The Economics of How Costco is Beating Amazon
Spoiler alert: the secret is in their business model
Amazon is killing retail — but not Costco.
Amazon has disrupted the traditional retail sector with its e-commerce platform that has forced thousands of retailers to file for bankruptcy and has caused revenues to decline.
Just last year, April 2, CNBC reported that online shopping overtook a major part of retail for the first time. The total share of online sales rose from below 5 percent in the late 1990s to about 12 percent in 2019; according to the commerce department.
Today, this figure has risen to 16.1 percent representing $4.206 trillion of the $26.074 trillion value of the retail market in 2020; according to data collected by Emarketer.
Despite all these boring data which proves that Amazon and e-commerce are slowly killing the traditional retail sector, Costco is still going strong and it’s attracting and delighting even more customers and investors. Here’s how they are doing it…
The Greatest Business Model Ever?
It all starts with Costco’s amazing business model.
Unlike most retailers, Costco is a retailer that runs on a subscription-based business model. Rather than Costco spending a lot to get you into their stores, you pay them to enter their stores.
“Costco’s ability to grow and attract new members without expensive advertising is one major attribute that makes it one of the best retailers around.” — Investopedia
This creates a magical effect that heavily benefits Costco and its shareholders. When you pay for their membership, you make a commitment to the brand.
Why else would you shop at any other retailer when you have already paid for your membership at Costco? You would be wasting your money if you shop anywhere else since you’ve already paid for their membership.
This might seem like a liability for the customer but Costco’s low prices, high-quality products, amazing customer service, and delicious free tastes significantly makes up for the cost.
This doesn’t just create a commitment with existing customers, it also creates brand loyalty because customers are getting so much value from Costco’s membership program.
Another benefit of this amazing subscription-based business model is that Costco can sell at a ridiculously cheaper price than its competitors.
Money.com (2019), states that Costco often operates at very low margins since it sells products at a cheap price. It can do this thanks to the revenue it generates from its membership program.
Costco has developed a reputation for having consistently lower prices than it’s competitors, it has something called “price authority,” meaning it can rely on consumers to steadily continue signing up for memberships.
Most of the time, Costco sells products at basically wholesale prices or extremely low markups wherein they almost don’t reap any kind of profit.
The revenue they gain from the membership fees is pure profits for the company. It only has a fractional cost to print the physical cards and hire customer service agents — so Costco keeps almost 100% of what you pay to join their club.
Key Takeaway: Costco’s subscription-based business model allows them to retain customers, build loyalty, and provide customers with extremely low prices with solid profits.
Employees Are Assets Not Liabilities
According to Investopedia, Costco pays its employees with a starting pay of $11.50 per hour, which is close to other retailers, but the average employee wage at Costco is around $20 per hour.
The national average wage for a retail sales worker is just $11.39. In addition to high wages, the vast majority of Costco employees also get company-sponsored healthcare.
They can pay employees this much because their employees are productive and generate a lot of revenue for the company.
According to this data from YCharts, Costco almost triples the revenue it generates from its employees compared to its competitors. These great numbers are mostly due to Costco’s business model.
When compared to big-box retailers, Costco’s warehouses require far fewer employees to operate. They generate so much from so little which amplifies their ability to pay these few employees with higher wages.
This makes employees happy which makes them productive. With productive and happy employees comes amazing customer service and overall great customer experience which keeps customers coming back.
With more customers wanting to come back comes more revenue and with more revenue comes higher wages for employees and you already know what happens next when employees have high wages.
Key Takeaway: Costco treats its employees as an important part of its success that’s why it has amazing employees who provide customers with an amazing shopping experience.
Treasure Map
When you first enter a Costco store you either have a well-planned list of items you are going to purchase or you go full in, either way, Costco gets you to spend more.
This is because of the layout of their stores. Their layout encourages you to walk through the entire store, they put all of the necessities such as food that everyone needs way back at the end of the store.
That way you will need to pass all of the aisles first wherein they will softly kill you with all of the great deals that you will need to pass through.
This would seem that it should annoy shoppers as they unconsciously waste a lot of time at a retail store, but it does not.
You see, when shoppers at Costco walk through every aisle they don’t even think about how much time they are spending there because instead of feeling like they are wasting time, Costco’s shoppers feel like they are constantly hunting for treasure and great deals.
Key Takeaway: Costco gets you to spend more by putting all of the essentials at the other end of the store so that you’ll need to pass through everything else they sell.
The Power Of Kirkland
Here’s how Costco can provide customers both affordable prices and high-quality.
Costco doesn’t just provide you with the best and most affordable prices, they also provide you with only what they believe as high-quality products.
Unlike other retailers where they offer customers with hundreds of brands for one type of product, Costco only aims to provide you with one or two choices that they deem as high-quality.
Besides making their shelves a scarce resource for brands, according to Investopedia, the average income of Costco’s shoppers is around $93,000 and if you’re a brand, you’ll be fighting for a chance to have these high-income customers to see and buy your products, right?
Well, that’s what is happening at Costco, multiple brands are fighting for so few spaces on Costco’s shelves and they want it bad. Costco’s customers aren’t just high-income individuals, they’re also extremely loyal customers thanks to their subscription-based business model.
This is where Kirkland comes in…
Since multiple brands are fighting for so few shelve space, Costco has the upper hand in every negotiation that happens. Costco uses this negotiating power by requiring those brands to lower down their proposed prices and increase the quality of their products.
The scarce shelve space and high-income customers aren’t the only tools that Costco uses to attain negotiating power.
If brands do not want to comply with Costco’s low price and high-quality requirement or Costco doesn’t see your product as high-quality, then Costco will just make their own better version through its Kirkland brand!
Those brands just lost the opportunity to have Costco’s high-income and loyal customers to buy their products, they lost the opportunity of having their product be perceived as high-quality, and they missed out on potentially being the only few options on Costco’s shelves.
This is so powerful since it enables Costco to have leverage over brands and suppliers. This ultimately allows them to consistently provide customers with affordable prices and high-quality products.
Key Takeaway: Kirkland allows Costco to have leverage in every negotiation with brands which enables Costco to provide you with only the best prices and the highest quality products.
The Management
James Sinegal, Costco’s co-founder & former CEO, was said to be a retail legend which absolutely shows. He and Costco’s management were somehow able to turn every bit of Costco’s weakness into a competitive advantage.
Its membership subscription business model, in theory, should make customer acquisition difficult. Yet it enables them to attract new customers who are mostly high-income individuals and allows them to have existing customers that are loyal to the brand.
Their store layout should annoy customers and encourage customers to switch to e-commerce. Instead, customers enjoy the entire shopping experience because of the free tastes and all the great deals that they see.
Their strict policies on quality & prices and extremely scarce shelve space should discourage brands from wanting to be on Costco’s shelves yet it allows Costco to have negotiating power and provide those chosen brands to have access to Costco’s high-income customers.
That’s why Costco is thriving, why investors should consider investing in Costco shares, and why Amazon should pay attention.
