Costco Wholesale Corp. (COST) has been around for almost 40 years and has transformed the way Americans do their grocery shopping. Today, the warehouse store is one of the largest retailers in the world with 663 stores across the globe. Why is Costco so successful? What differentiates the company from its competitors and why is its profit so small compared to Wal-Mart Stores Inc. (WMT)?

Memberships

Costco’s business model is called a subscription business model – customers who want to shop at the store must buy a membership (currently $55 in the U.S.) with the promise of lower prices to make up for the initial upfront cost. 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 in that a customer isn’t subscribing for goods, but rather, for a service. The service that Costco provides is its ability to use economies of scale to bulk buy a large amount of goods at low prices and then to pass these savings onto its customers.

Because a service is intangible, there needs to be a certain level of confidence or perception that the service being subscribed to is worth the cost. With Costco’s 91% renewal rates in American and Canada and 87% renewal rates internationally, it’s clear that customers consider the price-cutting service well worth the membership cost. (For more, see: Costco Just Extended Its Advantage Even Further.)

Consistently Low Prices

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 mark-up that an item has. Costco doesn’t publish its margin caps but, by looking through the company’s 2014 financial statements, we can see that for the past five years, their margins have held steady at about 10.6%. This means that for every $100 that Costco spends to buy its products, it’s selling them, on average, for $110.60.

The word average is important in that explanation. Costco has its own brand, Kirkland Signature, that does surprisingly well for a store brand. This label, obviously, earns a higher profit as there are less middlemen involved and Costco can charge a higher mark-up to account for its lower cost of obtaining the products. The 10.6% average mark-up therefore, includes the higher margins on Kirkland Signature brands meaning that a name brand product will sell for an even smaller margin than the 10.6% average. This is how Costco maintains its low prices: it makes virtually no money by selling name brand products. (See also 3 Reasons Costco Is a Great Company.)

Loss Leaders

Regular grocery stores will do this as their loss leader strategy: send out a weekly flyer with an amazing sale splashed across the front page – something like $1 per pound of blueberries – to entice shoppers to visit and, while they’re there, to buy other items with higher margins. This is why, around Thanksgiving, turkey falls to ridiculously cheap prices at every grocery store – because the stores have just doubled the prices of potatoes and cranberry sauce.

Costco doesn’t send out weekly flyers, however; instead, they use word of mouth advertising and keep the same loss leaders week after week. The biggest Costco loss leaders in America right now are rotisserie chicken, the hot dog & soda combo and gas. A Bloomberg article has calculated that Costco earns only $14 million in profit a year on its sale of 70 million chickens.

These chickens, placed deep into the store along with the cheap fruits and vegetables, mean that customers have to walk through lots of merchandise to pick one up – and hopefully along the way they’ll grab some other products to make their trip to Costco worthwhile.

High Wages

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 him. By removing some of the incentives a person would have to quit their job, Costco is able to reduce employee turnover and save money.

Few SKUs

Costco has a policy of carrying a lower number of products than traditional grocery stores. The benefit of having fewer SKUs (stock keeping units) is twofold. First, having fewer products to order, track and display means cost savings for Costco. Their warehouses stores’ space is limited and is packed to the ceiling with goods. A larger product selection would result in larger warehouse stores and more man hours required in order to organize, ship and negotiate prices for the products.

The second reason that Costco limits its SKUs is to increase its purchasing power. By having a limited retail space, suppliers must bid for Costco shelf space to get their products sold. This competition drives down the price and, since the supplier knows that the competition between brands will be almost nonexistent, the suppliers are willing to give Costco a better price to be the only ketchup or toothpaste brand 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. (See also, How Much Does a Costco Store Sell Each Year?)

The Bottom Line

Investors and analysts looking to Costco look at a company that doesn’t make a lot of profit but sells products like wildfire. How many retailers make the majority of their profit by selling the right to shop? How many retailers cap their margins to a bit over 10%, in addition to consistent loss leaders that drive customers into the store? How many retailers pay their staff, on average, over $40 000 per year, plus benefits? Costco has found it in its best interest to do all of this and, with the stock price and the number of stores worldwide continuing to increase, it’s clear that investors and consumers love Costco and its unique business model.

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