Costco: a fine example of a great business model

Starting a business is always a challenge. The number of things you have to do is so immense that if you would list them all up front, nobody in their right mind would ever, ever do it.

One of the items on that list is to define a business model for your company. You have to describe the value you are creating for your customers, how you are going to deliver value to your customers, and how you are going to make money by doing that.

One of the great examples of a business model is Costco. The simplicity of its business model is something to admire. Costco’s competitors have found it difficult to compete on prices, and more importantly, value.

If their business model is so simple, what is the secret?

Costco is not making money on selling products. Especially not their $1.50 hotdogs!

Costco, with revenue of $227 billion is among the largest retailers right after Walmart and Amazon. Now, Walmart has about 120,000 different products in its stores and Amazon has about 12 million. Costco has about 4,000. Walmart’s revenue was $611 billion and Amazon online retail was $220 billion. That's roughly $57 million per SKU (Stock Keeping Unit, pronounced ‘skew’ for the uninitiated) compared to Walmart at $6 million/SKU and Amazon at $18 thousand/SKU.

You can imagine the overhead costs associated with running procurement for 4,000 items versus 120,000 or 12,000,0000. Yet, the volume of products sold gives Costco pricing power over its suppliers.

Costco marks up on any product is between 10% and 14%. Walmart is about 33%. That's why products at Costco are cheaper (not counting sales events with the other retailers.) Costco also sells high quality products which command a higher price.

That margin is to pay for any operational expenses – people, warehouses, and other operations. Costco has 300,000 employees compared to Walmart’s 2.1 million. That's $757k revenue per employee as opposed to Walmart's $290k per employee.

Where is the profit coming from then?

The one simple word: membership.

In order to get the best price for high quality products, you have to drive to a warehouse (not a fancy department store) and buy a membership to shop at Costco. That membership is a pure profit center for the company. It costs nothing to fill out a form, take a picture, and print your membership card. Memberships have to be renewed annually which now stands at 110 million members and brings in $4 billion a year.

With every new member, Costco adds $2k per year revenue and $60 profit. With every member, Costco can get better prices from its suppliers, which means lower prices for its customers, which tell all their friends how much they save at Costco. This cycle repeats on and on and on.

Add to this the fact that Costco's inventory turnover is close to 12 (which is good). Their high inventory turnover means that within every month they sell everything in the warehouse, and the payment terms to its suppliers are net 30. You realize, quoted directly from Costco's financial statements, 'to the extent that sales increase and inventory turnover becomes more rapid, more inventory is financed through payment terms provided by suppliers rather than by our working capital.' Costco doesn't use its own money to finance the inventory.

Yes, Costco is missing the almost instant gratification of Prime membership which you can get from Amazon, but obviously 110 million people are willing to exchange convenience for cheaper price of quality goods. And the convenience is costing Amazon a significant amount of money. How much? Enough that they are now offering $10 cash back on order over $25 if you come to its location to pick it up yourself. There is suddenly a crack in the brand image and value proposition, isn't it.

The simplicity, almost an elegance of Costco's business model is something to envy and hard to compete with.

When you decide to start a company or invest in one, try really hard to understand the business model, the value proposition and how to compete in the marketplace. When done right, your company will become the recurrent pattern which everyone will be talking about.