Costco Wholesale (NASDAQ: COST) has become one of the world’s most successful retailers. Shareholders have reaped huge rewards over time, as Costco stock has soared 72,600% since going public in the early 1980s.
A big part of Costco’s popularity has come from the fact that you can get just about anything you want there. The warehouse retailer is probably best known for its cost-conscious rotisserie chickens and hot dog meals. Customers also like to stock up on essentials like toilet paper while they’re shopping, and the company’s outside gas stations offer an inexpensive way to fuel up after making the drive.
Yet much of the fun of shopping at Costco comes from the wide assortment of product releases you’ll find. Everything from furniture to gold bullion is finding a place online and on warehouse floors.
It’s natural to assume that Costco’s profits come from its decisions to stock popular merchandise. Yet retailers across the industry know how hard it is to keep margins wide, especially on commodity items that are easy to get anywhere. That’s why the true secret of Costco’s success comes from one simple decision that nearly all of its customers take for granted — yet which contributes the vast majority of its profits each and every quarter.
Selling stuff doesn’t make Costco much money
Costco sells massive amounts of products every year. Once you add up a billion rolls of Kirkland Signature Bath Tissue, hundreds of millions of chickens, more than a ton-and-a-half of gold bars, and the rest of the company’s sales, Costco brought in $237.7 billion in product sales in fiscal 2023.
Yet Costco’s business strategy isn’t to make a huge amount of money on selling products. Instead, it sets prices low in order to encourage volume purchases, even though it means settling for razor-thin margins.
Adjusted gross margin at Costco was just 10.6% in fiscal 2023 when you look solely at merchandise sales and costs. When you include marketing and general overhead expenses, plus Uncle Sam’s cut in income taxes, Costco’s profit margin last year was just 2.6%.
Paying to get in the door
Of course, given how much Costco sells, 2.6% of a big number is nothing to shake a stick at. Costco’s profits in fiscal 2023 amounted to $6.29 billion.
As it turns out, though, $4.58 billion of that profit — 73% of the total — had nothing to do with product sales. That money came from the membership fees that customers pay just to enter Costco’s retail warehouse locations.
Costco currently charges $60 annually for a regular Gold Star membership. This includes two membership cards for access to members of your household, along with the right to make purchases at the retailer’s Costco.com e-commerce website. Alternatively, an executive membership is available for $120 per year, which includes benefits and discounts on a number of services, as well as a 2% annual reward on most purchases.
Costco has held the line on its membership fees for over six years now, and many now anticipate a further increase. In the past, the warehouse retailer has typically implemented price increases every five years or so. The key is to ensure that any price increase properly balances extra revenue from a higher fee against the risk of having customers choose not to renew their memberships at an elevated cost.
Using what you pay for
Costco’s membership model was innovative when it first started. But it makes sense: Once customers shell out for access, they’re going to want to make the best use of it they can. Together with all the other tactics Costco uses to get customers in the door and keep them there to make big purchases, membership has proven to be the key driver of the warehouse retailer’s competitive advantage and a big part of the reason for its impressive share-price gains over the decades.
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Costco Sells Everything From Gas to Gold Bars. But It Gets 73% of Its Profit From Somewhere You Wouldn’t Expect. was originally published by The Motley Fool