The Store That Does Everything Wrong

How Costco Defies the Retail Rule Book

Source: Chat GPT. Obviously.

Most retail companies run on a handful of obvious, common-sense rules.

Rule #1: put shareholders first. Making owners richer is career-enhancing for most managers. In retail, managers do this by trying to

Maximize gross margin. Raise prices until margin dollars decline. After all, why limit profits?

Cut costs. Squeeze suppliers and workers. Because it is difficult to improve retail productivity, it is especially important to minimize labor costs.

Operate efficient logistics. To reduce inventory costs, large retailers combine point-of-sale data with high-tech distribution centers. They break down bulk shipments from suppliers to quickly restock the sales of each store. Walmart is legendary for this.

Allow 2-3% for credit card services. Nobody can avoid Visa and MasterCard.

Add new stores. Same-store sales tend to plateau, so to grow, companies need to open new stores. Ask Starbucks or Lululemon.

Borrow to finance inventory. You’ve bought stuff, and it is on your shelves or in your warehouse. Banks will lend you money to pay for that stuff. Simple.

Evaluate legal risk. Treat legal risk like any other business risk and subject it to cost-benefit analysis. When the cost of compliance exceeds the cost of non-compliance, don’t comply. You accidentally hired a union agitator? Fire her. Worst case? A bit of back pay.

Move everything online. Retail is sixteen percent online, and the share grows annually. Even Walmart has found that e-commerce is easier to scale up than physical stores. 

Rule #2: Define and dominate your retail segment. Starbucks does not sell hammers. Apple does not sell shoes or airline tickets. Stores try to: 

Offer a wide selection of core products. It would be insane for Nike to only make one model of shoe.

Spend big to bring customers in the door. Use advertising and coupons to lure customers. Welcome every customer who walks in.

Limit returns. Apple takes returns for two weeks. Amazon’s window is 30 days for most items. REI allows 90 days – but a year for members.

Rule #3: Follow common business sense.

Don’t sweat the small stuff. Big company CEOs speak in millions and billions, not dollars or cents.

Do not compete with suppliers. Retailers buy from suppliers. They do not operate factories to supply their stores.

Protect trade secrets from competitors. Duh.  

Few retailers even consider these rules; they cannot imagine behaving otherwise. But thanks to a recent Acquired podcast, I realized that America’s most interesting retailer has not been paying attention. Costco seems to do everything wrong.

Costco does not put shareholders first. At all. This is not because it is indifferent to investors. Consider: 

Costco does not maximize profit margins. Many retailers mark products up by 100%, meaning that if an item costs $5, they sell it for $10. This yields gross margins (markup/price) of 50%. Costco is, by design, an 11% gross margin business. They will not mark up anything more than 14% except in-house Kirkland products, which they mark up 15%. They deliberately leave money on the table. This is  not optimal for shareholders, but it brings people back, ensures steady growth, and deters competitors.

Long-time Costco CEO Jim Sinegal explained, "You could raise the price of a bottle of ketchup to $1.03 instead of $1, and no one would know. Raising prices by just 3% would add 50% to our pre-tax income. Why not do it? It's like heroin. You do it a little bit, and you want a little more. Raising prices is the easy way."

Costco does not minimize every possible cost. Its buyers work so closely with suppliers that they know when their input costs rise or fall. Impressively, Costco has found many ways to improve retail worker productivity. They now pay an average hourly wage of $30 per hour plus good health insurance and a 401K match. This is about $5.50 above the average retail worker wage, according to the Bureau of Labor Statistics.

How can they afford to do this? Costco has a business model that makes workers much more productive. They do not pay people to unwrap, shelve, and price a huge number of individual items. Look at the results:

Costco does not rely on advanced logistics. Costco warehouses are simple cross-dock operations. Pallets from suppliers come in one door and go out the other. Costco avoids the cost of breaking bulk in distribution centers and making bespoke shipments to retail stores. 92% of Costco's merchandise is cross-docked compared with only 10% of Walmart’s.

Costco does not pay normal fees for credit card services. For many years Costco took only cash or checks – no credit cards at all. An 11% margin businesses cannot give up 3% to Visa. Now they auction off the privilege of processing billions of credit card settlements yearly.

Costco aggressively grows same-store revenues. They do not do it by building bigger stores. In 1998, Costco stores averaged sales of $600 per square foot. Today it is $1,800 compared with Target at $450 and Walmart at about $600. The average warehouse generates over $200 million in revenue – a decent size for a company. Some are double that. Most years, Costco grows same store sales by double digits. Last year, same-store revenue was up 14%.

Costco does not borrow money to finance working capital. When a supplier drops a pallet of goods in a Costco logistics center, it sends Costco an invoice. Costco has 30 days to pay, but it only takes them 26-27 days to sell the goods. This gives the company “negative working capital” or a “negative cash conversion cycle”. Meaning that inventory is a source not a use of cash. For comparison, Costco turns their inventory 12.4 times per year, Walmart eight times, and Home Depot five times. Faster is much better.

Costco does not subject legal compliance to cost-benefit analysis. The company’s oft-repeated #1 value is “Obey the law”.¹ This has consequences. In the mid-1980s, the Washington State Liquor Control Board examined Costco, which was applying to sell alcohol. Incumbent liquor stores and distributors pressured the Liquor Control Board to deny Costco a license. Because of their strict adherence to legal norms, however, Costco was squeaky clean. Despite every effort to dig up dirt on them, they got their permit.

Costco avoids e-commerce. Costco has no interest in becoming an e-commerce company. They know that if you come to the warehouse, take stuff from the shelves, and drive it home yourself, they can give you a better price than any other retailer. The cost to pick, pack, and deliver retail products means that most online sellers without Amazon’s scale charge a convenience premium.

Costco does not focus on a narrowly-defined customer segment. As the highly-recommended Acquired podcast noted, Costco will sell you not only discounts on Southwest Airline tickets, but

“a 2½ pound container of cashews, prescription eyeglasses, a tank of gas, new tires for your car, 96 rolls of toilet paper, a new refrigerator, an outdoor shed, a 10-carat diamond ring, some freshly prepared sushi, (or) fine wine at a great price. And you could even grab a hot dog with a soda and a free refill on your way out for just $1.50.” (Costco has not raised the price of their hotdog and soda combo in 47 years).

Costco does not maximize selection. Most retailers, including Walmart, assume that shoppers demand a large selection. However, high selection complicates the life of a retailer, so Costco makes a different bet. Costco buying teams select the best one or two items in every category. They bet that consumers will forgo selection if everything is of very high quality and low price. It works. Moreover, having a very low SKU count drives many of the advantages listed here.

Do you need 8 ounces of nuts? Costco will sell you a 2½ pound jar. If you walk away, and some people surely do, Costco considers it “an intelligent loss of sales”. This is not a concept they teach in business school.

The typical Walmart has between 100,000–250,000 SKUs. (SKUs are stock-keeping units – the number of items for sale, including variations in size, color, etc). Ten years ago, Costco had around 4,500 SKUs. Today, it is 3,800. Result: Costco stocks about forty times fewer items than Walmart but, on average, sells fifteen times more of each item.

Costco does not advertise or serve just any customer who walks in. Costco only serves members. Membership has many advantages. Membership fees are close to 100% profit (they make up 70% of Costco’s operating income). And because members are forced to prepay, they are more likely to return to take advantage of low store prices. Finally, membership favors wealthy customers – as does buying in bulk, which requires a home big enough to store stuff. One independent research firm found the typical Costco consumer makes about $125,000 a year and has a four-year degree. Walmart customers have a median income of about $80,000. (The median US income is $71,000, suggesting that Costco members have a 70% higher income than the US median).

Costco does not limit returns. Costco has a lifetime, no questions asked full-value return policy. They copied the policy from their Seattle neighbor, Nordstrom (which has since capped returns). Costco lets you return anything, anytime for a full refund. The iPad you bought at the Apple store has a two week return window, but if you buy it at Costco, you can return it any time. Can you return a set of tires after driving on them for 30,000 miles? Maybe once. Then they will politely kick you out and refund your membership.

Finally, Costco does not follow what most retailers consider common business sense.

Costco sweats the small stuff. When you operate on 11% margins, you sweat every penny. As Acquired’s Ben Gilbert put it, “You talk to someone at Costco, and they tell you it cost $3.89. It's not just $3 things, they'll tell you that that cost $180.89. It's ingrained in the culture that every cent matters.”

Costco is willing to vertically integrate. This is a lot more than baking their own muffins, although Costco owns bakeries to do that. Costco sells 500 million chickens annually – 130 million of them roasted on in-store rotisseries. That’s about a third of the rotisserie chicken sold in the US each year. To do this, Costco built a facility that processes two million chickens per week. They contracted with two other facilities that are now dedicated to processing chicken for Costco. They make their own hotdogs, since they sell 130 million annually. And Costco also owns and operates three optical grinding labs to make prescription eyeglasses. This is another area where owning works better than contracting with suppliers to keep costs low.

Costco shares its secrets. When Sam Walton called Costco’s spiritual founder Sol Price to better understand warehouse retailing, Sol took him to dinner and explained the model. Walton went home and started Sam’s Club. In his book Made in America, Sam describes going around to Price Clubs (Sol’s Costco predecessor) with a tape recorder. He made notes about prices, inventory levels, and displays. When store security confiscated Walton’s tape recorder, Price returned it to him.

At about the same time, Bernie Marcus, the ex-president of the Handy Dan hardware store chain, came out to visit Sol Price in San Diego. His board had fired him and he was looking for a second act. Sol showed him the Price Club warehouse and gave him the playbook. He urged him to “open the Price Club of hardware stores”. So Marcus went home and started Home Depot.

How’s Costco working out? Spectacularly. Costco sold $240 billion of stuff last year, making it the third largest retailer in the US. They have 124 million members worldwide. One-third of US shoppers are Costco customers. The company sells one-third of all jumbo cashews worldwide. Kirkland (Costco’s house brand) is now America's largest consumer packaged brand.

Even though Costco places the law, customers, employees, and suppliers ahead of investors, shareholders have done quite well. If you invested $10,000 in their 1985 IPO, you would have $3.3 million today. This is a 330X return, not counting the considerable dividends you would have earned along the way.

Costco has plenty of room to grow globally, but it returns 80% of its profits to shareholders. It can only open a few $200+ million warehouses each year. It takes time to buy property, construct a warehouse, expand suppliers, enlarge cross-dock facilities, hire and train people, and adjust inventory to new geographies. Money is not the constraint.

Costco has built a ferocious internal culture. Company leaders nearly all started their careers as baggers and checkout clerks. Every month, they fly every market manager and country manager to Costco headquarters. They sit in a room for two days and discuss what's working, what's not, and how the company can learn and improve.

The CEO of Costco reportedly visits each of the company’s 890 stores annually. This is 2-3 store visits/day if the CEO drops by stores 365 days/year. This makes no obvious sense — but welcome to Costco.

Thanks again to Acquired for most of the research reported here. For a terrific history of how Costco emerged from FedMart and earlier discount wholesalers, check out the podcast.

1. Costco’s values, in order, are: 1. Obey the law. 2. Take care of our members. 3. Take care of our employees. 4. Respect our suppliers.