Costco is a crazy business


Emailed on October 11th, 2019 in The Friday Forward

In one of the more interesting Twitter threads I've read in a while, investor Ryan Reeves breaks down the business model of your dad's favorite store, Costco.

You know that pack of 37 protein bars you bought for the price of 12? Costco broke-even on those. Their margins are only 11%. So when you bought those bars for $10, it cost the retail giant $9.

So how does Costco make money? A few things...

Annual membership fees

They make all their gross profit from the $60 annual membership fee you paid them. This covers that dismally low gross margin (for comparison Walmart's is 25%, Target's is 30%). 

Extremely high inventory turnover

Costco's low prices produce high sales volumes and *very* high inventory turnover. This allows Costco to maintain lower margins than anyone else. The inventory turnover is so high that Costco typically sells goods before they are required to pay the suppliers for them, even while taking advantage of early payment discounts.

All that s*** you don't need is just advertising

When you walk in to Costco and see a 70" tv for $300 less than what you saw at BestBuy, it's just reinforcing the idea that you will not find a better price on *anything* anywhere else other than Costco. You'll renew your membership. 

In fact, "Membership renewal rates stand at about 90% in the U.S. and Canada, and they did not materially differ from this level during the Great Recession. On a global basis, renewal rates stand at about 86%…"

Pricing authority

That high inventory turnover also gives them tremendous negotiating power with suppliers. Costco's aggregated demand can be leveraged against suppliers to dictate pricing terms. But even when they lack leverage, like when supply and demand curves take charge, the annual membership fee also allows them to keep prices low and temporarily absorb negative gross margins when competitors have to raise prices.

Last fun fact for your Friday: Membership fees only make up about 2% of sales but normally a little bit more than 100% of profit. The company has more than 53 million paid members, of which 37% are executive members.

This means Costco will haul in about $4.3 billion in membership fees, about 110% of its net income for 2019.

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Sean Steigerwald