Costco: An Amazing Business Model

Some businesses have remarkable business models. One such business is Costco Wholesale Corporation (NASDAQ: COST). In this article, I am going to discuss why Costco’s business model and operational philosophy make it an elite company.

Costco provides a very clear description of itself in its third quarter 2023 earnings report. Costco says that it “operate[s] membership warehouses based on the concept that offering members low prices on a limited selection of nationally-branded and private-label products in a wide range of merchandise categories will produce high sales volumes and rapid inventory turnover.” Let’s look at this in more depth.

As of last May, Costco has 582 warehouses in North America, Europe, and Asia. The vast majority are in the United States (68.8% of the warehouses) and Canada (12.6%). Although Costco’s warehouses are very large (averaging about 146,000 square feet), it doesn’t try to compete by offering the largest selection of products possible. Instead, it limits the number of different products it offers. Costco warehouses offer less than 4,000 stock keeping units. In comparison, an average Walmart supercenter carries about 120,000 stock keeping units, an astounding 30 times more!

Why does Costco keep a tight limit on the number of different products it offers? What are the advantages of this? Well, there are multiple. To begin with, it helps to with inventory turnover. Costco has plenty of data from past experiences to allow it to know what items its members want to buy, and by having a more selective offering, it can focus on carrying only items which are in very high demand. Many retailers which offer a wider selection of items end up with a significant amount of underperforming inventory which takes up valuable shelf space and ends up having to be discounted. Costco’s approach allows it to significantly reduce this type of situation happening at its warehouses. Costco’s inventory turnover ratio is 12.17, much better than Walmart (8.20) or Target (5.70) and even still significantly better than competing member warehouse retailer BJ’s Wholesale Club (10.86).

Additionally, having a more limited assortment can help to reduce costs. By having a smaller selection, Costco can buy the items it does carry in greater quantities, giving it greater ability to negotiate lower prices with suppliers. Having fewer different items also can make logistics and inventory management more streamlined and efficient. Even unloading cargo and moving it to its designated place in the warehouse is a more efficient process than it would be if Costco had a greater number of different items.

The greater inventory turnover and increased efficiency which come from having a more limited selection both help Costco to reduce costs, which is essential for its business. Costco is able to pass these savings onto its customers, allowing Costco to offer lower prices than many of its competitors. Offering lower prices is the primary draw for Costco, helping it to convince people to signup for its memberships. Without these cost savings, Costco’s entire business model would be severely disrupted.

Costco doesn’t just focus on its members. Costco also puts an emphasis on trying to be a good employer. Costco focuses on offering competitive pay and benefits as well as career advancement opportunities. This helps Costco to be able to retain employees, which reduces the cost of hiring and training new employees. Having more experienced employees who generally are happy with their work leads to a more productive workplace and better customer service. In turn, this helps to create a positive shopping experience for customers, offering another reason why people choose to become a Costco member.

Low prices and a positive shopping experience aided by helpful staff members are two big draws for Costco that help it attract members. And attracting members is the cornerstone of Costco’s strategy. Unlike most retailers, Costco requires people to purchase a membership to shop there. At the end of the third quarter in fiscal year 2023, Costco had 69.1 million paid members. The membership fees that Costco collects allow it to be highly profitable even while having low margins on the goods it sells. In fiscal year 2022, Costco generated $4.224 billion in membership fees. Considering that selling memberships should have incredibly high margins, the majority of Costco’s operating income of $7.793 billion comes from membership fees.

The ability to earn substantial sums from membership fees allows Costco to operate differently than most retailers. It can prosper even when it has miniscule margins on the goods it sells. Furthermore, Costco benefits from a reinforcing cycle, in which collecting membership fees allows Costco to offer low prices on goods, and offering low prices on goods helps to entice more people to become paying members, which helps them to offer lower prices, and so on.

Costco’s business model also makes it less susceptible to disruption by Amazon and other ecommerce companies. Costco does run an ecommerce operation, but the vast majority of its sales still come from in-store sales. As previously explained, Costco’s business model allows it to sell goods at low prices, prices which ecommerce companies struggle to match. It is, in my opinion, very unlikely that any ecommerce retailer will be able to equal or beat Costco on pricing anytime soon. As long as Costco maintains its pricing advantage, Costco will offer a compelling proposition to consumers and should be able to defend itself against competition from ecommerce retailers.

Another benefit that Costco’s business model presents is that it shouldn’t be as susceptible to economic downturns. Due to its low prices on goods, many consumers shop at Costco to save money, including on essentials such as groceries. Many members would be reluctant to give up their membership even during difficult economic times since they view their Costco membership as a way to save money.

Costco’s business model gives it the ability to undercut on price many competitors while still making a healthy profit thanks to membership fees. It also helps Costco be resilient to competition from ecommerce as well as during economic downturns. In sum, Costco’s business model is remarkable. Combine its business model with strong execution from management and it is no wonder that Costco has more than doubled the S&P 500’s return over the past ten years.

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