The Costco Paradox: Leveraging Low Margins, Erratic Availability, and Customer Loyalty for Long-Term Success

The New York Times had an interesting article a couple of weeks ago about Costco:

“Costco, which is the third largest retailer in the world, has changed how Americans shop in the last 40 years, making both bulk buying and the acquisition of big-ticket items on grocery runs a regular occurrence.”

And with it, the key sentence:

“But the success of Costco goes far beyond hoarding. The company has hacked the psyche of the American consumer, appealing to both the responsible-shopping superego (“Twelve cans of tuna for $18!”) and the buy-it-now id (“I deserve that 98-inch flat screen”).

The article focuses on the consumer behavior Costco has generated but misses the importance of the supply chain that aligned with, and allowed this behavior to be generated. 

Costco’s ability to achieve sustained profitability in a highly competitive retail landscape, despite employing what might seem like unconventional tactics, is a testament to its distinct business model. 

Let’s delve deeper. 

Low SKU Count: Strategic Minimalism for Operational Efficiency

Let’s start with the basics. 

Costco’s strategy of offering a limited number of Stock Keeping Units (SKUs)—around 4,000—compared to the 30–50,000 SKUs found in traditional supermarkets, may seem like a limitation, but is a deliberate decision rooted in operational simplicity. This reduced product assortment allows Costco to streamline inventory management, reduce procurement complexity, and create higher purchasing power with suppliers while also improving forecast accuracy. 

Costco’s low SKU count allows for economies of scale as the company achieves significant negotiating power with its suppliers by focusing on bulk purchasing and high-volume sales of fewer items, which enables the company to secure lower prices. These savings are passed on to customers in the form of lower retail prices, which aligns with Costco’s value-driven promise. Moreover, the lower assortment reduces stockouts and obsolescence risks, as products are sold and replaced quickly, keeping inventory fresh and storage costs low.

Erratic Availability: The Newsvendor Model in Practice

But this is only one aspect. 

A critical—and often misunderstood—component of Costco’s business model is its erratic availability of products, especially higher-end, non-essential items. To some, the unpredictable stock levels may seem like a flaw, but for Costco, it is a feature designed to drive customer engagement and manage inventory risk.

Part of it is also related to consumer behavior. Costco plays on the principle of scarcity and the endowment effect, where customers place higher value on items they perceive as rare or difficult to obtain. The random and infrequent availability of certain high-ticket or luxury items (e.g., a rare bottle of wine or high-end electronics) triggers impulse buying behavior, impacting basket sizes during each visit. Costco’s strategy revolves around creating episodic excitement, ensuring each shopping trip feels unique. 

But things go even deeper. 

Costco’s approach can also be explained using … the newsvendor model (if you didn’t see this coming from a mile away, you’re not a loyal enough reader, and for homework, you must read all the articles I’ve written until now. I’ll wait). 

The newsvendor model is particularly useful for products with uncertain demand and a short selling season—characteristics that describe many of Costco’s more exclusive or seasonal items. According to this model, retailers must balance the cost of under-ordering (lost sales and customer dissatisfaction) with the cost of over-ordering (excess inventory, obsolescence, and markdowns). The newsvendor formula says that the service level of a firm, or the likelihood of finding the product available, should be Cost of Underage / (Cost of Underage + Cost of Overage).

Costco’s Underage cost is very low since it operates on low margins. However, its Overage cost is rather high since carrying excess stock would significantly impact its profitability. Thus, Costco strategically under-orders certain items, accepting the underage cost to avoid the higher costs associated with surplus inventory. 

Costco maintains low underage costs because the lion’s share of its profits doesn’t come from selling products. In 2023, Costco’s membership fees generated $4.6 billion, contributing 72% of the company’s total $6.3 billion net income. This fee-based revenue stream allows Costco to operate on low margins for its products, distinguishing it from traditional retailers that rely heavily on markups for profitability. In other words, Costco doesn’t profit from selling you products, hence they don’t fret about limited product availability. 

Costco also reduces demand variability by limiting its exposure to stockouts of core items while strategically allowing variability in high-margin, non-essential goods. The erratic availability hedges against demand uncertainty, optimizing Costco’s inventory levels while maintaining profitability.

The combination of FOMO and low availability generated the behavior usually described as a “treasure hunt.” Costco’s “treasure hunt” shopping experience is a critical component of its customer retention strategy. Customers come to Costco not just for everyday necessities but also for the chance to discover exclusive or unexpected items. This experience fosters emotional engagement and repeat visits, even in the absence of convenience.

The EOQ Model: Why Costco Customers Buy More

Costco’s decision to open fewer stores in suburban and semi-rural areas with ample parking and large warehouse spaces reflects a clear understanding of its target market. 

From a real estate and operations management perspective, Costco’s store location strategy minimizes fixed costs associated with dense urban footprints, such as high rent and limited space. Instead, Costco focuses on suburban locations where they can build large warehouses capable of stocking bulk products, thus aligning the physical layout with their operational needs.

But again, things go deeper. 

Unlike traditional retailers that rely on frequent visits from urban shoppers, Costco attracts customers willing to travel greater distances to shop in bulk. This location strategy is completely aligned with making sure customers align their “supply chain” behavior with the firm’s one. 

Yes. Customers manage their own supply chain as well. 

Costco’s customer behavior can be understood through the “EOQ” (Economic Order Quantity) model applied to the retail context. 

Traditionally, EOQ focuses on minimizing a company’s costs related to ordering and holding inventory: 

In Costco’s case, this concept is flipped: instead of the retailer optimizing order quantities, the customers themselves engage in bulk purchasing to minimize their own transaction costs (time, travel, and effort) associated with shopping.

The reason Costco customers tend to buy more per trip (compared to customers who shop at regular stores) can be attributed to several factors:

Distance from Store: Costco stores are typically located in suburban or semi-rural areas, often farther away from where customers live. The increased travel distance means that customers are less inclined to visit frequently. To compensate, they purchase larger quantities on each visit, much like a reverse EOQ model where they stockpile goods to reduce the need for future trips. This behavior is driven by the need to reduce the frequency of trips, thereby lowering their total time and travel costs.

Membership Fees as a Fixed Cost: Costco’s membership fees act as part of the fixed cost for customers, encouraging them to maximize their membership’s utility. Once a customer has paid the annual fee, there’s a psychological incentive to make larger, more infrequent purchases to “get their money’s worth.” This is akin to the fixed ordering cost in an EOQ model, where the customer optimizes by making fewer, larger orders to spread out the membership cost.

Economies of Scale at the Household Level: Much like companies seek to optimize order sizes to minimize total inventory costs, Costco’s customers engage in bulk purchasing to take advantage of the per-unit cost savings that come with buying in large quantities. By purchasing more in a single trip, they effectively reduce their overall shopping costs, like reducing unit ordering costs in a standard EOQ framework.

The “Customer’s EOQ model” behavior helps explain why Costco enjoys such strong sales per customer visit. The combination of higher travel costs and membership fees compels customers to stock up, resulting in larger basket sizes compared to those at traditional retailers. Additionally, by encouraging bulk purchases, Costco can sustain its low-margin, high-turnover business model, creating a mutually beneficial dynamic where both the customer and the company minimize their respective costs.

In essence, Costco has created a shopping environment where customers are economically incentivized to behave like bulk buyers, turning the traditional EOQ model on its head and driving the company’s financial performance through increased sales per visit. This behavior, paired with the efficiency of Costco’s operations, explains why customers prefer Costco for bulk purchasing over regular stores despite the added friction of travel distance and membership fees.

The Warehouse Club Stores Model

While reading this, you may be wondering why other chains don’t use the same model. 

After all, it sounds simple… 

The paper “Shopping Activity at Warehouse Club Stores and Its Competitive and Network Density Implications” by Stanley Lim, Elliot Rabinovich, Sungho Park, and Minha Hwang focuses on the unique strategies employed by warehouse club (WC) retailers like Costco. 

The study is motivated by the observation that WC retailers such as Costco and Sam’s Club operate under a sparse store network configuration, unlike traditional retailers who opt for a denser store presence in markets. This raises questions about WC stores’ resilience to spatial competition and their ability to attract customers despite higher travel costs for consumers. Additionally, the paper explores how WC retailers outperform other retail formats despite operating fewer stores over large geographic areas.

The key questions posed by the paper include:

1. How resilient are WC stores to spatial competition from non-WC stores, given their sparse network design?

2. How does the distance between WC stores and households affect stores’ resilience to spatial competition?

3. At what distance does the advantage of WC stores over non-WC stores disappear, and how does this impact their long-term demand saturation?

The authors use data on household shopping behavior from ACNielsen’s Homescan database, focusing on five distinct markets served by Costco, where it operates as a stand-alone store. The paper applies a quasi-experimental difference-in-differences (DID) approach to compare household spending and travel cost allocations between Costco and non-WC stores. 

The study uses panel data from ACNielsen’s Homescan on household-level shopping trips across major retail formats, including WC and non-WC stores. The data captures weekly expenditures and travel distances. Additional control variables include household size, income, age, pre-existing WC memberships, and retail gas prices.

The results are interesting: 

Resilience to Spatial Competition: For the same level of travel costs, households spend a significantly higher share of their shopping budget at WC stores. Specifically, for an equivalent fraction of travel costs, Costco absorbs 61% more spending than other stores. This effectiveness is attributed to Costco’s bulk sales model, which encourages more concentrated, less frequent shopping trips, inducing customers to spend more per visit to offset their higher travel costs. This is very much consistent with the discussion above on the EOQ model. 

Effect of Distance: The advantage of WC stores diminishes as the distance between the store and the household increases. Beyond approximately 21 miles, the competitive advantage of Costco all but disappears. This threshold acts as a reference point for spatial competition between WC and non-WC stores. In other words, there is a limit to the idea that distance drives bulk purchases. Beyond a certain level, it starts discouraging travel completely. 

Demand Saturation: The paper estimates that demand at a typical Costco store takes approximately three years to reach saturation. However, this time frame decreases by 12% when only considering the market segment within the 21-mile threshold.

The findings from this study provide important insights into Costco’s operational success. The company’s strategy of sparse store network configurations is highly efficient in reducing capital and inventory costs. At the same time, households are willing to incur higher travel costs due to the pricing and product offering advantages of WC stores. But while the model works well in markets where WC stores face limited spatial competition, Costco’s success could be challenged in areas where the distance stays within the 21-mile threshold. 

Costco vs Sam’s Club

But these are, of course, only parts of the puzzle. 

Wayne Cascio’s paper “Decency Means More than “Always Low Prices”: A Comparison of Costco to Wal-Mart’s Sam’s Club” explores Costco as an alternative model to Walmart’s well-known low-wage, low-price strategy by examining Costco’s unique business approach. While Walmart is often criticized for its labor practices and pressure on suppliers, Costco stands out as a company that manages to deliver low prices without sacrificing employee well-being or supplier relationships. 

The paper seeks to analyze how Costco maintains cost leadership while adhering to higher ethical standards in employee treatment and customer service, challenging the widely accepted notion that low prices must come at the expense of workers’ wages. In particular, it explores the trade-offs between maintaining employee satisfaction, delivering low prices, and ensuring shareholder value, in comparison to Sam’s Club —a part of Walmart.

The main observations:

Employee Wages and Turnover: Costco’s employee wages are significantly higher than those at Sam’s Club (Costco: $17/hour vs. Sam’s Club: $10.11/hour). Due to its higher wages, Costco experiences far lower employee turnover (17% vs. Sam’s Club’s 44%), leading to cost savings in recruitment and training.

Productivity and Profitability: Costco’s employees are more productive, generating more sales per employee. In terms of operating profit per employee, Costco outperforms Sam’s Club, with $21,805 per employee at Costco versus $11,615 at Sam’s Club.

Customer Satisfaction and Loyalty: Costco’s focus on value—meaning both price and quality—along with its high level of customer service, creates strong customer loyalty. This results in a higher renewal rate for its membership program and greater sales per square foot compared to its competitors.

Costco’s success demonstrates that cost leadership in the retail industry does not have to be achieved by cutting employee wages or benefits. Instead, by fostering a highly productive and loyal workforce, Costco can maintain low prices while offering superior customer service and achieving strong financial performance. This model offers an alternative to the “low wages equals low prices” paradigm, showing that ethical business practices can align with profitability.

Conclusion: Strategic Discipline in Action

In conclusion, Costco’s business model exemplifies strategic discipline by balancing operational efficiency, consumer behavior, and supply chain management to deliver consistent value to its members. The company’s low SKU count simplifies its supply chain, while erratic availability, justified through the newsvendor model, transforms inventory risks into customer engagement tools. The membership model provides a steady revenue stream, while Costco’s unique location and customer experience strategies create a loyal and enthusiastic customer base.

Costco’s business model offers a rich case study in strategic simplicity, supply chain optimization, and consumer behavior management. 

They are all linked. 

It’s a masterclass on how companies can align operational tactics with customer psychology (as well as rational decision-making) to create sustainable, long-term success.

And I can’t believe I wrote an entire article on Costco without mentioning their legendary $1.50 hot dog even once! I clearly missed the real secret to their success!