Costco Wholesale

Since it was founded in Seattle in 1983, Costco Wholesale (Costco) has become one of the country’s largest retailers by ignoring most of the tried and true rules of retailing. They never advertise. They never charge more than a 15% mark up on their products. They pay their employees well above minimum wage. What’s responsible for their continued success? Innovative operating and business models.

Operating Model

General Context

As of August 14, 2015, Costco operates 686 warehouse stores in nine countries with the vast majority being in the United States and Canada[1].  With an average warehouse size of 140,000 square feet, that equals 98.7M square feet in total. Costco sources their products directly from manufacturers. Purchased goods from a single manufacturer are brought to one of only twenty-three depots where goods are then distributed out to individual warehouse stores. This is quite a lean and efficient distribution model, even compared to other big-box retailers like Wal-Mart which operates 42 distribution centers [2].

Sales Overview

43% of Costco’s sales come from packaged food and sundry items (such as alcohol, snack foods, tobacco), while 14% comes from fresh food. 16% of sales are due to ancillary businesses that are present in stores, such as gasoline sales, pharmacy, the in-house optician and food court sales[1].

Employees

Costco’s approximately 200,000 employees world-wide are paid, on average, around $20.89 per hour. This compares to approximately $12.67 per hour at Wal-Mart [3]. High salaries, along with other benefits, results in Costco’s shockingly low 6% turnover after the first year of employment [4]. Not only does this allow Costco to avoid the costly activities of recruiting and on-boarding new employees, but it also results in a highly motivated workforce.

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Business Model

Reoccurring Membership Revenue

Costco has, since its inception, operated with a subscriber model. Customers need to pay for an annual membership in order to shop at the store (memberships start at $55). On average, 91% of Costco members renew their memberships each year, indicating that members find significant value in being a customer. Consequently, Costco views these memberships as a relatively stable revenue stream and they align the rest of the organization around this business model. In 2015, around 70% of Costco’s net profits came from membership fees.

Low Prices

One way they achieve this alignment is by having capped margins. Costco has capped margins at 15% (this compares to a supermarket where items are commonly marked up 25% or more). Customers know that they are receiving a good deal on the products they’re buying. By limiting the amount of merchandise it buys (only 3,800 SKUs are carried in the average store compared to over 60,000 in the average Wal-Mart [5]) and typically selling goods in large quantities to end-customers, Costco can command significant pricing power over its suppliers and pass these savings along to members. Another benefit of this approach is that they are able to negotiate favorable payment terms with suppliers, and need to use less of their own working capital to sustain the business.

Private Label Goods

Stores also feature a mix of brand names that customers know and trust, as well as, Costco’s own Kirkland Signature line of private label goods. According to Costco, “all Kirkland Signature products must be equal to or better than the national brands” [6] and in warehouses they make up around 20% of the SKUs offered. These private label goods allow Costco to strip out more costs versus the national brands, and consequently reduce prices to the end consumer.

Innovative Marketing Methods

By choosing not to advertise, Costco doesn’t incur some of the typical marketing expenses associated with a retail chain. Instead of seeing a weekly flyer in your Sunday paper, Costco hopes that you’ll hear about their great deals from your friends and want to come see for yourself. They also maintain a few loss-leaders, such as the famous $4.99 rotisserie chicken or the $1.50 hot dog and drink combo, to bring people into the store on a more regular basis.

Another unconventional method of bringing people in to shop is by making the experience fun and unexpected. Costco’s buyers are constantly on the lookout for new and interesting items to bring into the store – and they’re always a great deal. Products as diverse as cars, wedding rings, custom pet portraits and an exclusive limited edition bottle of Johnny Walk 1805 Blue Label (price: $20,000) [7]. The excitement of finding these unique items in the store makes the shopping experience fun and interesting for both affluent and middle-income customers, and encourages repeat visiting.

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A lean operating model and a relentless focus on customer value, all the while providing a fun shopping experience, has allowed Costco to succeed over the past thirty-two years. As long as they continue to provide a compelling value, and variety, Costco looks set to continue their long record of success.

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Sources

[1] – Costco Wholesale 10-K http://phx.corporate-ir.net/phoenix.zhtml?c=83830&p=irol-sec&seccat01.4_rs=21&seccat01.4_rc=10

[2] – Wal-Mart Careers – Distribution http://careers.walmart.com/career-areas/transportation-logistics-group/distribution-center/

[3] – ‘Costco CEO Craig Jelinek Leads the Cheapest, Happiest Company in the World’ – http://www.businessweek.com/printer/articles/123856-costco-ceo-craig-jelinek-leads-the-cheapest-happiest-company-in-the-world

[4] – ‘The High Cost of Low Wages’ – https://hbr.org/2006/12/the-high-cost-of-low-wages

[5] – ‘Costco’s Bulking Up Its Moat’ – http://ibd.morningstar.com/article/article.asp?id=638445&CN=brf295

[6] – Costco Kirkland Signature Website – http://www.costco.com/kirkland-signature.html

[7] – ‘Johnny Walker 1805 Limited Blue Label Edition’ – http://costcocouple.com/johnny-walker-1805-blue-label-limited-edition/