This newsletter comes out every other Thursday and hopefully provides you with thought-provoking content about the mundane, wacky, and weird. I will be writing until the 75th edition. If you know someone who may enjoy the newsletter, you can share it here.
In an age of e-commerce, grocery delivery, and retailers going bankrupt at a record pace, Costco has maintained a reliable source of revenue and loyal customers. Today, we will be diving into how Costco broke every rule in the grocery store rulebook and has become one of the most successful businesses of the last 40 years.
Costco wins for three reasons:
Membership program
Cutting costs
Buying more
Membership program
Costco makes most of its profits from its annual membership fee. The standard membership is $60 and the executive which gets you a few more benefits is $120. Unlike other membership programs (e.g. Amazon Prime), you need a membership to shop at Costco. No membership, no dice.
The membership is genius because it is pretty much pure profit. Costco makes 75% of its money from the membership fee. The sunk cost of the membership also plays a role in Costco’s success. I have seen this play out in my own history of shopping at Costco. I paid $60 for a membership to get these exclusive good deals, I might as well shop there as much as I can.
The founder and long-term CEO of Costco, Jim Sinegal observed, “The membership fee is a one-time pain, but it’s reinforced every time customers walk in and see forty-seven-inch televisions that are two hundred dollars less than anyplace else. It reinforces the value of the concept. Customers know they will find really cheap stuff at Costco”. Jeff Bezos was so impressed with Costco’s business plan that he has credited the membership as an inspiration for Amazon Prime. Customers are happy because 90% of members renew because they know they are getting their money’s worth.
Cutting costs
Costco is notorious for cutting costs. It is essentially a big warehouse, where you buy the items directly off the pallets. For comparison, Walmart has a back-of-the-house for their inventory, which comprises about 30% of the entire building.
Walmart incrementally adds items from the back to the customer-facing part of the store. For instance, if they are out of tuna cans they can check the back to see if they have any more. However, when you walk into Costco, their entire stock of items is in the store. There is no back-of-the-house inventory. The backup inventory is directly above where you are picking up food. This saves a lot of square footage and money.
This is part of the reason that Costco has one of the highest revenue per square foot of any retailer. They bring in about $1,600 per square foot vs Walmart’s $480 per square foot.
Costco is principled in keeping costs low. They spend essentially zero dollars on marketing and pass those savings on to the customer. They have a self-imposed markup of no more than 15% on any item. By comparison, Walmart averages a 24% markup and many other retail outlets average about 30% markup. Take this example, to see how the prices compare.
Costco’s low markups and wholesale purchasing power often drive its prices far below those of its competitors.
Previous CEO Jim Sinegal is famous for harping on keeping costs low. Many people come to Costco for the food court and particularly for their $1.50 hot dog soda combo which they have not raised the price on since 1984. He once told his COO and now CEO Craig Jelinek 'If you raise the effing hot dog, I will kill you. Figure it out”.
🤫 One other secret to their success, no one is stealing from Costco. Costco’s theft rate is 10x less than its competitors. Here are a few reasons why:
Membership - You have to show your membership card to get in.
Bulky items make it tougher to sneak out of the store.
Good employee morale. Costco employees are paid the highest minimum wage of its competitors, receive health care, 401(k), and stock options. Typically employees are a major cause of theft, however, Costco employees feel fairly treated and therefore less likely to steal.
Store layout - the exit funnels everyone into a narrow line and employees check everyone’s receipts.
Buying more
Yes, it is obvious that Costco sells big items, leading to higher ticket prices. The smallest amount of almond milk I can buy comes in a set of three. Additionally, there are no signs indicating where stuff is in the store. As a result, here is an example of a typical Costco shopper's journey in the store.
Along the way, you may run into their famous free samples. You know you shouldn’t shop on an empty stomach but many customers do just that, because they know they can enjoy free samples at the store. Plus, getting something for free makes you feel obligated to give something in return.
Selection is purposely sparse. There is a psychology term called the “paradox of choice”, where more options are worse. We say the more options the better. In reality, we get paralyzed by too many options and counterintuitively are more likely to buy something when presented with fewer options.
In one study, a grocery store was trying to promote high-quality jams. They ran two experiments. In the experiment with more jams to sample, they only sold 3% of jams. However, the experiment with fewer jams sold 30%. When presented with a ton of options, people got overwhelmed and didn’t buy anything.
Costco puts the paradox of choice into practice. The average supermarket has 30,000 items, Walmart superstores have 140,000 items, but Costco only has 4,000 items. Costco typically only has one or two products for each item. Trader Joe’s is another retailer that does a good job of reducing the number of products per item.
Costco locations are mostly in cheap industrial/suburban areas. This is the opposite approach of Trader Joe’s which focuses on highly sought-after real estate with high foot traffic. As a result, people almost inevitably have to drive to Costco, which plays right into their strategy of people stocking up on big items. I often bike to Trader Joe’s but I am always driving to a Costco.
The future of Costco
Costco consistently opens 20-30 stores a year, despite investors wanting them to be more aggressive. Costco will stick with its core ethos of high-quality goods at low prices. However, it will continue to expand its e-commerce business and expand internationally, especially in Asia. When Costco opened its first store in Shanghai there was a 3-hour line to get in! Below is a picture of the opening day. Is that kid ready to get out or excited about the screaming good deals?
Quote I’m pondering
“Mood follows action”
-Rich Roll
Cooking hack
Pre-cut lemons and de-seed them. One of the pillars of good cooking is acid, and lemons are a key way of getting acid in your food. I’ve also heard someone say that olive oil, salt, and lemons are like a cheat code in cooking.
What I’m listening to
Burna Boy - On the Low
Nigeria has an emerging and unique hip-hop scene. In Nigeria over 6 million people regularly watch Youtube, but only 87,000 on Spotify. As a result, the best Nigerian music is often created, consumed, and found on Youtube. 🇳🇬
One trick I have done for Youtube is to create multiple accounts that all have specific purposes. For instance, I have an account for music that expands my music taste, another for sports + comedy, and many more.
Pic of the Week
Chloe turned 1 this past week 🎉
Getting a dog has been more work and more fun than I expected. Chloe has such a sweet soul, despite her mischievousness.