In a logical world, Costco would suck. Low prices, spartan settings, and immense crowds. That’s an unholy trinity that should ruin just about any shopping experience.
But it doesn’t, and I think that’s remarkable. Costco is a freakishly well-run business.
Over the last weekend, I slipped into the store by avoiding eye contact with the greeters. My goal was to do some comparison shopping and see if this often-discussed store was actually as good as people said it was. Along the way, I saw that name brands truly were going for cheaper than generic products at other stores, and I walked out with a Costco card.
Sure, I’ve known about the store for a long time, but never went. Right at the time when buying in bulk started to make sense for me, there was a massive global pandemic which I hid from for two years like the extremely brave man that I am.
My recent experience means I may be the last person on Earth who hadn’t gone to a Costco prior to a week ago, so I want to take a moment to appreciate the business model in the way only a newbie can.
Cheap & classy usually don’t go together
Let’s just get this out of the way. We all know intuitively that cheap items aren’t usually classy, and classy items aren’t usually cheap. But why exactly is that?
Sellers of cheap items typically have low profit margins. That means they have to cut costs somewhere – often in quality of materials, customer service, or something else that isn’t really critical to shipping a minimum viable product.
Hence, cheap goods tend to fall apart, stop working, taste worse, or generally be crap. And that’s fine, really, because sometimes you only need a product that meets the bare minimum standard.
Like many Americans, I have a sneaky regard for Dollar Generals for this reason. Sure, they’re cluttered, dingy, and their products break easily – but they’re also incredibly affordable, easy-to-find, and completely unpretentious about their goals. All in all, chaotic good.
But Costco notably does not have low-quality products, and that’s part of why they have such an obsessive fan base. Name brand foods regularly sell for cheaper than generics. They have a massive selection of organic items. The employees are friendly and even well-compensated. The return policy is generous and the produce is fresh.
So what gives? How exactly is Costco able to do this?
5 ways Costco cuts costs without cutting quality
Even when I’m not working, the business part of my brain always is. I can’t go into a store without seeing their branding and operations, and wondering how it all works. Going to Costco for the first time was no different, and I – like all normal people – felt the need to do additional research on the subject when I got home.
1. Costco is a giant warehouse
Let’s start with the obvious – Costco is an enormous, walk-in warehouse. The shelves go up probably 20 or 30 feet into the air. Employees on forklifts abound. Aesthetics don’t matter here – the floors are unpolished, the high ceilings show open ductwork.
That’s not to say that you will be uncomfortable in the store – the heat and A/C are pumping, the lighting is adequate, and everything you need is within reach. But the store doesn’t feel the need to present itself like a Whole Foods, and that saves an enormous amount of money.
Additionally, everything in the store is sold in bulk. That means when people go to Costco, they get enormous amounts of stuff for very reasonable prices. The customers walk away feeling like they got a tremendous amount of goods for the money, and Costco knows that the average customer is going to have a high order volume. Nobody walks into a Costco to buy a gallon of milk and leave. You fill the cart up or you don’t show up.
2. Costco incentivizes shopping with its memberships.
Much like its peer, Sam’s Club, Costco requires you to purchase an annual membership before you shop there. The cheap one is $60 with no special perks, and the more expensive one is $120 – where you get 2% cashback from your purchases.
Both of these membership levels are very interesting, because you might think that memberships discourage people to shop. But that’s just not the case. Costco’s brand name is well-known enough to pull people into trying the membership, meaning that the annual fee poses minimal friction to new customers who want to try the store.
But a funny thing happens when you spend even just $60 – you feel compelled to “get your money’s worth.” Costco takes advantage – mostly benignly – of the sunk cost fallacy. Basically, if you spend money or time on something, you’re more likely to commit to it, whether or not the costs outweigh the benefits. In other words, once you spend that $60, you’re more likely to spend more.
And the $120 level? Well, if you’re getting 2% cashback, you have a strong incentive to spend $3,000 per year or more in order to “break-even” on the higher-tier membership. Indeed, I paid for the $120 membership because I know I can spend more than $3,000 per year – or $250 per month – on goods purchased at Costco, simply because I need what they sell to make my household run.
Overall – not only does Costco get money from the membership fees, but they also get money from people spending money to feel like they got the most out of their membership fees. Consumer psychology is weird like that!
3. Costco uses food courts and samples to pull people in.
Costco – like other warehouse stores such as Sam’s Club and even IKEA – needs to keep people in the store for a long time so they can purchase a lot of items. That’s why they use samples to lure people in the door and food courts to keep them there.
Costco, like Sam’s Club, gives away free samples of its products. This encourages people to try things they wouldn’t normally, and often, make a purchase. Giving away $0.05 of food to 100 people is often enough to make hundreds of dollars in extra sales. It’s a really effective tactic.
Costco also knows that because their warehouses are big, people spend a lot of time there, and the shopping experience is often strenuous, they need to give people a chance to recharge. Their food courts sell items ranging from “the best hot dog in America” to acai bowls. The food is priced so cheaply you know they’re not making money on it. The goal is to keep people in the store and to provide a good customer experience.
4. Costco carries a more limited selection of items than you would think.
Now you might say, “OK, but all of what you’ve said is also true for Sam’s Club, but people seem to like Costco better.”
This is where things get really interesting. Costco only has about 4,000 SKUs in its store, compared to a typical supermarket’s 30,000. If you’re not familiar with SKUs, the basic idea is that every variant of every item has a different SKU. A T-shirt that comes in three colors and four sizes has 12 different SKUs. A bottle of ketchup that comes in 5 oz, 12 oz, and 20 oz has 3 different SKUs.
Having lots of SKUs means having lots of variety, but it also means managing inventory is complicated. Costco cuts down on the costs associated with purchasing and managing a bunch of different SKUs by…not having a bunch of SKUs.
But yet you wouldn’t think that when you walk in the store, which has everything from laptops to treadmills to fresh produce to frozen meals. What is easy to miss is that every item is sold in bulk. You cannot buy a little bit of something at Costco – you have to buy a lot at a time. That keeps the overall SKU count low.
But Costco makes sure the options are good. Many of the foods at Costco are organic, and their white label brand – Kirkland Signature – often makes use of the same manufacturer as name brand products. Costco truly is the master of “less, but better” which is why professional celebrity chefs can say with a completely straight face that Costco has great olive oil.
5. Costco limits methods of payment to cut down on transaction fees.
Finally, one way that Costco cuts costs is by reducing the number of different payment methods. You can only use Visa credit cards, cash, or debit cards at Costco. You cannot use MasterCard, American Express, or Discover credit cards. Why? Because Visa agreed to only charge Costco a transaction fee of 0.4%. The standard fee is 2-3%.
Now frankly, not being able to use my cashback Mastercard or Skymiles Amex drives me nuts. I actually think this is quite bad for customer experience. But given the fact that Costco is able to pocket about 2% extra revenue per sale by limiting payment methods, I can understand how this is part of a larger plant to keep costs low.
As much as I hate the limitations, in their situation, I would impose the same restrictions. Keeping costs low without compromising quality is so important that reducing the number of payment methods is a valid strategy to help Costco keep its competitive advantage.
Costco manages to reach buyers with multiple different decision-making styles
When you add up all these different ways to cut costs, it makes sense that Costco is able to stand out as both a classy retailer and a cheap one. This puts it in the unique position of being able to appeal to consumers with a variety of different decision-making styles.
Obviously, Costco is great for appealing to frugal shoppers. It’s a dead-heat tie with Aldi most of the time for lowest cost-per-ounce of basically any given product, and that’s really saying something because Aldi sells almost exclusively generic products and does not – by default – bag groceries for shoppers.
Appealing to frugal shoppers is not hard to understand, although it does take operational excellence to maintain the low prices that spark their interest. It’s also really hard to keep frugal shoppers loyal since they answer only to the dollar. This is why competing on cost is so dangerous – it’s tough to keep low prices, and if you can’t keep low prices, then you can’t keep frugal shoppers.
But Costco doesn’t just appeal to frugal customers. Perfectionist customers, who are very careful and deliberate, also like Costco. Perfectionists will go to a bunch of different stores and try a bunch of different strategies to find the one that works. They aim for the sweet spot: maximum value per dollar. Return on investment.
Not many people have the stamina to be perfectionist customers, but those who do often end up going to Costco. They know that Costco isn’t necessarily the cheapest option for every single product, but they do know that they have a staggeringly good chance to provide the best value per each product. Where else can you get 90 Cascade dishwasher pods for like $16 these days anyway?
Perhaps most weirdly, even some image-conscious consumers love Costco. Costco’s own Kirkland Signature brand has a weird mystique around it. The price is low, but everything from their batteries to their chocolate to their diapers are well-regarded. So much so that among a certain crowd of, say, suburban upper middle-class dads, this generic brand name is something of a status symbol. Even as a marketing expert, I find this hard to explain.
Final Thoughts
On its surface, Costco might seem incredibly ordinary. But its massive success is just plain weird.
For most businesses, we say: find a niche. Get really good at doing one specific thing. Costco comfortably occupies multiple niches. This shouldn’t work.
Much of the success of Costco comes down to the fact that it is an unusually well-run company. Being able to compete on price while still credibly claiming that they provide quality products is a unique, hard-to-copy position. I can only think of one other company that manages to do this: IKEA – and that’s a furniture store.
So next time you’re in a Costco, take a moment to appreciate the unique space is occupies in the business world. Or at least stock up on non-perishables.
