How Costco Makes Money (COST)

Costco Wholesale Corp. (COST) has been around for almost 40 years and has transformed the way Americans do their grocery shopping. With a market capitalization of $100.24 billion as of Dec. 12, 2018, Costco is one of the largest wholesale brands in the world with 663 locations globally. Costco announced Q1 2019 earnings on Dec. 13, 2018. The wholesale retailer reported revenues of $35.07 billion this quarter, compared to $31.81 billion over the same time last year.

Costco's dividends have grown year-over-year since the company began issuing them in 2004. So what is it about Costco that makes it successful? In this article, we break down Costco's business model and address why, despite years of continued growth, the wholesaler's profit margins remain so low.

Costco runs on a "subscription business model," that is, customers who want to shop at the store must buy a membership in order to do so. Memberships, which run at $55 per year at the time of writing, make up for their cost by offering customers lower, wholesale prices for goods. But Costco wasn’t the first company to implement this business model. Newspapers, gyms, and telecommunication companies also earn their money from subscriptions.

Costco is different from other subscription-based businesses, however, because its customers aren't subscribing for goods — they are subscribing for a service. The service that Costco provides is its ability to use economies of scale to bulk buy large quantities of goods at low prices in order to sell them back to customers for cheaper.

Unlike a good, a service is intangible. That means there needs to be a certain level of confidence about the service in order for it to be worth the cost (in Costco's case, $55 per year). With Costco’s 90% renewal rates in North America and 87% worldwide, it’s clear that customers consider the price-cutting service well worth the membership cost.

Costco members know that the warehouse store has consistently lower prices when compared to traditional grocery stores. While other stores may have occasionally lower prices on their loss leaders, Costco has permanently capped its margins to ensure that members can justify paying for a membership.

What are capped margins? A capped margin is a maximum price markup that an item has. Costco doesn’t publish its margin caps but, by looking through the company’s fiscal year 2017 financial statements, we can see that they are operating at a margin of 11.4%, down 2% from 2016. That means for every $100 that Costco spends to buy its products, it’s selling them, on average, for $111.40.

The word average is key to that definition. Costco maintains its own brand, Kirkland Signature, that earns the retailer a higher profit margin because there are fewer middlemen involved in production. That means that Costco's 11.4% profit margin actually isn't quite right for many brand name products. In reality, the brand name products at Costco are sold at a much lower profit margin than the 11.4% average, but that average is offset by the Kirkland Signature products sold at a higher profit margin.

This distinction gets at how Costco maintains low prices — the company makes little to no profit selling brand name products while bolstering its business with the Kirkland Signature brand.

Regular grocery stores run their businesses on a loss leader strategy. You are likely familiar with this business model, even if it's the first time you're reading that term. At the end of the work week, grocery stores typically send out a flyer with advertised specials and coupons, say $1 per pound on blueberries. (If only.) The end goal for grocery store owners is to bring shoppers into their store and sell them other items at higher price margins. That's why turkey prices fall ridiculously low around Thanksgiving time — because stores are doubling the prices of sweet potatoes and cranberry sauce.

Costco, by comparison, doesn’t send out weekly flyers. Instead, the company uses word of mouth advertising to keep the same loss leaders week after week. Costco's biggest loss leaders in North America right now are the company's rotisserie chicken, hot dog and soda combo, and gasoline. Costco sells approximately 60 million rotisserie chickens every year, according to a recent report from NPR, but only makes $14 million in profit from them — less than $4 per bird.

The idea is that no one goes to Costco just for a rotisserie chicken. And even if they do, Costco hopes to derail those plans by selling its chickens deep in the store, usually alongside cheaper fruits and vegetables. In order to further cut costs, Costco recently announced plans to open its own farm-to-table chicken farms in Nebraska that would supply 40% of the company's needs.

Costco is well-known for paying its employees high wages. In America, a Costco worker earns, on average, about $21 per hour and receives health benefits, ample vacation time, and a 401(k) match. As illogical as it sounds, Costco’s high employee wages are part of its cost-savings plan. With employees earning a decent wage, they are more productive and less likely to quit.

Employee turnover is a huge cost of business. Between being short-staffed and the associated costs of finding and training new employees, it can cost a company between 40-150% of an employee’s annual salary to replace them. By removing some of the incentives a person would have to quit their job, Costco is able to reduce employee turnover and save money.

Costco has a policy of carrying a lower number of products than traditional grocery stores. The benefit of having fewer Stock Keeping Units (SKUs) is twofold. First, having fewer products to order, track, and display means cost savings for Costco. Despite the sheer size of Costco stores, the space in their warehouses is actually fairly limited with goods often packed to the ceiling. In order to expand its product selection, Costco would need larger warehouse stores and more employees to organize, ship, and negotiate prices for the products.

The second reason that Costco limits its SKUs is to increase its purchasing power. Due to limited shelf space, suppliers must bid for Costco shelf space to get their products sold, which in turn drives down the price of goods. Brands are willing to drop their prices to get in the door of Costco because they know they may be the only brand of ketchup or toothpaste sold in the store. This lower price ultimately brings in more consumers looking to purchase the products for less money than they would spend at a traditional store.

Investors and analysts don't turn to Costco because the company turns high profits — it doesn't. They turn to it because the company fulfills a market niche. Ask yourself: how many retailers do you know of that make the majority of their profit by selling the right to shop? How many retailers cap their margins at just over 10% and build their business on consistent loss leaders? How many retailers pay their staff, on average, over $40 000 per year, plus benefits?

For now, the only answer to all of those questions is Costco. The company has clearly found its lane since its Sept. 15, 1983 founding and is only expected to expand in the coming years. With the company's stock price and international locations growing year-over-year, it looks as though Costco has figured out to retain store members and market investors, alike.