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How Costco Wholesale Corporation Makes Most of Its Money

By Daniel B. Kline - May 5, 2017 at 9:16AM

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The company has a different model than most retailers.

Costco (COST -12.45%) remains one of the few retailers that reports sales every month.

That metric would seem to be important. It certainly is for most retailers, but in Costco's case, it's not. The warehouse club makes arguably all of its profit from membership fees. Because of that, the most important metrics for the company are renewal rates and membership growth.

Costco uses low prices as way to entice people to pay $55 for its basic membership or $110 for an Executive Membership, which gives them 2% cash back on eligible purchases until they earn $750 back. Those fees will increase to $60 and $120, respectively, on June 1, making the company even more money.

Membership fees are essentially pure profit because they have a very low cost of goods. Aside from the cost of printing a card and, in some cases, a little help from a customer service agent, they don't cost the company anything. That makes every $55 or $110 collected a boost to the bottom line.

A Costco store

Costco drives its earnings by selling memberships. Image source: Costco.

How much does Costco make?

Through two quarters of its fiscal 2017, Costco has reported $1.06 billion in income (profit). That number is slightly smaller than the $1.26 billion it collected in membership fees.

If you examine the company's sales, it brought in $56.59 billion in net sales with a merchandise cost of $50.21 billion and sales expenses of $5.92 billion. That's a small loss when it comes to actually selling goods, but that's not a problem because the warehouse club uses the stuff it sells to drive memberships, indirectly driving revenue.

Costco sells its goods and services at a very low markup in order to entice people to join. That has been a very successful strategy as the chain has maintained strong renewal rates while slowly growing its user base.

How big is Costco's membership base?

Costco steadily hovers around a 90% renewal rate around the world and has also shown consistent growth in total members. The chain finished the second quarter with 37.5 million Gold Star members, up from 37.2 million at the end of the first quarter. It also added 100,000 business members, but lost 100,000 business add-on members, which, during the second-quarter earnings call, the company attributed to those customers getting their own memberships. Total accounts, CFO Richard Galanti noted, rose to 48.3 million from 47.9 million in the first quarter.

"Total card holders, [were] 88.1 million at second quarter end, up from 87.3 million 12 weeks earlier," said Galanti, according to Seeking Alpha's transcript of the call (registration required). "As of Q2 end, our paid Executive Memberships stood at 17.9 million, which is an increase of about 200,000 from 12 weeks earlier, or about 17,000 additional per week.

Steady as she goes

Costco is raising its membership prices in June, but that increase will take two years to fully hit the bottom line. In addition, the chain has traditionally put much, if not all, of the revenue it makes from membership fee increases into lowering prices.

The warehouse club has a model where it sells customers items at cost of goods plus cost of overhead in exchange for them paying a membership fee. That's a very attractive deal for consumers and the company. It also creates a loyal relationship where the shopper knows he or she is getting a good value, which leads him or her to renew no matter how much or how little the membership was used.

It's also a model that protects Costco from the internet retailers that have pressured many of its retail rivals. Even Amazon can't afford to sell at the margins Costco does, and its membership program, Prime, has significant shipping and premium video costs. Costco's model may constrain its ability to have a breakout quarter, but it's a steady-as-she-goes system that should pay off for a long time to come.

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