In this segment of Business Breakdowns, Namaan Mian and Jenny Rae Le Roux dive into the genius behind Costco’s business model. From its razor-thin margins to its strategic membership fees, they explore what makes the warehouse giant an unstoppable force in retail.
Each leader shares the three key metrics they would prioritize if they were running the company—covering everything from customer retention and inventory turnover to revenue per square foot.
Whether you’re a business enthusiast, an aspiring consultant, or just curious about what keeps Costco thriving, this conversation is packed with actionable insights and behind-the-scenes strategies you don’t want to miss.
Business Breakdowns drops on the 1st and 3rd Wednesday of each month. Loving it or have ideas to grow the segment?
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Transcription: Costco Business Model Breakdown
I notice when I'm in a room with students, and I say, what's a business that you admire?
And they say Costco, but they have the star in their eye. But what they aren't thinking about is how would they make Costco better? How would they improve what Costco is doing today?
How do you build the Costco of 2030? And what does that look like? And I get really excited when I think about how it would not just be to evaluate Costco as a business today, how to think about buying a stock in Costco, but how to think about shaping the future of Costco.
That's what this episode is all about. So whether you're preparing for a case interview, you want to know a little bit more about business, whether you're on the job and trying to understand how business managers manage, or if you want to just understand business metrics and a fun business like Costco, we're super glad that you're here. Let's dive in.
We're doing a business model breakdown for Costco today. And honestly, it's pretty easy to fangirl or fanboy Costco, but there are a lot of ways that Costco under the hood has both a ton of superpowers, but also opportunities for growth. And that's what these business model breakdowns are all about.
So we're going to take a look at the business overall. We'll take a look at what kind of business model Costco uses. We'll take a look at some of the key metrics that we would be managing to if we were in leadership at Costco, if we were advising Costco.
And then finally, we'll end with a hot take. I'm here with my colleague Namaan. Namaan, welcome.
Let's jump in. Here we go. We're going to talk a little bit about just the high level data for Costco.
Costco in their most recent fiscal year, which ended September 1st, 2024, had $249.6 billion in revenue. Not too shabby. Costco also had a gross income of $27.267 billion, and then annual operating income of $9.285 billion.
The categories that Costco sells in, and I think this becomes really important when we talk about the business model later, are number one, their largest category are foods and sundries. That does not include fresh foods. Their second largest category are non-foods.
They are the underwear and the Lego and the other items that you see when you first head into Costco. Number three are the fresh foods. This includes milk and vegetables.
And then number four are the ancillaries. That includes Costco gas, Costco optical, Costco travel and more. And so what's really interesting when we kind of start to break this down is that you see some of the mix of Costco, how they've been managing over time, and what's growing.
Just a couple of other fun facts about Costco. Costco has 891 stores, 614 of those are in the US. And to my surprise, 277 of them were international.
I kind of thought that they were much more US dominant than that. That means that their revenue per store is around $280 million. And we're going to dive into some more of the metrics as we talk through the details.
So for now, Namaan, I'll throw it over to you. What's the business model of Costco and why should people care?
Yeah, absolutely Jenny Rae. Costco is a fantastic business. There's a reason it was one of Charlie Munger's favorite businesses.
And as we started to take a look at Costco's business model, it became apparent that Costco is primarily a variable cost-based business. And what this means in plain terms is that there's an incremental cost to every product that Costco sells that they have to account for. And so they are really paying attention to margins and pricing on each individual product that they're moving through their stores.
So are there fixed costs at Costco? Absolutely, there are. But what's the primary cost driver that Costco is paying attention to?
It's the variable cost line. So with that being said, I took a look at Costco and put myself in the shoes of the CEO, the advisory board, even an investor, and thought through if I had some influence at Costco, what are the three metrics that I would be managing to and paying attention to the most? And here are the three that I identified.
Metric number one that I would be paying attention to for Costco. Membership growth, renewal rate and mix. I was stunned when I found this out, Jenny Rae.
So Costco at the end of 2023 had 71 million paid members worldwide. 73% of Costco's gross profit comes from its membership fees. Membership fees make up 2% of revenue, yet contribute 73% of gross profit.
That was stunning to me. And Costco in the last 10 years has almost doubled its membership while retaining a 90% renewal rate. So the first thing that I'd be paying attention to if I was at Costco is how do I continue to grow membership and how do I continue to retain the members that I already have.
The third kind of subcategory underneath membership that I'd be paying attention to is membership mix. So Costco has different tiers of membership. And there's a standard tier and there's an executive tier.
More than half of Costco memberships are at the highest executive tier, which is $130 a year membership fee, versus the standard tier, which is $65 a year. So when you can continue to move members from standard to executive, you are doubling your margins right off the bat. And you're also incentivizing those customers to spend more.
It has proven that executive members spend more than standard members because they get a 2% rebate on every purchase that they make. And Costco has done the math to realize that they spend more than 2% incrementally than the standard members do, so that they are increasing the margin and the value that they extract from that executive customer. Now, along with membership growth, renewal rate and mix, you have to make sure that you are increasing continually or at least maintaining the value or the perceived value of that membership.
And the way that Costco does that is by keeping prices low. And the way that Costco keeps prices low is that it caps the gross margin that it extracts on third-party products to 14%. And it caps the gross margin that it extracts on Kirkland brand products to 15%.
So this keeps costs low. Costco has put an artificial cap on the gross margin it can extract from every single product inside of its store. This keeps costs low, and it enhances, therefore, the value proposition of the membership.
It also keeps supplier relationships strong, because Costco isn't as incentivized to push people to its own branded products the way that a Walmart or a Kroger or a Target or another store would be. So, when you think about Costco's secret sauce that you mentioned, Jenny Rae, a big part of that is its warehouse distribution model. It's also its strong supplier relationships, and that contributes directly to the value proposition of the membership itself.
So, that's metric number one. Metric number two that I'd be paying attention to is shopper traffic and spend per visit. So, a little bit of just historical context for you.
In the quarter that ended on June 30th, shopper traffic was up over 6% year-over-year. And if you strip out the US and Canada, you'll find that shopper traffic was actually up 7.5% year-over-year. So, if I'm at Costco, I'm looking at the US market, and I'm starting to try and pay attention and figure out, have I reached a saturation point in North America?
And does it make sense for me now to prioritize other international markets to expand to next? So, I'd be looking at shopper traffic by region, and I'd also be looking at spend per visit. Right now, the average spend per visit at Costco is around 150 US dollars.
But what I don't know and what I want to know is, how often do members visit, and what percentage of members come more than once a week? Can I target those members with special offers, with some kind of retargeting based on purchase history, to increase the spend per visit for those members even higher than the average? The third and final metric I'd be paying attention to if I was at Costco would be inventory per store.
One of the things that's unique about Costco is that it maintains a limited overall inventory per store. It's only around 4,000 products. And this is orders of magnitude less than similar stores that have similar or even larger retail footprints.
So way less SKUs per square foot. And so what Costco does is it cycles in enough new products to keep members coming back. It gives you this adventurous experience when you walk into the store.
What's new here out of the limited selection that's at Costco? And the metric that Costco uses to determine which products stay and which products don't are really how fast they can cycle through a 30-day inventory cycle. On average, Costco moves an inventory shipment through its stores in around 27 days.
So it takes them 27 days to sell a month's worth of procurement. And their suppliers are on net 30 payment terms. So Costco doesn't have to up front necessarily put up the money for the inventory that it's procuring.
By the time it comes time to pay suppliers, they've already moved all of that inventory and product. So it minimizes their inventory costs and they're also technically making a little bit of money on that three day float. So if your profits are good on a per product basis, you can then really focus on volume, getting more people in the store, purchasing more products because you know that you've got a set margin on each one that's healthy enough.
So those are my three metrics that I'd be paying attention to for Costco. Jenny Rae, how about you?
Namaan, like you said before, I think Costco is super misunderstood because I think people look at these big warehouses and they look at the piles of inventory and they think that's a really expensive business to operate, must be a fixed cost business. And I am really impressed when I look at some of the metrics of Costco on how they have managed to their core metric, which is the gross margin per product. And then therefore, once you've managed that, you have a decent gross margin, you just push volume, you just push volume all day long.
And so when I look at some of the metrics that I care about, I'm actually thinking about ways that if I were advising Costco today, not 10 years ago how they got to where they are today, but today forward, what are some of the things that they need to improve on? What are some of the things that they need to double down on? What are some of the ways that they need to make sure they're enhancing their business?
So number one for me is e-commerce as a percentage of revenue. Costco cites that they have 19% growth in e-commerce, and I bet that's off of a base of like a million dollars, right? A tiny, tiny amount of overall revenue.
They don't actually disclose it in their 10K, but I'm imagining it's a very small percentage of revenue, and I think this is a big opportunity for Costco. Whether it is buy and reserve to pick up in store, whether it is buy and have a shopper pull it for you, and then you pull it at the entrance, whether it is shipped to home, I think there is a major opportunity to enhance the consumer experience and to grow the share of wallet of the things that you're purchasing in your life to get more from Costco. I'm a Costco member and I've only been a member for the last year and a half.
I became a member because of their travel program and because of their rental car discounts. I found that they had the most attractive rental car discounts. I do not visit the store incredibly often.
I'm not necessarily their typical customer, but I'm drawn in by gas. Oh, I need to grab gas. Costco is a good place to grab gas, and I'm drawn in by the seasonal items, but I'm kept away by the hassle of going through a Costco shopping experience.
And so I think there are some customers that they could really gain share of wallet from if they enhance their e-commerce experience. Number two, their profit per item. This isn't something that they're not managing to today, but I think that they're managing each on the each margin basis, but not necessarily on the dollar cost per item basis.
And I would like to understand that 10 percent of a $4 product is 40 cents. What I'm the most interested in is making sure that people walk out of the store with my 20 and my 30 and my $50 items because if I'm getting 10, 11 to 15 percent on every item, I want the more expensive items inside their cart. And so while Costco does, I think, a masterful job having a few loss leaders, I would really optimize my floor plan, my marketing for those more expensive dollar items to try to drive up overall basket size, but recognizing that actually the dollars that they spend are much more important than the percentage margins overall that we get.
And if you've already maximized or optimized for percentage margin, you focus on the dollar per item. They don't disclose what the average price per item is. I would estimate from being a Costco shopper, that's somewhere in the 10 to $20 range.
But again, like then you're just trying to get more of those items in, but you're definitely trying to get a $20 item. If I'm picking a $20 item in lieu of a $10 item. The third thing that I think is super interesting that I would manage to is their percentage of what I would call staple versus seasonal items.
So if you look at their fresh foods business, that's traditionally going to be a pretty low margin business, probably in the couple percentage range. Low, you know, five or under percent range. That is, as a whole, their smallest category, but it's also been growing.
Their non-foods business, which I would imagine, is their highest portion of their business by profit percentage, right? That's where you're going to have your Costco tables that are 50 bucks that cannot cost anywhere near, you know, $42 to $45 to procure for them. You've got, you know, your clothing items, right?
Which are probably on the order of a couple of dollars, and then they're passing them off to you for the $20 mark. Those are going to be at the higher end of that margin line. And I would imagine that the more that I can get somebody to opt in to those, the better.
So the percentage of staple versus seasonal items, when a customer is walking out of the store, how many things did they come in for regularly that they're rebuying? If they're Costco, you know, the 10 Costco snacks that they always keep in their pantry, that they're rebuying every month, and the groceries that they're planning to use and cook for the month versus the things that I got them to buy that they weren't coming in for, that I'm trying to pull quick inventory turns on.
I think they already do a masterful job of that. A lot of write-ups about Costco say, you know, it's about $100 per grocery visit, and then $25 to $50 for the extras that you didn't know you wanted before you walked in the store. I think there's still growth opportunity there.
And I would really think about how to merchandise, productize, market, and to use these alternative channels. I feel like Costco's off-line channels and cross-channel promotions are incredibly weak, and that would really be where I would focus on driving increased basket spend. What are your hot takes, Namaan, on Costco?
Do I have a hot take for Costco? I don't know if it's a hot take, but it is a prediction, and it ties into the metric that you mentioned earlier. Costco has a robust US warehouse and distribution system set up.
That can really drive and facilitate e-commerce growth. And I think what you're going to start seeing in the next 12 to 36 months is that Costco dramatically slows down its expansion of physical stores in the US and reinvest that capital into e-commerce capability.
My hot take for Costco is that Costco pickup is going to become a thing. And I don't think this is just because I hope that Costco pickup is going to become a thing. I think that Costco pickup is an opportunity for Costco to utilize their stores to increase their inventory turns even faster than where they are today.
And I think it will create an opportunity. I think Costco has incredible leverage with their customers. You do not have to do Costco pickup for a gallon of milk.
What you should do it for is large basket items. If you buy $500 or more at Costco, you don't have to go into the store. And I can imagine watching some of the customers in the store that that could be very attractive.
I think it would really push them to get into better e-commerce delivery, better recommendation algorithms, better purchase history algorithms. Once I've bought a wreath one year at Costco in October, I should buy a Christmas item and they should be presenting exactly the same type of thing and price point to me the next year. If we have repetitive customers, we shouldn't think about it on a week or a month basis.
We should think about it on an annual basis. And I think that creating a pick up system to drive more throughput through the stores is really going to push them to accelerate that e-commerce capability. So that's all for Costco.
I mean, it's not all for Costco because there's a lot more that we could talk about. But we're curious, what do you think about Costco? Do you like them?
If we gave you a case study on how to make Costco better, what would be your point of view? How would you think about it? What metrics would you care about?
What data would you want to go get? And how would you make recommendations to improve the business? That's fundamentally why these business breakdowns are powerful, because we're not just thinking about why you should buy stock in Costco or not.
We're thinking about from a leadership perspective, standing from where we are today for the next one to two to five years. What would you do differently? And this is an opportunity for you to hone your business acumen, to prepare for case interviews and to get ready for life on the job.
Thanks for joining.