How Costco created a membership-based retail business?


The retail business sounds boring, right? It’s just buying from a manufacturer and then selling to the end consumer, which is you and I. But it’s actually not that simple. In fact, if you ask me, the retail business is a fascinating one. And what Costco does is even more fascinating because it’s different from all of the other retailers.

Basically, Costco sells products at almost breakeven and then makes all of its profits from a $60 annual membership fee that it’s charging its customers. The key is that the company keeps its gross margins very low, which in turn gives Costco pricing authority because they sell a lot of volume and they’re able to provide customers great breaks.

People don’t even look at the price when they’re shopping at Costco because they know that it’s going to be the best out there. The company is able to do this because of its meticulous merchandise sourcing strategy. Costco maintains around 4000 SKUs or different products in store if you compare it to Walmart, Walmart has about 100,000 different SKUs.

So which means that Costco has a narrow focus and this allows the company to have more leverage over it’s suppliers because they sell a lot more volume for each of these narrow set of products that they keep in the stores. For merchandise Costco’s gross margins are around 10%.

So when you buy any product, let’s say for $100 at Costco, it typically would have cost the company $19 to purchase. On the other hand, Target and Walmart, two other retailers have a 30% and a 25% gross margin respectively. This means that the same $100 product that you bought at Costco would cost around $115 at Target and $112 at Walmart.

So you get worst prices at these two companies. On top of this, the inventory management done by Costco is very, very impressive. Costco’s cash conversion cycle is four days. This means that in four days, Costco goes from inventory in its stores to cash in the bank.

This is quite good for a physical retailer. Some retailers, like Dollar General, have a cash conversion cycle of more than 30 or 40 days. So Costco has a 25 to 20 day advantage over these other retailers. Right. So they can buy more inventory, make more sales, gain the customers trust. And this cycle keeps on going on and on.

Finally, let’s look at the percentage of net income that Costco earns from its membership fees. Let’s take 2021, for example. In 2021, the company’s total net income was about 5 billion, and the membership fees that it collected were 3.8 billion. So even though membership fees only made up 2% of the overall things that the company did, they make up 80% of Costco’s net income.

So even though membership fees only made up 2% of the overall sales of Costco, they make up 80% of Costco’s net income. Along with that, they also contribute about 60% to Costco’s operating income, which is substantially great considering that it’s only 2% of their overall sales.

The company has more than 60 million paid members as of 2021. Each of these members pay them an average of $60 per year. Golf course business model is to sell products for as low margin as possible so that they can  aggregate the demand and then go to their suppliers and get better prices from their customers.

In total, Costco annual membership fee of $60 to get access to these better prices. That’s it. That’s how simple it is. But no other company in the world has been able to replicate this till now.