Why big retail chains always win on price
It's all about volume.
Why do people like to shop at big retail stores like Walmart, Costco, and Kroger? Even though most of these stores require some travel time and effort to visit.
Of course, there could be several reasons, like store experience, product variety, etc. But the core one, you’ll agree, is price. Compared to a local grocery store, their prices are lower, correct?
Now, the question is why.
This is where the concept of economies of scale comes in. Big retail chain stores buy products in massive quantities. This helps them negotiate lower prices from suppliers, spread fixed costs like salaries, rent, etc. over a large number of units, and get better price from logistics companies. All of these reduces the average cost per unit, allowing them to sell at lower prices.
So, it’s all about the large scale of purchases and sales. The larger the scale, the lower the cost. The lower the cost, the lower the selling price while still keeping a healthy profit margin.
Let’s say there’s a Walmart Supercenter with monthly sales of $50 million and 1.5 million units sold.
Fixed costs (spread across volume or scale)
Fixed costs are costs that don’t change based on transaction volume. For example, staff salaries are a fixed amount you need to pay every month, irrespective of how many sales or purchases you made that month.
Rent and utilities: $1.20 million/month
Staff salaries: $3.50 million/month
Technology and systems: $0.80 million/month
Total fixed costs: $5.50 million/month
When this fixed cost is spread across sales or units, here’s what happens:
Per dollar basis: fixed costs/sales = $5.50 million / $50 million = $0.11 per dollar of sales. This means Walmart spends 11 cents on fixed costs for $1 of sales made.
Per unit basis: fixed costs/number of units sold = $5.50 million / 1.5 million = $3.67 per unit. This means Walmart spends $3.67 as a fixed cost on every unit sold.
Now, imagine if the sales volume doubled ($100 million revenue with 3 million units sold). You’ll see the fixed costs per dollar drop to $0.055 and per unit to $1.83.
This is economies of scale in action.
Bulk purchase and discount
Let’s say a supplier charges $9.50/unit to small retailers but $8.75/unit to Walmart. That’s a discount of $0.75 per unit. On 1.5 million units, that unit discount translates into a total savings of $1.125 million a month.
The reason suppliers give extra discounts to large retail chains is obvious. Who doesn’t want their products to reach the shelves of Walmart? Forget sales and profit; your product on Walmart shelves means free advertisement in front of millions of customers each day.
Distribution and logistics
Large retail chains also get volume discounts from logistics companies. Also, these chains have centralized distribution centers across the country. This further reduces the transport cost per unit.
Logistics costs: $2 million/month
Spread across 1.5 million units = $1.33 per unit
A small retailer moving 150,000 units might pay $2 per unit as a logistics cost.
Makes sense?
For better understanding, let’s look at a small regional store with monthly sales of $5 million and 150,000 units sold.
Fixed Costs
Rent and utilities: $150,000 a month
Staff salaries: $400,000 a month
Technology and systems: $50,000 a month
Total fixed costs: $600,000 a month
Spread across:
Per dollar basis: $600,000/$5 million = $0.12 per $1 of sales
Per unit basis: $600,000/150,000 units = $4 per unit
Walmart’s fixed cost per unit was $3.67 because they sell 10X more units as compared to this regional grocery store. By the way, that’s a saving of around 8% for Walmart.
Purchase
Supplier charges $9.50 per unit (vs. Walmart’s $8.75). On 150,000 units a month, that’s $112,500 more in costs compared to Walmart.
Logistics and distribution
No negotiation power with logistics companies. Also, no centralized distribution.
Spread across 150,000 units = $2 per unit (vs. Walmart’s $1.33)
Total cost (per unit)
Walmart: $13.75 per unit ($3.67 + $1.33 + $8.75)
Regional grocery store: $15.50 per unit ($4 + $2 + $9.50)
Now, here’s where things get interesting.
Let’s say Walmart decides to sell the product at 25% markup on the total cost. So, 25% added to $13.75 is around $17. What about the regional store? Let’s say they too want to markup at 25%. So, 25% added to $15.50 is around $19.
With the same profit markup, Walmart offers the product for $17 and the regional store offers the same product for $19.
Note, in this example, for simplicity, we’ve ignored costs like marketing, etc. Also, note that, practically, product price is calculated by marking up landed cost and not total cost as shown here. This example is solely to help you understand the concept of economies of scale.
What are your thoughts? Comment below.