4 Problems With Costco's Business Model

Costco Wholesale Corporation (COST) is a solid performer. On Jan. 1, 2020, Costco's stock was trading below $300. Two years later, the company's share price nearly doubled. On top of this, Costco shares offer investors an annual dividend with an approximate annual yield of 0.53%, though Costco announced in April 2020 it would be increasing the dividend amount to $0.90 per quarter.

The retailer has a unique business model that could impact its long-term outlook, earnings, and share price. At its most basic, the company's approach is to keep prices so low that they are barely above cost and makeup on lost potential revenue by selling memberships. The company also sells some of its own brands and makes a little more on these items. It offers some things online, but the bulk of its business is in-person, in-warehouse sales. In a nutshell, Costco makes a lot of its money off of those memberships.

Key Takeaways

  • Costco has a business model that depends heavily on repeat shoppers buying memberships and retaining brand loyalty.
  • Like many other companies Costco is at risk of shifting customer preference. However, Costco's reliance on specific geographical regions heightens this risk.
  • Costco must compete with other membership providers in hopes of securing customer loyalty.
  • Costco is not an industry-leader regarding e-commerce capabilities, though it has made investments in the space to become more competitive.
  • Costco has begun expanding its delivery service to ensure better customer interaction with the sale of larger, bulkier goods.

So far, Costco has been very successful. The company boasts a membership renewal rate of 91% in the U.S. and Canada as well as 89% worldwide. In 2021, its members paid $3.9 billion in membership fees, up 9% from the year before. Company-wide net sales for the fiscal year 2021 were $192 billion, an increase of 18% from 2020.

Although Costco has experienced tremendous success, there are several risks to its business model.

1. Consumer Preferences

Changing consumer preferences could affect Costco. The company uses a warehouse approach as it buys certain items in large quantities and tries to sell them as quickly as possible. This method only works if it can maintain those high volumes. If consumer preferences change, Costco could be left with large amounts of unwanted, and possibly perishable, goods.

Costco is also highly dependent on the operational performance of specific segments. For example, the United States and Canadian operations comprise 86% of company-wide net sales. Specific to the United States, California operations comprise of 28% of U.S. net sales. Changes in these markets ranging from increased labor costs, energy costs, competition in these specific areas, or customer preference to even lower margin products expose the U.S. and Canadian operations.

2. Memberships

One of the biggest risks with Costco's business model is its dependence on memberships. This strategy works well as long as its members keep coming back and continue purchasing items in bulk as they have historically, but several issues could affect that trend. Customers could choose to move their memberships to a competitor, such as Walmart's Sam's Club. Membership costs—which range between $60 and $120 per year at Costco—are roughly the same at other wholesale retailers and the discounts are fairly similar as well. The only real difference is selection, and that is also tied to consumer preference.

Over 11 Million Members

At the end of 2021, Costco had 111,600,000 total members, and over 50 million cardholders paid for the Gold Star membership.

In Costco's annual report, it admits "membership loyalty and growth are essential to our business." Costco's Kirkland Signature brand generally carries higher margins than other national brand products, any loss of member acceptance or decline in memberships could adversely impact sales.

Costco's membership approach also poses a risk for self-cannibalization. The extent of membership growth is somewhat tied to warehouse openings in new markets. If Costco decides it more beneficial to open warehouses in existing markets, there's increased risk in decreased membership growth due to an already saturated market.

3. Omnichannel Experiences

Right now, most retailers are adopting an omnichannel focus, which offers the option to buy products online or in stores. Consumers today use different connected devices to shop online, research products, and compare prices. While Costco's emphasis on the warehouse allows the bulk discount retailer to keep prices very low, it does not really translate to the type of omnichannel experience many customers expect now.

Costco is making some investments towards that goal, such as by testing out curbside pickup in select locations, but there is no guarantee that those efforts will be successful or that the changes will be implemented in time for the company to remain competitive.

In addition, Costco has recognized the need for an online, e-commerce presence. Website sales grew 44% year-over-year from 2020 to 2021, largely due to the introduction of frozen grocery deliveries and improvements for delivery of bulky items such as appliances or furniture.

4. Bulk Items Delivered

When buying in bulk, transporting everything home can be a real problem. For people in urban areas who may be unable to park near their buildings or families with young children who may find transporting bulk goods too much to handle, it can be a deciding issue.

Costco offers some online services, but there are other discount bulk providers such as Amazon Prime that offer similar deals and free shipping. Amazon offers Prime membership, which includes free shipping, streaming video, and several other benefits, for $139 per year.

Although it is investing in its digital presence, Costco only carries up to 11,000 unique SKUs online. Still, the company acquired Innovel Solutions in 2020. Now rebranded as Costco Wholesale Logistics, Costco has the ability to potentially scale last-mile delivery — specifically for large bulky products that may require white-glove service.

What Type of Competitive Strategy Does Costco Have?

Costco's competitive strategy is to drive customer loyalty through memberships. Members are often loyal to Costco's brand, even if its Kirkland Signature brand charges higher-than-average margins compared to other national brands.

What Are the Chief Elements of the Strategy That Costco Wholesale Is Pursuing?

Costco has recently turned its attention to the e-commerce space. By expanding its capabilities of delivering goods and increasing the number of products that can be purchased online, Costco is strategically positioning itself to adapt to the digital approach of generating sales.

How Well Does Costco Link Its Mission and Strategy With Its Philosophy and Values?

Costco's mission is to continually provide members with quality goods at the lowest prices possible. It is investing in warehouses around the world, promoting the value of household memberships, and expanding its digital presence, As Costco's strong stock market performance has indicated, the company is linking it's values and strategy well.

What Competitive Threats Does Costco Deal With?

There are other membership-style companies that Costco must rival to garner customer loyalty. In addition, larger online retailers may have greater digital capabilities such as larger inventory or greater delivery capacity.

Article Sources
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