Costco’s business model: How Costco makes money

Charlie Munger is a fan of Costco. In fact, Costco features in Charlie Munger’s portfolio of just three stocks. In a Daily Journal annual meeting in 2017, Munger said that he’s comfortable with having a concentrated portfolio. He believes diversification is for investors who do not know anything about the stock market.

So, what makes Costco such a compelling investment that such an astute investor like Charlie Munger would invest in it? Let’s look at the company’s business model to understand Costco further.

Business model

Costco Wholesale operates membership warehouses. You can get items in bulk at rock bottom prices. This place is not for the faint hearted. Snickers are sold in boxes instead of bars that you find at normal grocery stores. They also sell everything from apparels, electronics, furniture, jewelry, optical glasses, gas for your car — you name it, they got it.

To gain access to deals in Costco’s 140,000-square foot warehouses, you will need to purchase an annual Costco membership. They have two tiers of membership – a basic and executive plan for consumers/businesses, which cost $60 and $120 respectively.

Each member is entitled to issue a free supplementary card to a member living in the same household or to a fellow staff working in the same company. In 2020, Costco had a total of 58.1 million paid members and 105.5 million cardholders.

Over the past decade, the number of paid memberships has grown from 31.6 million to 58.1 million. Renewal rates are consistently above 89% in the U.S. and Canada, and 85% worldwide, giving Costco a steady source of recurring revenue. Although Costco’s membership fee revenue of US$3.5 billion pales in comparison to merchandise revenue of US$163.3 billion, most of it flows down to Costco’s operating income of US$5.4 billion. Because, come on… how much could it cost to run a membership scheme?

Overall, Costco’s revenue, including the sale of merchandise, has more than doubled from US$78.0 billion in 2010 to US$166.8 billion in 2020. The wholesaler has also gone from a lonely warehouse down in Seattle in 1983 to 803 locations worldwide.

Economic moat

Costco is the cost leader of its industry. The business thrives on selling products that are cheaper than what you can find anywhere else. However, Costco does not cut prices at the expense of quality and profitability to gain market share, but through cost optimization and economies of scale, passing down savings to their members in the form of lower prices.

Prioritizing the interests of its customers has garnered Costco millions of loyal members. It caps markups on national brands at 14% and on their house brand, Kirkland, at 15%. Because of this, Costco members reap the immediate benefits of any increase in volume discount the wholesaler gets from their suppliers.

For example, this article writes: ‘Not long ago, Costco was selling Calvin Klein jeans for US$29 a pop — already US$20 less than almost anywhere else — when a change in its purchasing deal meant Costco could get them for even less from the vendor. Instead of keeping the extra profit from the improved deal, it lowered the jeans’ price to US$22.’

Costco’s emphasis is on selling only inventory that have high sales volume and rapid turnover, and holding not more than 3,700 stockkeeping units in their warehouse. (Compared to Walmart’s 29,000 to 142,000 stockkeeping units.) Having US$145 billion dollars of cost of goods sold in 2020 coming from the sale of 3,700 different items gives Costco the upper hand when negotiating volume discounts with suppliers.

Furthermore, since Costco’s inventory flies off the shelves – with a cash conversion cycle of no more than 6.7 days in the past ten years, the wholesaler can take advantage of early payment discounts. Typically, it is 2/10 net 30 days. This means that Costco will receive a 2% discount on their purchase if they clear their invoice within 10 days.

To get the best prices, Costco cuts out the middleman and purchases directly from the source. Goods are delivered straight to their warehouses or are consolidated at one of their depots before it gets distributed to Costco warehouses within 24 hours. Everything is stored in their no-frills warehouses, each literally 140,000 square feet of space filled with towering shelves. Costco uses the bottom racks for retail and stores excess inventory above, pretty much like what you see at IKEA.

Costco has a powerful strategy in place that widens their cost advantage as they grow. Members shop frequently at Costco to recoup their membership fees from the savings they get. The increase in demand, in turn, drives the wholesaler to expand its presence and purchase more goods from suppliers. From there, they will gain an economy of scale and lower their prices, and the cycle repeats.

Risks  

Naturally, the biggest risk is the threat of e-commerce players like Amazon. According to Business Insider, Costco beats Amazon 80% of the time when they compared prices of 100 items across four areas: household staples, baby and pet, beauty and toiletries, and health between the two retailers. So far, e-commerce is not a threat to Costco. It’s going to be a challenge to turn a profit for e-tailers to ship bulky goods and sell them cheaper than Costco. At the same time, investors need to be watchful as Amazon has the scale, money, and resources to directly price compete with Costco if they choose to.

The fifth perspective

Costco is a low-cost leader in an industry that is largely resistant to economic recessions. In fact, people are more likely to shop at Costco when they need to tighten their purse strings! Costco’s membership revenue also gives you a predictable stream of recurring income and sets a sizable floor to the company’s revenue.

At the same time, the threat of e-commerce cannot be dismissed. But as long as Costco is able to offer some of the lowest prices that one can find for consumer staples and essential services, it’s hard to beat what Costco has to offer for the cost-conscious shopper.