How Did Costco Become a Members-Only Retail Giant?

TL;DR

Costco earns most of its profit from membership fees, not product sales, with 92% of net income coming from fees that renew at roughly a 90% rate. It keeps thin margins, stocks only about 4,000 carefully chosen SKUs, pays workers well, and rotates inventory to drive impulse buying and loyalty.

Transcript

Costco is a retailer that has figured out how to get its customers to pay for the privilege of shopping there, and its members decide the privilege is worth the cost year after year after year. The now global chain of warehouse stores counts more than 55 million members around the world, and around 90% of them renew their memberships each year. If ... Read More

Key Insights

• Costco's profit engine is membership fees, not merchandise. Last year 92% of total net income came from membership fee revenue, which drops nearly straight to the bottom line because there is basically no cost associated with it.
• Costco counts more than 55 million members worldwide, and around 90% of them renew their memberships each year, giving the company a highly predictable, recurring revenue base built on customer loyalty.
• A basic Costco membership costs $60 per year, while the gold star executive membership costs twice that ($120) and adds 2% cash back up to $1,000 annually plus travel and insurance perks.
• Inventory is tightly controlled despite the warehouse appearance. A single Costco carries only about 4,000 SKUs, whereas a Walmart Supercenter can carry nearly 150,000 distinct items.
• Costco was an early pioneer in collecting and analyzing customer data, using card swipes and a team of more than 100 buyers (per Evercore ISI) to seek out items members would appreciate.
• Rotating stock creates a 'treasure hunt' effect. Products cycle in and out, so items on shelves may be gone in a month or two, encouraging impulse buying on each visit.
• Costco treats employees well, paying better wages than many retailers, on the logic that happier associates deliver better service, creating a virtuous circle that ultimately benefits shareholders.
• The company faced pandemic pressure, spending $283 million on Covid-related safety and sanitation in Q3 2020, and saw sales fall in April for the first time in a decade before rebounding.

Questions & Answers

Q: How does Costco make most of its money?

Costco makes most of its money from membership fees rather than the actual sale of goods. According to the video, 92% of the company's total net income last year came in the form of membership fee revenue. Because there is basically no cost associated with collecting that fee, the revenue drops straight to the bottom line. Margins on the products on Costco's shelves are extremely thin, much thinner than those of grocery stores, so the store effectively exists to get members to renew year after year.

Q: How much does a Costco membership cost?

A basic Costco membership costs $60 per year. There is also a gold star executive membership that costs twice that, or $120 per year. The executive tier comes with perks such as 2% cash back rewards up to $1,000 per year, savings on trips booked through Costco Travel, and discounts on other services like identity protection, auto and home insurance, and bottled water delivery. Someone who only collected the 2% cash back would need to spend $6,000 per year to recoup the $120 executive fee. Costco also raises membership fees every few years.

Q: What is Costco's membership renewal rate?

Costco has more than 55 million members around the world, and around 90% of them renew their memberships each year. This high renewal rate reflects fiercely loyal members who decide the privilege of shopping is worth the cost year after year. Because the company is highly dependent on membership fees for its profits, this loyalty is central to its business. Costco's membership numbers held steady and even increased during the recession that began around 2008, though the video notes it remains to be seen how resilient the business is during more recent challenges.

Q: How did Costco get started and merge with Price Club?

What is today called Costco grew out of a merger of two similar retailers. Price Club was started in 1976 in a converted airplane hangar in San Diego by Sol Price, who pioneered the club warehouse model. Costco itself was founded in 1983 in the Seattle, Washington area by Jeff Brotman, a lawyer, and Jim Sinegal, who had worked closely with Price at FedMart and Price Club. Costco grew from nothing to $3 billion in sales in under six years. Price Club and Costco merged in 1993 as PriceCostco, becoming just Costco in 1997.

Q: Why does Costco carry so few products compared to other stores?

Costco keeps inventory tightly controlled despite the appearance of a vast warehouse stuffed with goods. A single Costco carries only about 4,000 SKUs, which are stock keeping units for the unique barcode on each item, whereas a Walmart Supercenter can carry nearly 150,000. Items are packaged in large quantities but the number of distinct products is relatively small, and those products are very carefully chosen. This limited, curated selection lets Costco use its massive membership base as leverage when negotiating lower prices from suppliers while focusing on delivering good value.

Q: How does Costco use customer data to choose products?

Costco was a pioneer in the now common practice of collecting and analyzing customer data. When a member makes a purchase, the first thing they do is swipe their Costco card, generating shopping data. Evercore ISI estimates Costco has a team of more than 100 buyers who access this shopping data to determine what products to stock. They use it to seek out items members might really appreciate but that would not be obvious, such as leather coats, unique jewelry, or innovatively packaged cameras and lenses not sold elsewhere. This creates what the company calls a treasure hunt for shoppers.

Q: Why does Costco pay its employees better than other retailers?

Costco is known for treating its workers well, with store employees making better wages than those at many other retailers. The company justifies the better pay and benefits on the grounds that happier employees will be more helpful to members and improve the shopping experience. As one commentator explains, if associates are happy and excited to be there, customers see that in the service levels they receive. This creates a virtuous circle: the best way to benefit shareholders longer term is to take care of customers, and a key way to do that is to take care of associates.

Q: What challenges does Costco face going forward?

Costco faces several challenges. Younger generations have grown up shopping online, and companies such as Amazon have taken some of Costco's secrets and applied them to e-commerce with one-click convenience. The coronavirus pandemic hurt the company: sales fell in April 2020 for the first time in a decade due to lockdowns, and Costco spent $283 million on Covid-related safety and sanitation in the third quarter of 2020. Because Costco needs shoppers to physically visit its stores and relies heavily on membership fees, economic downturns that make consumers cut subscriptions pose a real risk.

Summary & Key Takeaways

• Costco pioneered a retail model that charges people a fee for the privilege of shopping there. With over 55 million members and about 90% annual renewal, its members are fiercely loyal, deciding year after year that the membership is worth the cost despite paying at least $60 annually.

• The company makes most of its money from memberships rather than goods, with 92% of net income from fee revenue last year. Margins on shelf products are extremely thin, and Costco has refused price hikes on goods just to keep customers coming through the door.

• Costco grew from a 1983 Seattle founding and a 1993 merger with Price Club, reaching $152.7 billion in 2019 sales. It stocks only about 4,000 carefully chosen SKUs, rotates inventory to spur impulse buys, uses member data, and treats workers well.