Basic math may indicate that Costco has 225 million good reasons to increase its annual membership fee. In truth, shoppers of Costco may have more to gain, since those fees go toward lowering its prices. The behavioral economics behind Costco’s successful membership model.
Costco sells chicken coops. For $380, I can buy a duplex chicken coop at Costco that would set me back $394 on Amazon.
The best part is Costco’s annual membership fee is lower than the price of Amazon Prime. But what if that fee went up, as Costco hinted at in a recent call with analysts? The answer relies on Costco’s clever operational strategy, through which the fees support its lower prices.
And Costco counts lots of fees — about 34 million individual members pay $55 a year, and 10.6 million business members pay $110. If it raises its fee by a mere $5 per membership (some project business memberships could go up $10), then Costco has at least $225 million to gain from the increase.
Those fees go straight to the bottom line, which sounds lucrative. But the real story behind Costco’s success is its operating model and commitment to understanding how behavioral economics, or simple psychology, influence its members to buy more.
This works especially well for Costco because its annual fees, which generated $2.65 billion in fiscal 2016, are directed toward reducing price. And Costco is fanatical about how it approaches this distinguishing element. As Richard Galanti, Costco’s chief financial officer, explained to analysts: “We’re going to invest in loyalty and growth while it’s raining on everybody as it relates to higher levels of deflation.”
The extent of shoppers’ gains therefore depends on a separate basic equation: how much they shop at Costco.
Benefits of Fee-dom
Here are some data points that further illustrate why memberships are so important to Costco:
- Costco posted a fiscal 2016 net income of $2.35 billion, slightly below its membership fee total.
- Yet the fee has not been a barrier to entry. Costco operates 103.2 million square feet of retail floor space. That compares with nearly 240 million square feet at Target (further emphasizing Costco’s store scarcity). Yet Costco’s annual sales exceeded those of Target. In Target’s most recent fiscal year (ended Jan. 30, 2016), it posted $73.8 billion, compared with Costco’s $116 billion. Sam’s Club, meanwhile, posted annual revenue of $57 billion on a total square footage of 87.6 million (also as of Jan. 31, 2016).
Applying simple math and breaking that down to sales per square foot (acknowledging that online sales are not factored in), it shakes out to: $308 at Target, $650 at Sam’s Club and $1,124 at Costco.
- Costco’s commitment to low prices apparently draws shoppers back. Costco’s gross margin is less than 11.4% of total sales. That compares with 25.3% at Walmart, 34.4% at Amazon (fiscal 2015) and 29.5% at Target. This means it is keeping prices as low as possible even when doing so compromises near-term performance.
As Costco states in its annual report: “(We) seek to maintain what we believe is a perception among our members of our ‘pricing authority’ — consistently providing the most competitive values.” This means reducing prices to meet those of its competitors as well as “holding prices steady despite cost increases instead of passing the increases on to our members, all negatively impacting near-term gross margin as a percentage of net sales.”
A Specific Kind of Shopper
Costco’s willingness to take a hit on gross margin is evidence of its commitment to its model, which is designed to appeal to a specific kind of shopper. However, if it increases fees in 2017, Costco will need to be transparent about its intention to keep prices low.
Following are three counterintuitive ways Costco has done this so far, with success:
The Amex switch: In 2015, Costco took the risky move of ending its exclusive relationship with American Express and signed a deal with Visa, making Citigroup its only credit card provider. This may have alienated a number of members, but Costco wagered the move would attract many more. “Limiting payment options and directing all perks through a single partner is yet another way of delivering lower prices and more benefits to customers,” wrote Denise Lee Yohn in her book, “Extraordinary Experiences: What Great Retail and Restaurant Brands Do.”
The selection ceiling: Regardless of the variety of items one can purchase at Costco, from safari tours to caskets, individual product choices do not run deep. In fact, it reportedly only carries about 4,000 unique items at a time. It may offer just four toothpaste brands, while Walmart carries dozens of sizes and brands. The logic behind this limitation is simple: Studies have shown when given too much choice, consumers tend to purchase less.
The line on signs: Among the items Costco eschews in an effort to reduce costs (and therefore prices) are aisle signs that tell shoppers where products are. The upshot is shoppers tend to spend more time wandering its stores, perhaps taking in and following the delicious smells of freshly baked goods. The more time consumers spend ambling around the store, the more likely they are to spend.
That spending may be on an unexpected coffin or a chicken coop. The magic is that by paying a fee to access these items, the shopper leaves feeling a bit privileged. As long as the price is right, that’s a formula for success.