costco-business-model

Business Strategy Lessons From Costco Business Model

Costco business model strategy can be summarized as a selection of high-quality items that get sold in bulk sized in warehouses around US and Canada primarily. 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 inventory 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.

There are also a few other interesting aspects of the Costco business model that we make it unique and make its value proposition compelling.

A glimpse at Costo 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 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 model 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 ability to move merchandise efficiently from manufactures to its warehouses allows the company to sell its inventory quickly.

Indeed, thanks to its memberships Costco knows for sure it will sell most of its inventory pretty 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.

It’s quite counterintuitive to think of as a strength the limitation in merchandising; Where other large players like Walmart and Amazon praise themselves on making available any merchandise.

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.

net-sales-costco

Source: Costco annual report 2017

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

membership-costco

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: 

membership-costco

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:

membership-fee-revenues-costco

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 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 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 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 about Costco business model is hot 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 model 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 the business strategies that Costco uses can also be copied and applied to your small or medium sized business. Below some business pills that you might want to test to your business, 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 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

Resources for your business: 

Handpicked popular case studies from the site: 

Related sidebar

Published by

Gennaro Cuofano

Creator of FourWeekMBA.com | Head of Business Development at WordLift.io | International MBA

Leave a Reply