Costco (NASDAQ:COST) is the second largest retailer in the country, trailing only Wal-Mart in annual revenue. Yet the warehouse giant generates far less profit from its product sales than its bigger rival. Its gross margin was 13% over the past year, or about half of Wal-Mart's figure.

The gap almost disappears when it comes to net profit margin, though. And that overall success is thanks to Costco's large -- and growing -- pool of membership fees.

A different approach

Costco's strategy is built around maintaining what management calls "price leadership". This approach boils down to delivering the lowest available prices on everything from groceries to gasoline. In many cases, the company warns in its annual report that it'll make pricing decisions that hurt gross profit in pursuit of the broader goal of signing up more members. "This format is designed to reinforce member loyalty and provide continuing free revenue," executives explain. 

And it's working. The company collected $2.6 billion in subscription fees last year as the number of paying members rose to 47.6 million from 44.6 million. That's up almost $1 billion from the fee charges collected in 2010. 

Chart showing rising membership fee income.

Fee income in millions. Chart by author. Data source: Costco filings.

Costco's membership fee income makes up most of its operating income, so it's helpful to think of it as a club engaged in subscriber sales rather than a retailer focused on profiting from sales volume.

Why it's rising

A quickly rising warehouse count and the surging membership base that goes along with it have been the biggest factors driving fee income growth recently. Costco added 29 stores to its footprint last year to nearly match its fastest expansion pace on record. The retailer sees a long runway for international growth ahead, and it just entered two new countries: France and Iceland. Still, the majority of Costco's 29 new stores last year were opened in the U.S.

A customer browses a warehouse retailing aisle.

Image source: Getty Images.

The membership fee total also benefits from a long-running shift toward higher-priced executive plans that come with extra perks such as cash back. These premium members made up 39% of the subscriber base last year, up from 30% in 2008. 

Thanks to these trends, membership fee income is up a healthy 5.3% over the first three quarters of Costco's 2017 fiscal year. The number should get a nice boost starting in fiscal 2018, too, as the effects of its $10 per year price increase -- its first in over five years -- start hitting the bottom line.

What to watch

The two best indicators to watch for signs of long-term strength in Costco's membership income are sales growth and subscriber renewal rates. Both figures were unusually weak last year. In fact, comparable-store sales gains fell to 4% from 7% in the prior year. Renewal rates dipped by almost a full percentage point, too.

The renewal slump likely had more to do with the disruption caused by Costco's switch to a new member credit card. Executives are confident that the shift is a win-win, though, since it is sending better perks to shoppers today while lowering the retailer's costs. Those savings are set to roll right back into lower prices, of course, which should keep subscribers happily filling up their carts.

Comps growth sped up to a solid 5% in Costco's most recent quarter, and the renewal rate appears to be rebounding as well. That momentum, in addition to the fee increase that will begin lifting results next year, suggests healthy gains ahead in this critical source of earnings growth.