Costco (NASDAQ: COST) markets itself as a warehouse club where, in exchange for a membership fee, consumers get access to a variety of food, merchandise and services at discounted prices.
Of course, the company does offer those things, but that's not really the chain's business model. In many ways, Costco operates like a gym. It sells memberships knowing that many of its members won't show up. It's not upset if they do — and it takes care of its members who spend the most — but, in reality, it only needs customers to see the value of joining, not actually have them do any shopping.
How does the gym model work?
Discount gym chains such as Planet Fitness (NYSE: PLNT) actually market to people the company knows won't show up. That's why the chain's average gym has 6,500 members while only about 300 could be accommodated at any given time, NPR's All Things Considered reported in December 2014.
Essentially, when many people join a gym, they do so with the best of intentions. They want to be healthier and get into better shape. Even as they rarely or never go, they stay members because the idea that they will someday become regulars.
The gym doesn't need to serve that audience. Instead, it can focus on a smaller group of dedicated customers who work out most days and keep them happy, while also showing less engaged members that the whole enterprise does work, which keeps them from quitting.
Costco's business works the same way. Members are lured in by the prospect of saving money, and even if they don't take advantage, they renew because they intend to in the future.
The chain makes about 75% of its profits from membership fees, and a big piece of the remaining 25% comes from its best customers who spend much more than the average member. Like a gym, the warehouse club makes money whether people come in or not, and its sales are just icing on the cake.
How does Costco make its money?
The chain uses low prices to entice people to pay either $60 for its basic "Gold Star" membership or $120 for an Executive membership, which gives members 2% cash back on eligible purchases until they earn $1,000 back. Either membership gets people in the door to the warehouse club, but Costco knows that only Executive members are likely to take significant advantage of its low prices.
During the chain's earnings calls each quarter, CFO Richard Galanti notes the growth in Executive memberships. He then points out that about one-third of its customers pay the higher price to join, but that they account for two-thirds of sales.
Costco closed Q3 with 18.3 million Executive members who generated roughly $20 billion of its $28.2 billion total sales, excluding membership fees. Its 37.8 million Gold Star members accounted for only about $8 billion.
That's rough math, but it shows a clear disparity between the warehouse club's two classes of members. Even though the figures aren't exact, the data shows that during Q3, Gold Star members spent about $211 each, while Executive members averaged $1,092.
It's about memberships
Costco isn't selling goods and services. It's using those things to get people to buy memberships. Gold Star members shop at the chain often enough to see the value of renewing, but probably not often enough to make remaining a member worth their while.
In theory, that's a danger for the chain, but just as consumers will pay $10 a month to maintain the illusion that they might visit Planet Fitness, they're willing to do the same with the warehouse club. Costco offers the promise of spending less money, and for a large percentage of its audience, that's enough to keep them hooked.
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