Costco\'s Unique Business Model PDF

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Case Study of Costco's Unique Business Model...

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How Costco's Unique Business Model Resulted In Global Success In this strategy study, we’ll take a look at how Costco pioneered the business model, what elements make it as successful as it is, and why it allows Costco to do things other retailers simply can’t or won’t do. Written by Cascade Team July 13, 2021

Costco is the third biggest retail player in the world - behind only Walmart and Amazon. Yet there is something very unusual about the retail giant. Costco makes way less money per a sold product compared to other retail stores. The company’s average gross profit margin in 2020 was only 11.2%. That’s way lower than your average retailer gross margin that ranges from 20% all the way to 50% for department stores. E.g. Walmart’s average margin in 2020 was 24.1%. In fact, Costco even loses about $40 million a year on their $5 roasted chickens alone. It also doesn’t have nearly as many stores as other big retailers, yet it outperforms everyone but Walmart. Costco has “only” 803 stores around the world, while Walmart has 11,443 stores, Schwarz Group, which is behind Lidl and Kaufland, has 12,500 stores, Kroger has nearly 2,080 stores and Target has 1,897 stores. So how can Costco be so successful? After all, the company boasts:      

$163.22 billion net sales in 2020 9% increase in annual sales from 2019 to 2020 273,000 employees Stores in 12 countries 100+ million worldwide members A 91% membership renewal rate in the U.S. and Canada and an 88% renewal rate worldwide

Members - that’s Costco’s secret. Their warehouse retail stores are membership-only and that’s the foundation of their extremely successful business model. Costco’s story is a masterclass of thinking outside the box and creating win-win scenarios which satisfy customers and employees while achieving the company’s business goals.

It all begins with a warehouse club Costco’s story begins with Price Club which was founded in 1976 by Sol Price and his son Robert Price. The store introduced a brand new concept - a retail warehouse club. In order to shop there, you had to be a member.

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At first, Price Club was limited exclusively to business members, who could purchase a wide range of supplies and wholesale items. But after a while, it opened up its membership to employees of local businesses, non-profit organizations, and government. One of the people who were instrumental in fine-tuning the new warehouse club concept was Jim Sinegal, the executive vice-president of merchandising, distribution, and marketing. He was previously employed by Sol Price and was familiar with the Price Club business model. Seven years after the first Price Club store, Sinegal used his expertise to co-found Costco Wholesale with Jeff Brotman, and together they opened the first warehouse in Seattle, Washington in 1983. In 1993, Costco and Price Club agreed to merge operations since Costco's business model and size were similar to those of Price Club, which made the merger more natural for both companies. Costco has transformed the retail world as the world's first membership warehouse club for the wider public which accepted non-business members. While the idea of charging people to shop in your store seemed very bold and was not followed by any of the retail giants, it proved to be the right move. It allowed Costco more efficient buying and operating practices while giving the members access to unmatched savings. Costco’s operating philosophy has always been simple: Keep costs down and pass the savings on to our members. People loved the concept, which resulted in Costco’s meteoric rise. By the end of 1984, 200,000 people held Costco memberships and Costco soon became the first company ever to grow from zero to $3 billion in sales in less than six years since its inception. The annual membership of Costco’s first Seattle store back in 1983 was $25. The cost of a membership nowadays is $60, which is around the same as it was back in 1983 once adjusted to inflation.

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Costco’s membership trend In 1993, Price Club and Costco merged into Price Costco and thus created the world's most successful warehouse club. In 1999 the name of the company was changed to Costco Wholesale Corporation and remained as such until this day.

Key takeaway #1: thoughtful innovation pays off Costco’s innovative membership model paid off because it offered members substantial benefits that offset the initial membership price. At the same time, it provided Costco with an additional source of income that fielded its growth.

A successful global expansion Before Costco's international expansion, there was quite some doubt whether the innovative Costco retailing strategies would result in success outside the United States. Target's exit from Canada in 2015, Tesco's shutdown of its U.S. Fresh and Easy chain, and Walmart's store closings in Brazil in 2016 show that being successful on the global market is not given even for the biggest retail players. However, Costco's expansion, which began in 2013, succeeded in ways that Target, Walmart, and Tesco failed to achieve. By March 2021, Costco is present in 11 countries outside the US and Puerto Rico. Costco membership sign ups in the first 8 to 12 weeks of a new store opening overseas are generally 10 times greater than at Costco store openings in the United States. Additionally, the company’s international membership renewal rate was 88% at the end of 2020. While many other retail chains open international locations as a defensive strategy in order to shore up declining sales, Costco isn't compensating for domestic weakness. Costco's

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international expansion came in the middle of high profits in the U.S. market, allowing the company to focus on a long-term international strategy and to test if its business model would be well-received in other markets. And talk about great reception! In 2017, before Costco opened its doors in Iceland, one out of eight Icelanders had already signed up for membership. On the opening day, search-andrescue teams were deployed to manage the crowds. Perhaps even more impressive is Costco’s opening of its first store in mainland China in Shanghai in 2019. On an opening day, 139,000 people got their Costco membership. The store even had to close early on the first day due to traffic jams caused by crowds of shoppers and three-hour wait times just to park.

Key takeaway #2: universally understood benefits drive global expansion Costco’s operating philosophy “Keep costs down and pass the savings on to our members” proved to be universal regardless of nation, race or religion. Its business model is appealing no matter the country. Now let’s see what exactly makes Costco’s business model so successful.

Understanding Costco’s business model The basics Costco’s mission is “to continually provide members with quality goods and services at the lowest possible prices.” This mission statement is directly linked to its business model and strategy. It emphasizes quality and cost leadership, which are two factors that top consumer’s priority charts. While they might seem mutually exclusive, Costco is known for both. Costco is primarily a big-box store. Such stores achieve economies of scale by focusing on large sales volumes and are meant to be a one-stop shop for customers. Establishments like Costco took “the one-stop shop” bit a step further and don’t offer just groceries and store products, but also a food court, optical services, gas stations, tire garages, or photo processing services. Big-box stores typically carry items in extra-large sizes and lure customers with the promise of saving by buying in bulk. Costco is no exception - real bargains can be had by purchasing bulk non-perishable items or items with long shelf life. As a result, Costco’s generic strategy is cost leadership. This strategy entails maintaining the lowest prices possible and is used by many retail giants. However, Costco’s strategy incorporates the warehouse club membership business model, which differentiates it from other retailers and enables Costco to offer lower prices than its competitors.

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Costco is so effective because its revenue is broadly divided into two streams:  

Product sales, which is revenue from all the sales of goods and services through all Costco’s channels. Membership fees, which is revenue from Gold Star, Business and Executive memberships to customers worldwide.

This is a very basic overview of Costco’s general business model. Now let’s go into more details and look at some specific elements - starting with the core of the business model, Costco’s membership.

Costco’s membership As said, Costco uses a membership-only warehouse club business model, which means consumers pay a membership fee to access the low-cost products available at Costco stores. Each member is entitled to issue a free supplementary card to someone living in the same household or to a fellow staff member working in the same company. Non-members may accompany members, but only members are allowed to purchase products in stores. In 2020, Costco had a total of 58.1 million paid members and 105.5 million cardholders. Costco has two tiers of membership – basic and executive plans for consumers and businesses. Basic plans cost $60 per year, while Executive plans cost $120 per year. Executive members get an annual 2% cashback on their purchases (up to $1,000 per year). This makes executive membership an enticing offer for people who often shop at Costco and there’s plenty of them. In fact, 39% of members pay $120 for the Gold Star Executive membership.

These membership fees actually represent the majority of Costco's operating profit. Yes, Costco makes most of its money by selling access to affordable products and not by selling those products. In 2019, Costco made $3.35 billion from membership fees, an increase of 7% from the previous year. Its entire net income for the year was $3.66 billion. Costco’s membership is also a powerful play on the human psyche. Once a customer pays the membership fee, it treats it like a sunk cost. The investment has been made and now it is

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time to get value from it. Because of that, customers will make additional trips to Costco to make sure they get value from their investment. While other retailers need to worry that a decline in same-store sales will lead to collapsing profits, Costco doesn’t really face this problem. Its profits are mostly dependent on its memberships, which are getting renewed on an extremely high basis (91% in the US and 88% internationally). Obviously, such high renewal rates aren’t a coincidence. Costco does reinvest the membership fees into low prices for customers and by doing so ensures that everyone wins. We’ll talk more about product prices later on, but now let’s see what kind of people Costco wants for its members.

Target market: suburban homeowners From the very beginning, Costco targeted relatively affluent and college-educated customers who would understand the value of membership. A typical Costco shopper is an upper-middle or upper socioeconomic class and has an income of about $93,000 a year. But if Costco employs a cost leadership strategy, why does it target relatively wealthy people? Well, while all shoppers like a bargain, Costco’s customers also have the means to buy in bulk, which is the only way one can buy most products Costco stocks. While the price of an individual product generally is the lowest around, shoppers usually have to buy at least a three-pack, which means that the average transaction total is quite high. That also explains why the vast majority of Costco stores are located in affluent suburban areas both in the U.S. and around the world. It’s hard to make the most of a Costco membership if you’re renting a small flat as it takes a lot of space to store bulk purchases. That’s why a typical shopper is a suburban homeowner. Speaking of buying and selling in bulk - that is also an important part of Costco’s business model.

Bulk purchasing Product quality is a crucial aspect that Costco focuses on for driving growth and maintaining customer loyalty. Instead of selling a hundred thousand different products as most other retailers, Costco’s merchandise is limited to under 4,000 items (for comparison, Walmart sells over 142,000 SKUs in each of its supercenters). This allows Costco’s procurement team to rigorously screen each product in order to provide the best quality and the best price to members. Each item Costco sells is meticulously selected. As a result, consumers don’t suffer from choice paralysis and can always rely on Costco for selling quality products. Because of the lower number of options, each option has a higher perceived quality and is more likely to sell, which allows Costco to order more stock and thus lower the product’s

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price. Remember that Costco is selling most products in bulk packaging, so shoppers can’t buy just one cereal box but have to get 5 or them - which complements Costco’s ordering model. Costco also sources its products directly from manufacturers which eliminates intermediaries and further lower prices for the customers. By selling products in bulk Costco entices customers to buy large quantities of items. The perception of getting a deal often negates the fact that one may not even need all the products. Customers believe they're saving more money by spending more money, which leads them to spend more in the long run. According to Perfect Price’s research from 2015, customers spend by far the most money per shopping trip when visiting Costco compared to other retailers. Here are the top 10 stores where customers spend the most per shopping trip: 1. Costco, $136 2. Sam’s Club, $81 (similar membership model) 3. Target, $62 4. HEB, $59 5. Stop & Shop, $56 6. Wal-Mart, $55 7. Meijer, $54 8. Whole Foods, $54 9. Trader Joe’s, $50 10. Kroger, $50 There’s another part of Costco’s business model we haven’t mentioned yet that makes big purchases less risky.

Best in class refund policy Costco has a very liberal return policy where customers can return almost anything they have purchased at any time. Even their membership. On Costco’s website it says: “We are committed to providing quality and value on the products we sell with a risk-free 100% satisfaction guarantee on both your membership and merchandise.” Having such a liberal return policy is almost necessary if you want to entice shoppers to try new products which they can only buy in bulk. If you know you can return anything if you don’t like the first product in the box of ten, you’ll be much more inclined to buy something new. And yes, members can also claim a refund on their memberships at any time if they are not satisfied with the service, which means anyone can try shopping at Costco risk-free.

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There was even a case of a woman who successfully returned a Christmas tree 10 days after Christmas because the tree was dead.

Efficient inventory management and warehouse design From a logistics standpoint, Costco is one of the most efficient retailers in the world. This is because of two factors: inventory management and warehouse design. Costco uses its warehouse-style stores as retail and storage spaces in one. It utilizes crossdocking, which means that products from a supplier or a manufacturing plant are distributed directly to the retail chain with marginal to no handling or storage time, which reduces inventory management costs and storage space costs. Costco also displays goods in their shipping pallets, instead of arranging individual items on shelves, which further reduces inventory costs. Costco’s warehouses are strategically designed to make restocking as easy as possible. Warehouse design allows forklifts to restock the store, which also makes it easier to rotate seasonal products and enables the treasure-hunt experience. This purposeful design saves both time and costs. The combination of impeccable inventory management and warehouse design also allows Costco to utilize the just-in-time stocking principle, which is a management strategy that has a company receive goods as close as possible to when they are actually needed. Once you combine everything mentioned thus far in this chapter, you can see why Costco can cut prices even lower and pass on the savings to their members, thus attracting more membership sign-ups and directly increasing their bottom line. However, their store design serves yet another purpose. “Costco doesn’t use any fancy decor or lighting, instead, they make sure that their store resembles a warehouse with exposed beams, pallets, and simple metal shelving,” says Mark Ortiz, a marketing expert and founder of Reviewing This. “This is smart because it tricks the consumer into believing that they are purchasing goods at low prices. Logically, you would think, less money spent on decor equals less overhead cost equals the opportunity to lower your prices.” The warehouse design is a part of “the Costco Experience”, which Costco is famous for, which shouldn’t be neglected when talking about their business model. Let’s see what the famed experience is all about.

The Costco experience and Costco culture Shopping at Costco is often called “The Costco experience”. As offering superior customer experience is the key to customer loyalty, Costco does its best to be an experience in itself. By putting customers first in every choice and innovation, Costco continues to build its loyal customer base

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Consumers go crazy for a deal, and Costco has designed its entire strategy around this core tenet. A good deal “feels like winning,” says Bob Nelson, the senior vice president of financial planning and investor relations at Costco. And Costco would like their members to feel like they’re always winning, even if this means resisting the urge to raise prices and increase profits. James Sinegal, Costco’s co-founder and former CEO, once talked about how once Costco was selling Calvin Klein men’s jeans for $29.99 a pair. The pants were selling faster than Costco could stock them, and when he bought another shipment for $22.99 per pair, it was ultra-tempting to charge more. However, Costco stayed true to their philosophy of passing the savings to their members and sold the jeans for $22.99 per pair. Making sure that the customers get the best deal at Costco is an integral part of Costco’s culture. Besides providing an exceptional shopping experience, Costco is also famous for an employee-focused organizational culture, which we’ll explore later. The combination of cost, generous return policy, and satisfied employees resulted in a shopping experience that many customers get addicted to. It was believed at the company that culture is not the most important thing, but the only way forward. Costco saw promoting its core values as the only recipe for success. Maintaining integrity, passion, motivation, and customer trust is what enables Costco to outdo its competitors. Shopping features aside, there is something more to Costco that cultivates such a loyal customer base. "Costco relaxes my soul," says John, the founder of the I love Costco blog. "I do love that everyone at Costco appears to be relaxed humans,...