposition of Costco is to bring the most cost-effective products to middle-class consumers.

Why does membership matter?

Unlike other retailers, Costco generates most of its profits from membership fees instead of sales. In the first three quarters of its current fiscal year, Costco’s revenue from membership fees reached $2.302 billion USD, accounting for nearly 90% of its total net profits ($2.562 billion USD).

So why does Costco charge membership fees? As mentioned earlier, Costco puts service at the core of its retailing business. Membership fees can be seen as a ‘service fee’ that Costco charges customers for curating a selection of products. But, membership fees also serve several other important purposes.

First, membership fees help Costco identify high-net-worth individuals. In the US, Costco charges $60 USD per year for basic memberships and $120 USD for executive memberships. Low-frequency shoppers, such as singles, are less likely to fork out for memberships. The same is true at the Shanghai store, where a 299 RMB annual membership fee enables Costco to rapidly screen for high-frequency consumers.

Second, membership fees allow Costco to establish barriers to competition, as once consumers have paid for a membership, they are less likely to shop elsewhere.

Finally, a membership system enables Costco to collect user data, which can be used to reduce the brand’s operating and marketing costs.

Offering a more limited range of bulk products and charging membership fees alone, however, isn’t enough to establish loyal customers and Costco has sought out numerous other ways to engage and keep customers coming back. One significant move the company has made is the launch of Kirkland Signature, its exclusive label brand for household staples such as milk and eggs. Kirkland Signature has not only increased shopping frequency at Costco, but also enhanced Costco’s bargaining power over third-party brands, helping to reduce its sourcing costs.

In addition to creating its own brand, Costco is constantly looking for other ways to improve customer service and the customer experience. For example, Costco members enjoy access to cheaper gasoline and insurance products; its stores organise free pizza and candy tasting events; and the brand also locates heavily-discounted products in its stores in places which are more likely to be discovered by loyal, frequent shoppers.

These initiatives have paid off. Costco’s annual financial report for 2018 indicated a worldwide membership renewal rate of 88%. There are plenty of other retailers and e-commerce platforms that offer membership programmes, but few offer the same level of value. Indeed, Costco has created a win-win situation – by delivering better value to customers, it also increases its own profits.

Will Costco succeed in China?

Based on its strong start, many observers have high expectations for Costco in China. However, it is too early to say what the future holds for the American warehouse club given the numerous and considerable challenges of the Chinese market.

Can Costco accurately identify the consumption habits of China’s middle class and cater to their needs? It is worth noting that Costco’s Shanghai store is operated by a Taiwanese team whose ability to localise operations has yet to be proven.

Furthermore, the Chinese market has enormous regional differences that don’t exist in the US. Because of this, a business model that works in Shanghai might be difficult to replicate in Beijing. Likewise, an approach that works in first-tier cities might not work in second- and third-tier cities. In brief, Costco might be able to achieve success at one store in one city, but achieving success in hundreds of cities across China will prove a major challenge.

In addition, Costco’s success in the US rests mainly on its ability to pick the best products for customers. To establish a solid presence in China, Costco must gain an in-depth understanding of Chinese consumers and local competitors before deciding which products to source globally or locally, and this will prove to be a time-consuming process.

There are even greater challenges still on the supply chain side, which could be both good and bad news for brands that compete for shelf space at Costco. On one hand, Costco generally demands the lowest possible prices from brand partners; but at the same time, there are a multitude of rival retailers in China who may create obstacles to prevent brands from giving Costco the most attractive prices.

China’s retail market is undergoing rapid changes that could provide stiff competition for Costco. International players such as Carrefour and Metro that entered China more than 20 years ago are now looking to leave. Carrefour SA has agreed to sell an 80% stake in its China unit to local retailer Suning for 4.8 billion RMB. There are also rumours circling that Metro AG plans to sell off its China operations. In the US market, consumers have learned over the years to trust retailers and have developed a sense of loyalty. In a Costco store, for example, many consumers will happily buy any product, regardless of the brand. Chinese consumers, in contrast, place their faith in brands rather than in retailers. Most Chinese shoppers would be happy to buy a Sony TV from any retailer providing that the price was attractive. Therefore, it is as yet uncertain whether Costco can reshape the shopping habits of Chinese consumers to more closely resemble those of their American counterparts.

Another striking difference between Chinese and US consumers is that more than 70% of China’s middle-class consumers make purchasing decisions after arriving at a store, while more than half of US consumers make their decisions before setting off for a store. As a result, competition amongst retailers in the US is less fierce than competition amongst product brands. Conversely, retailers in China face a brutal battleground and local retailers are quick learners, meaning Costco will be forced to constantly innovate and create business barriers to remain one step ahead.

In summary, Costco’s first store in China has already proven to be a tremendous hit, but it will be another couple of years before we can know for certain whether the company can succeed in China in the long run.

Dr. Fang Er is a Professor of Marketing and Co-Director of the CEIBS Research Center on Digital Economy and Smart Enterprises at CEIBS. His teaching and research interests include marketing strategy, B2B marketing, China strategy and marketing management. For more on his academic and professional background, please visit his CEIBS faculty profile here.