How Did Costco Become a Members-Only Retail Giant?

TL;DR

Costco became a members-only retail giant by combining recurring membership fees with low merchandise margins, carefully selected products, and a shopping experience built around value and discovery. More than 55 million members shop with the chain, around 90% renew each year, and membership fees generated 92% of net income last year. Read on to see how Costco’s history, limited inventory, customer data, and employee strategy reinforce this model.

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 did Costco become a members-only retail giant?

Costco combined low-margin merchandise with annual membership fees, giving shoppers access to carefully selected products at low prices while creating recurring revenue. It grew from its 1983 founding near Seattle and its 1993 merger with Price Club to $152.7 billion in sales in 2019. More than 55 million members worldwide and an approximately 90% renewal rate help sustain the model.

Q: How does Costco make most of its profit?

Costco makes most of its profit from membership fees rather than merchandise sales. According to the existing page content, membership fee revenue accounted for 92% of total net income last year and carries basically no associated collection cost. Merchandise margins remain extremely thin because the stores are designed to give members reasons to renew.

Q: How much does a Costco membership cost?

A basic Costco membership costs $60 per year, while the Gold Star Executive membership costs $120. The executive tier includes 2% cash back up to $1,000 annually, plus benefits involving Costco Travel and services such as identity protection and insurance. A member relying only on the cash-back reward would need to spend $6,000 annually to recoup the $120 fee.

Q: What is Costco’s membership renewal rate?

Around 90% of Costco members renew each year, and the company has more than 55 million members worldwide. This loyalty gives Costco a predictable stream of membership revenue. Membership numbers also held steady and increased during the recession that began around 2008.

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

Sol Price opened Price Club in a converted San Diego airplane hangar in 1976, building on the low-margin, membership-based approach he had used at FedMart. Jeff Brotman and Jim Sinegal founded Costco near Seattle in 1983, and Costco reached $3 billion in sales in under six years. Costco and Price Club merged as PriceCostco in 1993, then adopted the Costco name in 1997.

Q: Why does Costco carry only about 4,000 products?

Costco limits each warehouse to about 4,000 SKUs and chooses those products carefully, despite the stores’ warehouse appearance. By comparison, a Walmart Supercenter can carry nearly 150,000 distinct items. The smaller selection helps Costco concentrate purchasing power and negotiate lower supplier prices.

Q: How does Costco use customer data and rotating inventory?

Costco collects shopping data when customers swipe their membership cards, and a team of more than 100 buyers uses that information to select products members may value. Inventory cycles in and out, so an item may disappear within a month or two. This creates a treasure-hunt experience that encourages shoppers to make purchases when they find something appealing.

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

Costco pays store employees better wages than many other retailers because it links employee treatment with customer service. The company’s reasoning is that happier associates provide better service, which strengthens the experience for members. That cycle is intended to benefit customers, employees, and shareholders.

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.