What we can learn from Costco
As long as it’s not the weekend, Costco might be one of my very favorite places to shop. On a recent trip to grab our family staples from paper towels to blueberries, I realized Costco was probably the only “large” store I enjoyed… again, as long as it’s not the weekend. I’m all about simplicity in most areas of my life, so Costco doesn’t actually fit in my typical shopping vibe. I like small stores, with just a few quality options. It’s not pretty, there are long lines, and you have to pay to get in the door. So what is it about Costco that they have such a loyal customer base, and what can we as founders and entrepreneurs learn from their success?
First and foremost, we want to recognize that on average, retail stores have one the lowest net profit margins of any industry. As a reminder, net profit is what’s left at the end of the day. All costs to produce and sell your products/services and all operating expenses of your business have been taken out of your revenues. A 2018 Deloitte Study found the net profit margin for retail stores to be 3.2% (anything below 5% is low), and Costco’s net profit margin to be below around 2%. So how can a 2% net profit margin be considered a success?
Costco has a simplified yet diverse revenue suite, which is a definite key component to long-term profitability. They combine a membership model (high profit margin) with retail sales - general and online (low profit margin). It’s simple, yet complex. To be able to even shop at Costco, you must be a member.
Membership retention is above 90%. A high retention metric typically reflects customer loyalty. The members find value in paying and renewing their membership fees. Retention rates above 90% typically represent the perceived quality of the product/service exceeding the membership fee. Your clients are happy, they stay with you. While membership revenue is a recurring revenue stream, which is always a good component of a balanced long-term financial strategy, it doesn’t always have to be your primary source of revenue. Costco’s membership is approximately only 2% of its total revenue, but it’s at a high profit margin. It’s important to realize that the membership model also dominoes into the success of its retail sales. And, fifty million members each year guarantee the company over $2.8 billion. So while a small percentage of revenue, it’s a large percentage of net profit. Not bad!
So how does Costco make its money? Its diversified revenue stream creates a balance of low and high profit margins. The company offers low prices to its members with a limited selection of nationally-branded and private-label products in a wide range of merchandise categories.
Costco makes most of its revenue by offering deep discounts (low prices) on its products to its members. They provide national and private labels of a wide range of categories to purchase in the store, and online. Interestingly in the era of online everything, Costco’s online sales are only around 3% of total sales. People want to go there. It’s true, there is a mindset of exclusivity when we have to show our membership card to walk in the door. But, members come for the discounts and the quality of the goods. So Costco doesn’t need to provide an experience to its members, no fancy stores, and no extra frills.
Costco has perfected its distribution system and cut out the middleman. They purchase most merchandise directly from manufacturers and route all items either directly to the store (their stores are their warehouses), or to a cross-docking consolidation depot. They’ve basically streamlined as much as possible in the distribution process to keep the product cost low, which they pass along to their customers. They also limit what they purchase to only high-selling models, sizes, and colors. Makes sense now, right?
There are so many detailed nuances that all contribute to why Costco is so successful, but there’s one more I must mention. There are two ancillary offerings that provide almost no profit margin: gasoline and pharmacy. Why would they continue to sell something that brings in no profit? The answer is simple. Selling gas and providing an in-person pharmacy allows Costco to attract people to its warehouses (have you seen the gas lines the last six months?!) Going to Costco is an “experience” for its loyal members. From purchasing their gas to stocking the car of merchandise. Costco leverages these sales not for profit, but to bring as many customers back to its warehouses consistently.
So what can we learn and apply from Costco?
Diversification of your revenue is important, but knowing the % of revenues and net profit of revenues is pivotal. What sells the most, what makes the most, and what brings your customer loyalty? Monthly Recurring Revenue is gold. But, you need to monitor your retention rate!
When you are in an industry with a low profit margin, it’s vital to build your business strategically for the long term, and stop looking for quick money wins. For example, If your business is labor heavy, like my business as a firm or agency, your profit margins are going to be lower than a business that doesn’t provide 1:1 services. That doesn’t mean you have to build a service outside of 1:1 work, but it does mean you need to know your numbers to make a profit and pay yourself and your team.
Sometimes we need to keep offerings even if they aren’t making a big profit. Know your customer cycle. Why do they come to you, and what makes them stay?
Simplification of your “back end” systems and processes are very important. Don’t make everything so complex. Use one, maybe two, payment processors. Automate your client onboarding process. Intentional and efficient marketing. Make sure your team makes sense, who’s doing what and why.
As a loyal Costco member, it has been so fun to dive deep into their business model. It’s given me insight into creative ways to utilize different revenue sources, and therefore makes me a better financial strategist.
