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.

Costco Memberships — Costo had 65.8 million paid members in 2022, compared to 61.7 million in 2021 and 58.1 million in 2020.

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.

aldi-business-model — By the end of World War II, Theo and Karl Albrecht took over the small grocery store of their mother to make it become one of the most successful discount supermarket chains in the world. ALDI operates according to the motto “the best quality at the lowest price.” The company generated €24.2 billion in revenues in 2020.

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.

costco-financials — Costco generated almost $227 billion in revenue in 2022, compared to nearly $196 billion in revenue in 2021, and over $166 billion in revenue, in 2020. Costco also generated $5.84 billion in net income in 2022, compared to $5 billion in 2021 and $5 billion in 2020.

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:

costco-membership-revenue — Costco generated $4.2 billion in membership revenue in 2022, compared to $3.87 billion in 2021 and $3.54 in 2020.

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

Costco is a giant, and for a small business, it is hard to relate to it.

However, with a better look, you realize that Costco’s business strategies can also be copied and applied to your small or medium-sized business. Below are some business pills that you might want to test for your business, and where it makes sense to do so:

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.