Business Strategy Lessons From Costco Business Model

Costco’s strategy can be summarized as a selection of high-quality items sold in bulk sized in warehouses around the US and Canada primarily and with a substantial part of its business focused on selling merchandise at a low-profit margin. Costco also uses a single-step distribution strategy to sell its inventory before it gets paid to suppliers. Costco generated almost $227 billion in revenue in 2022, of which $5.84B came from 65 million paid members.

History of Costco

Here is the story of how this retail behemoth carved out its own niche in what is an extremely competitive market.

Price Club

Price Club was founded in 1976 by Sol Price who, with brother Robert, raised $2.5 million to build a retail store which initially catered to business customers only. This later expanded to employees of local businesses, government, and non-profit organizations.

Back then, consumers paid $25 annually to purchase bulk products at discount prices in a basic, warehouse-like environment.

Price Club expanded to 94 locations across North America and by 1992, reported revenue of $6.6 billion and profit of $134 million.

The original Price Club store in a converted airplane hangar in San Diego, California, still operates to this day under the Costco banner.

Costco is founded

Costco was founded seven years after Price Club by Jeffrey H. Brotman and James D. Sinegal. The similar warehouse-style retailer was launched to take advantage of strong industry growth and later became the first company to reach $3 billion in sales in under six years.

The first store opened in Seattle in 1983, and by the end of 1986, it boasted 17 locations, 1.3 million members, and 3,740 employees.

Merger

Price Club merged with Costco in 1993 after Price himself declined an offer from Walmart to be incorporated into the Sam’s Club chain. The merger was a natural fit for both companies since each had a similar business model and maturity level.

The subsequent company became known as PriceCostco, but consumers with a Price Club membership could shop at Costco and vice versa. Around this time, the first locations were opened in the United Kingdom and then in South Korea.

In 1994, Sol and Robert Price left the company to start PriceSmart, a warehouse chain for the Central American and Caribbean markets.

Rebranding

Costco launched its Kirkland Signature private label in 1995 – a highly successful brand emblazoned on everything from batteries to cashew nuts that today accounts for around $58 billion in sales. The Kirkland brand was named after the location of the company’s Washington State headquarters.

Three years later, PriceCostco became Costco Companies, Inc., and all remaining Price Club stores were rebranded.

The company also introduced its Executive Membership where members could earn a 2% reward on eligible purchases and access additional benefits.

Existing Costco locations retain many of the characteristics of Price Club stores.

Each warehouse is sparsely decorated, but the company has remained committed to low prices and also pays its employees an attractive wage.

Costco business model at a glance

Costco’s business model and business strategy can be summarized as a selection of high-quality items sold in bulk-sized warehouses around the US and Canada.

With a substantial part of its business focused on selling merchandise at a low-profit margin, Costco also had 65.8 million members in 2022. 

Which generated $4.22 billion in revenue for the company in 2022. 

Membership revenue has been consistently increasing over the last few years. 

Costco also uses a single-step distribution strategy that allows it to sell its inventory even before it gets paid to suppliers.

Just like ALDI tries to keep its prices as low as possible, Costco managed to do so by deliberately lowering its profit margin 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 few other interesting aspects of the Costco business model make it unique and make its value proposition compelling.

A glimpse at Costo’s business model few key ingredients 

The value proposition of the Costco business model is quite strong. The company offers low prices to its members with a limited selection of nationally-branded and private-label products in a wide range of merchandise categories. 

While those items will produce high sales volumes, they will also be driven by fast inventory turnover.  

Costco offers merchandise in a few key categories: 

• Foods which comprise dry foods, packaged foods, and groceries
• Sundries which comprise snack foods, 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

Let’s see the critical ingredients of Costco’s business model and business strategy success, starting from how the company manages its inventory.

High inventory turnover: the key is cross-docking and single-step distribution channels

Costco generally sells inventory 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’s ability to move merchandise efficiently from manufacturers to its warehouses allows the company to sell its inventory quickly.

Indeed, thanks to its memberships, Costco knows it will sell most of its inventory pretty quickly. Thus, inventory losses (shrinkage) are well below typical retail operations.

Indeed, where in 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 at Costco warehouses, they don’t need many repackaging or complex and expansive operations.

Rather the merchandise gets 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 with 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 gas to stocking the car of merchandise.

The two primary ancillary businesses Costco leverages 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.

It’s quite counterintuitive to think of as a strength the limitation in merchandising.

Whereas other large players like Walmart and Amazon praise themselves for making available any merchandise.

Costco, like ALDI, does the opposite and praises itself for limited stock selection.

This allows Costco to get better vendor agreements, and Costco customers might be happier to have less.

Still, higher quality merchandise becomes way more accessible 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 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.

The power of the membership model to create a stable revenue stream that enhances profitability

If you 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% worldwide in 2017. 

Usually, those renewals 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: 

With almost 66 million paid members in 2022, most of them representing a good chunk of US households, membership fees increased over the years.

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 revenue growth, and a stable revenue stream represented by its members
• that revenue 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 membership revenue stream – also though it represents only about 2.26% of Costco net sales yet 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 stable revenue stream 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 on about Costco’s business model and business strategy is how it sells merchandise in bulk and in larger quantities 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’s main business drivers 

A few key drivers that Cosco leverages 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’s business model and business strategy with high profitability and a constant revenue stream

Business lessons you can apply to your company

• On top of your primary revenue 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 reasonable price.
• Sell larger quantities at a lower price: if you sell a physical good or an intangible service, you can sell them at higher volumes for a more reasonable 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 discuss optimizing our business operations. However, you need to lose money on something else to make money. 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; on the other, you sell a complementary good or service with high margins. This strategy can be applied pretty much to any business. For instance, imagine a digital agency selling a website design at a meager price by making 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 crucial to any business’s 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.

Key Highlights

• Business Model: Costco’s business model revolves around offering a selection of high-quality items in bulk-sized quantities through warehouse-style stores. The company focuses on selling merchandise at low-profit margins and relies heavily on its membership model for revenue.
• History: Costco’s roots trace back to Price Club, founded in 1976 as a warehouse store catering to business customers. Costco was founded in 1983 by Jeffrey H. Brotman and James D. Sinegal, following a similar warehouse-style approach.
• Merger: Price Club and Costco merged in 1993, creating a natural fit due to their similar business models. The merged entity became PriceCostco, later rebranded as Costco Companies, Inc.
• Kirkland Signature: Costco introduced its private label brand, Kirkland Signature, in 1995. This brand has become highly successful, accounting for a significant portion of the company’s sales.
• Inventory Management: Costco employs a single-step distribution strategy that allows it to move merchandise efficiently from manufacturers to warehouses. Cross-docking consolidation points play a key role in this process.
• Limited Merchandise Selection: Costco limits its merchandise selection to fast-selling models, sizes, and colors. This strategy helps the company negotiate better vendor agreements and manage its inventory more effectively.
• Ancillary Businesses: Costco leverages ancillary businesses like gas stations and pharmacies to attract more customers to its warehouses, enhancing the overall shopping experience.
• Membership Model: Membership is central to Costco’s strategy. Members pay an annual fee to access the store, and the high membership renewal rate provides a stable revenue stream for the company.
• Bulk Sizes and Value Proposition: Selling items in bulk quantities allows Costco to negotiate better prices with manufacturers and offer cost savings to its members. The company focuses on providing high-quality products at lower prices.
• Comparable Sales Growth: Costco’s primary business metric is comparable sales growth, which measures sales from warehouses open for more than a year. This metric reflects the company’s success in attracting and retaining customers.
• Online Commerce: While Costco’s primary focus is on its physical warehouses, it also uses online commerce to offer products and services that may not be available in-store.
• Expansion and Membership Growth: Costco’s strategy includes ongoing expansion, increasing membership base, and enhancing shopping frequency and spending per visit.

Business Model Recap

Element	Description
Value Proposition	Costco offers a range of value propositions for its customers: – Low Prices: Costco is known for offering low prices on a wide range of products, providing value to its members. – Membership Benefits: Costco provides exclusive membership benefits, including access to discounted prices, special offers, and access to Costco’s private-label products. – Quality Products: Costco emphasizes quality, offering a selection of high-quality brands and its private-label brand, Kirkland Signature. – Large Selection: Costco offers a wide selection of products, including groceries, electronics, appliances, home goods, and more, meeting diverse customer needs. – Efficient Shopping: The company’s efficient store layout and bulk packaging make shopping convenient for families and businesses. – Customer Service: Costco is known for its excellent customer service and hassle-free return policy.
Core Products/Services	Costco’s core products and services include: – Retail Products: The company offers a variety of products, including groceries, electronics, appliances, clothing, home goods, and more. – Kirkland Signature: Costco’s private-label brand, Kirkland Signature, features a range of products known for quality and affordability. – Membership Programs: Costco offers membership programs, including Gold Star and Executive memberships, providing access to exclusive deals and benefits. – Gasoline Stations: Many Costco locations have gasoline stations offering fuel at competitive prices to members. – Optical and Pharmacy Services: Some Costco locations provide optical and pharmacy services to members. – Travel and Services: Costco offers travel deals, auto and home insurance, and other services to members.
Customer Segments	Costco’s customer segments include: – Members: The primary customer segment consists of Costco members who pay an annual fee for access to exclusive benefits and discounts. – Families: Families and households looking for savings on groceries, household items, and more. – Small Businesses: Small business owners and operators often shop at Costco for bulk purchases of products for their businesses. – Individual Shoppers: Individual shoppers seeking value and quality products also make up a significant portion of Costco’s customer base. – Senior Citizens: Senior citizens appreciate the savings and services offered by Costco. – Organizations: Some organizations and institutions, such as schools and non-profits, shop at Costco for their needs.
Revenue Streams	Costco generates revenue through several revenue streams: – Membership Fees: Costco earns a substantial portion of its revenue through membership fees paid by Gold Star and Executive members. – Product Sales: The primary source of revenue comes from the sale of retail products, including groceries, electronics, and more. – Private-Label Sales: Revenue is generated from the sale of Kirkland Signature products, known for quality and affordability. – Ancillary Services: Some revenue is earned through services like optical and pharmacy services, gasoline sales, and travel deals. – Online Sales: Costco generates revenue through its e-commerce platform, offering products and services to online shoppers. – Global Expansion: Costco’s international presence contributes to revenue through its global retail operations.
Distribution Strategy	Costco’s distribution strategy is designed for efficiency and value delivery: – Warehouse Stores: Costco operates large warehouse-style stores with efficient layouts, offering a wide range of products at low prices. – Private Label: The company promotes its private-label brand, Kirkland Signature, alongside well-known brands, providing a value-oriented option for customers. – Membership Model: Costco’s membership model ensures customer loyalty and recurring revenue while offering exclusive benefits. – Bulk Packaging: Many products are sold in bulk packaging, allowing customers to buy in larger quantities at lower unit prices. – Online Shopping: Costco offers an e-commerce platform, allowing customers to shop online and have products delivered to their homes. – Global Expansion: Costco has expanded globally, operating stores in multiple countries, providing access to a broader customer base.

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