With a substantial part of its business focused on selling merchandise at the low profit-margin, Costco also has about fifty million members that each year guarantee to the company over $2.8 billion in steady income at high-profit margins. Costco uses a single-step distribution strategy to sell its inventory.
- Costco business model at a glance
- A glimpse at Costo business model few key ingredients
- High inventory turnover: the key is cross-docking and single-step distribution channels
- Ancillary businesses: leverage on tight margin merchandise and goods to sell primary merchandising
- Limit merchandising selection: better vendors’ agreements and payments with low prices and high quality
- Online commerce to offer what’s not available in the warehouses
- Comparable sales growth as a primary business metric
- The power of the membership model to create a stable revenue stream that enhances profitability
- Bulk sizes make it easier to cross-dock while Costco sells more and members save more
- Summarizing Costco main business drivers
- Business lessons you can apply to your company
Costco business model at a glance
With a substantial part of its business focused on selling merchandise at the low profit-margin, Costco also has about fifty million members that each year guarantee to the company over $2.8 billion in steady income at high-profit margins.
Costco also uses a single-step distribution strategy that allows it to sell its even before it gets paid to suppliers.
Just like ALDI tries to keep its prices as low as possible, so Costco managed to do so, by lowering its profit margin deliberately to pass those savings to consumers.
Indeed, Costco wants to be recognized in the minds’ of its consumer as high quality, low priced stuff that you can purchase in bulk.
A glimpse at Costo business model few key ingredients
Costco offers to merchandise in a few key categories:
- Foods which comprise dry foods, packaged foods, and groceries
- Sundries which comprise snackfoods, candy, alcoholic and non-alcoholic beverages, and cleaning supplies
- Hardlines which comprise major appliances, electronics, health and beauty aids, hardware, and garden and patio
- Fresh Foods comprising meat, produce, deli, and bakery
- Softlines comprising apparel and small appliances
- Ancillary which comprises gas stations and pharmacy
While Foods represented the largest category in 2018; each of those categories plays a crucial role in Whole Foods success.
Let’s see what are the critical ingredients of Costco business strategy success, starting from how the company manages its .and
High inventory turnover: the key is cross-docking and single-step distribution channels
Costco generally sells even before they’ve paid it. As pointed out in its annual report:
We buy most of our merchandise directly from manufacturers and route it to cross-docking consolidation points (depots) or directly to our warehouses. Our depots receive large shipments from manufacturers and quickly ship these goods to individual warehouses. This process creates freight volume and handling efficiencies, eliminating many costs associated with traditional multiple-step distribution channels.
The key ingredient to Costco ability to move merchandise efficiently from manufactures to its warehouses allows the company to sell itsquickly.
Indeed, thanks to its memberships Costco knows for sure it will sell most of itspretty quickly. Thus, inventory losses (shrinkage) are well below typical retail operations.
Indeed, where on a typical retail operation there is a multiple-step distribution channel where the retailer has to move the merchandise from the manufacturer to a warehouse and then again to a retail store where it gets sold.
Costo warehouses are stores themselves. Thus, when moved the merchandising there it gets sold quickly.
Another critical aspect is that when the merchandise arrives in bulk to Costco warehouses, they don’t need much repackaging or complex and expansive operations but rather those merchandises get sold directly in bulk.
Ancillary businesses: leverage on tight margin merchandise and goods to sell primary merchandising
Ancillary businesses within or next to our warehouses provide expanded products and services, encouraging members to shop more frequently. These businesses include our gas stations, pharmacy, optical dispensing centers, food courts, and hearing-aid centers. We sell gasoline in all countries except Korea and France, with the number of warehouses with gas stations varying significantly by country. We operated 536, 508, and 472 gas stations at the end of 2017, 2016, and 2015, respectively.
One might wonder why to sell an item that has a minimal profit margin like gasoline. And the answer is simple. Gas allows Costco to attract people to its warehouses.
Going to Costco is an “experience” all its way down. From purchasing the gas to stocking the car of merchandise.
The two primary ancillary businesses Costco leverages on to bring as many customers back to its warehouses are gasoline and pharmacy.
Limit merchandising selection: better vendors’ agreements and payments with low prices and high quality
Our strategy is to provide our members with a broad range of high-quality merchandise at prices we believe are consistently lower than elsewhere. We seek to limit items to fast-selling models, sizes, and colors. We carry an average of approximately 3,800 active stock keeping units (SKUs) per warehouse in our core warehouse business, significantly less than other broadline retailers. Many consumable products are offered for sale in case, carton, or multiple-pack quantities only.
Costco, like ALDI, does the opposite, praises itself for limited stock selection.
This allows Costco to get better vendors’ agreements, Costco customers might be happier to have less, but higher quality merchandise and it becomes way easier for Costco to manage that merchandising, which in comparison lowers its operational burden.
Online commerce to offer what’s not available in the warehouses
Online businesses provide our members additional products and services, many not found in our warehouses. Net sales for our online business were approximately 4% of our total net sales in 2017 and 2016, respectively, and 3% in 2015.
Even though Costco doesn’t focus on online sales, it uses it as a way to provide products and services that might not be available in its warehouses. This is a privilege that members enjoy.
Comparable sales growth as a primary business metric
Costco focuses relentlessly on sales growth, by looking at a simple yet effective metric: comparable sales growth.
This is defined as sales from warehouses open for more than one year, including remodels, relocations and expansions, as well as online sales related to e-commerce websites operating for more than one year.
Source: Costco annual report 2017
The power of the membership model to create a stable revenue stream that enhances profitability
If you want to want to enjoy the Costco experience, there is no way out than to become a member. Indeed, the member renewal rate was 90% in the U.S. and Canada and 87% on a worldwide basis in 2017.
Usually, those renew happen within six months following their renewal date. Memberships comprise four main categories
- Goldstar and Goldstar executive
- business, and business executive including add-ons
Memberships have been growing at a steady rate over the years:
Source: Costco annual report 2017
With almost fifty million paid members in 2017, most of them representing a good chunk of US households, membership fees have increased to over $2.8 billion in 2017:
Source: Costco annual report 2017
Why is this revenue model so interesting? For a few reasons:
- with a membership model, Cosco can pass part of the saving on the merchandise to its members
- at the same time, those members will spend more, and they will get more savings
- Costco will enjoy higher growth, and a stable stream represented by its members
- that stream can get invested to grow Costo even further
- while it will allow Costco to lower its prices further while keeping a high quality for its members
The membershipstream – also though it represents only about 2.26% of Costco net sales yet it carries high-profit margins.
Thus, on the one hand, Costco runs its primary business on tight margins, while it relies on fifty million members (and growing) that represent a stablestream for Costco business in the long run.
Bulk sizes make it easier to cross-dock while Costco sells more and members save more
Another key ingredient that it is essential to remark about Costco business model and business strategy is how it sells merchandise in bulk and larger quantity compared to other retail stores. This has a simple yet powerful logic:
- Costco gets better prices from manufacturers as it buys larger quantities
- it also sells more of that merchandise compared to traditional retailers
- at the same time members get lower prices at higher convenience
Summarizing Costco main business drivers
A few key drivers that Cosco leverages on for its future success are:
- increasing shopping frequency from new and existing members and the amount they spend on each visit (so-called average ticket)
- growing comparable sales by making available to Costco members the right merchandise at the right prices
- provide quality goods and services at competitive prices
- being perceived as a “pricing authority” (low price and high-quality merchandise)
- leverage on ancillary businesses to grow the sales of primary merchandise that carries higher profit margins (take the gasoline business which draws members to Costco warehouses)
- keep growing Costco warehouses
- membership format as an integral part Cosco business strategy with high profitability and a constant stream and
Business lessons you can apply to your company
- On top of your primary stream build a membership base: You can offer members exclusive advantages and offers in exchange for a small annual fee. This overtime will also enhance the sales in other areas of your business as members will be willing to buy more at a more convenient price
- Sell larger quantity at a lower price: either if you sell a physical good or an intangible service, you can sell them at higher volumes for a more convenient price. This will deliver more value to your customers while allowing you to get more sales
- Provide ancillary goods or services to sustain the sales of primary goods or services: we all like to talk about optimizing our business operations. However, at times to make money, you need to lose money on something else. In a way, this is a variation of the razor and blade business strategy. On the one hand, you sell a service where you don’t make money, while on the other side you sell a complementary good or service where you have high margins. This strategy can be applied pretty much to any business. For instance, imagine the case of a digital agency that sells a website design at a meager price by making it no profit on that. It will sell complementary digital marketing services that instead have a high-profit margin
- Use a single-step distribution strategy: distribution is a crucial ingredient to any business success. Rather than make it complicated try to simplify it to reduce the number of steps a service or product takes before it gets to the final consumers
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