How Costco Manages Its Inventory and Supply Chain

Originally published on January 19, 2016, by Phalguni Soni, this post was substantively updated on December 31, 2019, by Amit Singh.

Costco Wholesale (COST) has been growing its top line consistently, thanks to its impressive comparable sales growth. Notably, Costco’s comparable sales have grown faster than the overall industry—and most of its peers. The company derived total revenue $152.70 billion on retail square footage of 113.9 million in fiscal 2019.

Costco has also increased sales at a compound annual growth rate or CAGR of 6.3% over the past five fiscal years. Meanwhile, its competitors have the following CAGRs:

• 1.6% for Walmart (WMT).
• 25.6% for Amazon (AMZN).
• 1.2% for Target (TGT).
• 4.3% for Kroger (KR).

Merchandising categories

Costco offers its members a wide array of merchandise. The company’s product categories include: 

• Food and Sundries, encompassing dry and packaged foods, alcoholic and nonalcoholic beverages, snack foods, and candy.
• Fresh foods, including bakery, meat, produce, and deli.
• Softlines, including apparel and small appliances.
• Hardlines, including larger appliances, electronics, garden, patio, hardware, health, and beauty products.

Ancillary services

Costco, through its ancillary services, also offers expanded products and services. Its Ancillary businesses include gas stations, pharmacies, food courts, hearing aid centers, and optical dispensing centers at the majority of its warehouses. Cotsco gas stations, however, are currently not available in Korea, France, and China.

These services are valuable foot traffic drivers for Costco. Why? The pricing is usually more competitive at warehouse clubs like Costco than more mainstream retailers.

Costco’s performance by category 

In fiscal 2019, Costco reported an increase in sales and profits in all ancillary service categories. Changes in gasoline prices had an immaterial impact on net sales. All of Costco’s merchandising categories also experienced growth.

But the highest growth was in the ancillary businesses category, followed by hardlines and softlines. Ancillary businesses recorded about 12% year-over-year growth.

Costco food is a major driver

Costco derives about 53% of its sales from the Food and Sundries and Fresh Foods categories. And growth in the company’s food sales has been a critical sales driver.

The company has been consciously increasing its product offerings in the fresh foods segment. Also, Costco’s food category has been growing at a brisk pace over the last five years. That growth is in part due to Costco increasing its product offerings for private-label brand Kirkland Signature.

Geographic analysis of Costco’s revenue

Costco Wholesale (COST) derived total revenue of $152.70 billion on a warehouse base of 782 in fiscal 2019. The company’s revenues and profits mainly derive from the US and Canada. In fiscal 2019, Costco derived 87% and 84% of its net sales and operating income, respectively, from its US and Canadian operations. However, this geographical focus can be both a benefit and a disadvantage.

Since Costco reports in US dollars, higher exposure to the US market minimizes fluctuations in its reported results due to currency movements. On the other hand, this setup makes the company more vulnerable to the fundamental performance of the US and Canadian economies. 

The retailer is slowly diversifying its revenue stream to other geographies. And this geographical diversification is likely to accelerate Costco’s top-line growth. However, this strategy also exposes Costco to adverse currency fluctuations as well as geopolitical tensions around the globe.  

Costco’s US operations

At the end of fiscal 2020’s first quarter, Costco reported 546 warehouses in the US and 100 in Canada. The US accounted for 73% of the company’s sales and 65% of the company’s operating income in fiscal 2019. Comparable sales in the US, excluding the impact of changes in currency and gasoline prices, rose 6%.

Among US states, Costco’s performance in California is especially critical. The state has a larger percentage of higher-volume warehouses compared to the other markets where the retailer operates. The company derived about 30% of US net sales from California in fiscal 2019. 

Costco’s Canadian operations

Costco derived 14% of total sales and 20% of its operating income from Canada in fiscal 2019, making its Canadian operations its most profitable geography. Same-store sales, excluding fuel and the impact of the higher US dollar, rose 5%.

Investors should note that both Costco and Walmart are relatively optimistic about their prospects in Canada. Square footage and digital expansion are likely to drive sales and profitability in Canada. 

International operations

Besides the US and Canada, Costco also operates warehouses in the United Kingdom, Japan, South Korea, Australia, Mexico, Spain, Taiwan, Iceland, France, and China. The company derived 13% of total sales and 16% of its operating income from outside the US and Canada in fiscal 2019. Comparable sales, excluding fuel and the impact of the higher US dollar, rose 6%.

International operations also present a sizable growth opportunity for Costco. The company’s international sales have grown at a CAGR of 7% over the past five years. International growth would enable the company to take the concept of the warehouse club to new markets and diversify its revenue stream. Also, expansion in high growth markets like China is likely to accelerate sales growth.

Currency impact

However, the appreciating US dollar was a critical drag on overseas performance in fiscal 2019. Sales took a hit of 106 basis points, or $1.46 billion, due to adverse forex movements.

Analyzing Costco’s cardholder strategies

In contrast to other conventional retailers, Costco Wholesale operates as a membership warehouse club. Customers need to sign up as members by paying an annual membership fee to be able to shop at Costco locations. In return, members can shop for a wide array of quality merchandise at highly competitive prices.

Due to the implied savings on merchandise, members expect to be able to more than recoup their membership fees, cementing Costco’s value-for-money proposition. Besides, ancillary services like gasoline, ensure foot traffic and loyalty from existing members as well as an incentive for new members to join.

Types of Costco memberships

There are two types of Costco memberships. The Gold Star membership is available to individuals while Business memberships are, obviously, exclusive to businesses.

Memberships cost $60 annually in the US and Canada. Also, each member is eligible to receive a free household card.

Executive memberships are driving higher sales

Costco also offers an executive membership to existing Gold Star and Business members at an additional $60 a year, plus an upgrade fee. Executive members get 2% cashback on select purchases, subject to a maximum of $1,000.

Executive members tend to shop a lot more at Costco, and they’re vital to the company’s sales growth. Although they make up 39% of the membership base, they account for nearly two-thirds of the company’s sales.

Membership growth

Paid memberships at have grown at a CAGR of 5% over the past five years to 53.9 million last fiscal year. Costco also has a high membership renewal rate. More importantly, the company has been able to sustain its high renewal rate in the US and Canada at 91% in fiscal 2019. Globally, the renewal rate has risen from 87% in fiscal 2014 to 88% in fiscal 2019.

An increasing rate of Costco’s membership loyalty is a positive indicator for the company’s growth, particularly in an environment of cutthroat competition among retailers and the rising influence of online retailers. That said, the company is also enhancing its online capabilities. 

Comparative analysis

Walmart’s (WMT) Sam’s Club also operates on a membership basis, and business and savings memberships cost $45 per year. Walmart also offers Plus memberships for $100 annually. Plus members are eligible for $10 of cash rewards for every $500 they spend, up to a maximum of $500 annually.

BJ’s Wholesale Club offers two core memberships, including Inner Circle memberships and business memberships for $55. BJ’s also offers a higher tier of membership for $110 fee. The higher-tier membership offers 2% cash back on purchases made at most in-Club and www.bjs.com.

Why Kirkland Signature is a key growth driver

Costco Wholesale has been increasing the penetration of its in-store brand, Kirkland Signature. The company categorizes Kirkland Signature as a premium brand that it offers to members at a considerably lower price than national brand equivalents. So the brand remains one of the most significant store attractors for Costco.

Higher-than-average penetration rates

Kirkland Signature products represent about 27.5% of Costco’s sales in fiscal 2018, Retail Dive reported, citing data from a Coresight Research report. That percentage is well above the average penetration rate of 17%. Kirkland Signature brand also generated revenues of about $39 billion in fiscal 2018. 

Costco hopes to increase the penetration of its in-store brand even more for several reasons. Kirkland Signature provides Costco with a unique brand identity and a valuable differentiator versus the competition. And this advantage is particularly relevant, given the company’s value-for-money philosophy and high product quality.

Enhancing profitability

Also, private-label brands typically earn higher margins for retailers, as is the case for Kirkland Signature. Part of the reason stems from the higher control that private brands provide over their cost structure.

Retailers also typically spend less on advertising and building brand equity compared to national brands. As Costco’s pricing and margins tend to be highly competitive in comparison to peers, higher private-label sales would help Costco improve its bottom line.

Products and channels

To help with penetration, Costco has introduced new products under the Kirkland brand each year in categories as diverse as food, organics, apparel, optical, and pharmacy. The company has also collaborated with e-commerce delivery services like InstaCart to make Kirkland and other Costco products available through these channels. 

Why shopping at Costco is different

Costco Wholesale’s selling model is structured a little differently from other mainstream retailers. As we’ve seen, the company follows the membership warehouse concept, in which customers pay an annual fee for membership to shop at Costco. In return, members get to purchase store-brand as well as national-brand merchandise in higher volumes at competitive prices.

Selective stocking

Costco operates 785 warehouses (at the end of the first quarter of fiscal 2020) in the US and 11 other countries. Each warehouse is about 146,000 square feet on average. The company operates on a very lean operating cost model. The company seeks to limit the number of available stock, keeping units to 3,700 in its warehouses, as it believes in higher volumes drive a higher profit.

In keeping with its lean and mean cost model, the lower number of items at Costco ensures that the fastest-selling items are displayed to optimize retail space. The control over merchandise and inventory levels, as well as control over entrances and exits at its no-frills warehouses, also ensures lower shrinkage and lower employee costs for the company.

As a result of these strategies, Costco’s sales per square foot remain high versus competitors.

Costco’s competitors carry more products

All of that being said, the number of items Costco stocks is considerably lower than peers’—including other warehouse clubs. The average Sam’s Club, which Walmart operates, carries more products than Costco. Each And Sam’s Club averages 134,000 square feet in size.

Meanwhile, BJ’s Wholesale Club carries about 7,200 items. Supermarket chain Kroger (KR) stocks about 15,000 private-label items alone.

Costco’s same-store sales

Costco’s sales growth outperformance stems from its higher traffic and ticket size. Also, its value pricing and high membership renewal rates continue to drive traffic and average ticket size.

The company has reported higher warehouse traffic. And it’s also seen an increase in ticket size for several quarters in a row.

Fiscal 2019 marked the tenth straight year of positive comparable sales growth for Costco. The company’s comparable sales growth rate has also outpaced that of rivals Walmart, Target, Dollar General (DG), Kroger, and Dollar Tree (DLTR) over the past several years. Costco’s fiscal year ends in August–September while its competitors generally end in late January–early February. 

Note that fiscal 2019 has been an excellent year for Costco, as well as most of its peers. A solid macro backdrop, primarily in the US, drove consumer spending throughout the year. And the low unemployment rate, higher wages, and expansion of online services have all boosted revenues for most of the mass merchandisers. 

As for Costco, higher traffic and ticket size helped the retailer beat peers with its growth rate. This success is especially impressive when you consider that Costco was up against tough year-over-year comparisons in 2019. 

Costco’s big traffic drivers

Costco’s competitive pricing philosophy, provision of ancillary services, and increase in the penetration of in-store brand products under Kirkland Signature have had a lot to do with traffic growth. The company professes to provide value and keeping prices low to match competition.

Costco also tends to maintain prices, even in the face of cost inflation. It aims to maintain market share and keep customers coming. And while this strategy can prove detrimental to short-term margins, it has benefited membership loyalty.

Also, several mainstream competitors don’t offer gasoline services at retail outlets. As we’ve seen, gas also tends to drive higher traffic for Costco. Saving a few cents on the gallon for a recurring purchase like gasoline is also a way to recoup annual membership fees. Gasoline traffic tends to drive demand for other products as well.

Costco’s international growth opportunities

Costco Wholesale’s international sales have grown at a healthy pace, in part due to their smaller base. Overseas sales grew at a CAGR of about 7% over the last five years.

The company clocked international revenue (including Canada) of $40.95 billion in fiscal 2019, or 26.8% of total revenue. That total is up from 23.5% in fiscal 2010. And the company expects higher sales from international operations, especially with new warehouses opening in other geographies. 

New openings

Costco continues to open new warehouses internationally due to inherent growth opportunities. Since fiscal 2015, it opened 11 warehouses in Canada and 22 warehouses at other international locations.

Presently, the company has 39 warehouses in Mexico, 29 in the United Kingdom, 26 in Japan, 16 in Korea, 13 in Taiwan, 11 in Australia, and two in Spain. Moreover, Costco has one warehouse each in Iceland, France, and China.

International membership renewal rates

Introducing the warehouse club concept has resonated well in international markets where Costco has opened new warehouses. The company’s value-volume proposition, and its inclusion of locally sourced merchandise in its product offerings, are key membership drivers.

As a reflection of the unique proposition it offers, Costco’s global membership renewal rates have also been on the rise. They’re up from 87% in fiscal 2014 to 88% in fiscal 2019.

Improved profitability

Margins from international operations are also higher, which has benefited the company’s bottom line. That trend is partly due to little or no competition from other warehouse clubs. They’re a relatively new concept abroad. But the trend is also partly due to lower employee costs. Costco earned an operating margin of 4.1% from international sales in fiscal 2019, versus 2.7% from domestic sales.

So, having a bigger proportion of revenue from abroad makes sense for both the top and bottom lines. However, in the short term, the higher US dollar will likely affect Costco’s overseas performance, as we discussed earlier.

Shoppers flooded Costco’s China store

Costco had no brick-mortar stores in China, and it only had an online presence through its partnership with Alibaba. However, the company opened its first store in China in August this year. The company received an overwhelming response from Chinese shoppers for its first store. Costco’s Shanghai store flooded with customers, after which Costco suspended its operations. Moreover, the retailer had no choice but to close early. Also, Costco had record sign-ups in China. For instance, Costco had over 200,000 members sign up. 

Despite such a strong opening, Costco is taking a cautious stance in China. The company plans to open its next store in China in 2021. This slow pace of expansion seems justifiable to me. Most foreign retailers have struggled in China. And the company might expand the store count after seeing how the first store performs.

Costco’s online presence in international markets

Besides expansion in the brick-and-mortar channel, Costco Wholesale has also been slowly growing its presence in the online channel in international locations. So far, Costco operates e-commerce websites in the US, Canada, the UK, Mexico, Japan, and South Korea. The company has been steadily adding to the list of countries where its products are available. 

Enhancing their digital and physical infrastructure is critical for improving online sales for Costco and its peers. Costco’s warehouses serve as a natural hub for servicing omnichannel orders. However, the company has also been investing in new distribution depots. It aims to improve its fulfillment speed and minimize its shipping costs.

Delivery channels

Costco is also actively using alternative delivery services like InstaCart to enhance its own distribution network. This strategy reduces the onus of investing in its own infrastructure and allows the company to divert more investments in the brick-and-mortar channel. The availability of merchandise in its owned portals, as well as other channels, has also been steadily rising. However, this poses risk to Costco. 

Investors should note that peers—including Target and Walmart—have significantly expanded their e-commerce capabilities. And they’re also offering fast delivery options. The convenience of shopping and ultrafast delivery are driving higher traffic for both Target and Walmart right now.

Why Costco’s supply chain management is yielding strong results

Costco Wholesale follows a high-volume-low-margin strategy. It aims to sell merchandise in large volumes to customers at competitive rates. And the company also believes in stocking a limited number of products, an average of 3,700 at its warehouses.

The considerably lower number of stock-keeping units (or SKUs) at a highly competitive price enables Costco to achieve higher sales volumes. But this strategy doesn’t necessarily translate into higher margins.

Purchasing and handling efficiencies

One factor that benefits Costco’s margins is that higher volumes enable bulk purchasing and other efficiencies. This advantage helps Costco keep its prices competitive. Meanwhile, peer Walmart has leveraged its scale with considerable success. It’s negotiating advantageous terms with suppliers and passing cost savings on to consumers with lower prices.

Also, Costco and its peers are diversifying their suppliers’ base to other countries following the US-China trade war. Note that diversifying its supplier base is also likely to act as a hedge for Costco. 

Other efficiencies in the supply chain include buying products directly from manufacturers and arranging delivery to one of its 24 depots. These products then go to Costco’s warehouses using cross-docking techniques.

Cross-docking is a logistics system that aims to optimize shipments to stores from distribution points with minimal storage time. This approach reduces the costs of a multi-layer distribution system. Walmart, with one of the largest supply chain networks in the world, has employed cross-docking procedures for years.

In its international operations, Costco often tries to source products locally and build relationships with local suppliers. This strategy doesn’t just cater to local customer preferences. It also further reducing costs along the supply chain.

Working capital management

Inventory turnover at Costco is considerably higher than other mass merchandisers like Walmart and Target. Costco had an inventory turnover ratio of 11.8x last fiscal year, versus 5.9x for Target and 8.8x for Walmart. And Costco is usually able to sell its array of limited merchandise fast.

Despite Costco trying to take advantage of early-bird discounts, inventory usually sells ahead of the payment due dates to suppliers. As a result, suppliers largely finance Costco’s inventories. And this is a huge competitive advantage for the company—particularly given its no-frills model.

Costco’s cost model

Costco Wholesale operates on a high-volume sales model, but its margins are thin. As a result, the company has applied several strategies to get around lean product margins. The warehouse decor is very minimalist. Costco displays products for sale on pallets, along with often storing stock in overhead racks. This approach is typical of warehouse-style retail operations. The company also applies strict controls at entrances and exits at its warehouses, which minimizes the chances of inventory shrinkage, a chronic problem for retailers. 

Plus, high sales volumes and rapid inventory turnover combine with efficient distribution and early payment discounts to help Costco reduce costs and maximize profits.

Low labor costs

Costco’s overall labor costs are also relatively low. The employee requirement at stores is lower due to the self-service model for customers and the lower number of SKUs stocked. Costco stocks 3,700 products compared to more products at most of its peers.

Costco’s store hours are shorter than other retailers’. The company’s warehouses are open for 70 hours a week, excluding gas stations. In contrast, Walmart’s stores are open longer, and some of its supercenters are open for longer hours. Longer store hours increase wage costs.

Costco’s profitability comparisons

Due to the company’s competitive pricing philosophy and wholesale model, the company’s EBITDA and other profitability margins have trailed more mainstream rivals. Costco earned EBITDA of $6.27 billion on sales of $152.70 billion in fiscal 2019. Note that Costco’s EBITDA margin was 4.1%. And in comparison, other mass merchandisers were more profitable. Given below is the EBITDA margin (LTM) of the company’s peers:

• Walmart earned an EBITDA margin of 6.2%.
• Target clocked an EBITDA margin of 9.1%.
• Dollar Tree clocked an EBITDA margin of 9.7%.
• Dollar General clocked an EBITDA margin of 10.6%.
• Home Depot (HD) clocked an EBITDA margin of 16.2%.

However, Costco appears to be selling higher volumes in less space and less time. Also, due to its high degree of cost control, Costco’s profitability per square foot has consistently beaten competitors.

Analyzing Costco’s capital expenditure policies

Costco Wholesale operates on a no-frills basis. As a result, Costco’s annual capital expenditure has been consistently lower than its peers’, Walmart and Target. Also, both Walmart and Target have been investing heavily in their e-commerce arm compared to Costco.

Costco also employs a cross-docking system. As we’ve seen, most merchandise ships to depots directly from manufacturers and then reroutes to one of Costco’s warehouses. This logistics system minimizes the need to build extensive storage facilities, reducing capital expenditure requirements.

Expanding capital expenditure

Costco’s capex in recent years has risen. The company’s been focusing on expanding its operations. It also spent about $2 billion, or 1.8% of sales, in fiscal 2014—versus about $3 billion, or 2.0% of sales, in fiscal 2019.

Also, the retailer has looked at expanding its retail footprint through the organic route. Costco has added stores both in the US and overseas. The company added 25 net new warehouses in fiscal 2019. And despite the increase in capex over the years, Costco has managed to finance new warehouse openings, mostly through internal cash.

Costo’s capex outlook

In fiscal 2016, Costco plans to spend about $3.0 billion to $3.2 billion on capital expenditure. About 22 new warehouses are planned with three possible warehouse relocations. As per Wall Street’s estimates, Costco’s capex to sales ratio is likely to be 1.9% in fiscal 2020. Most of the planned capex is expected to finance new warehouse space, manufacturing and distribution facilities, information systems, and working capital. The company plans to fund these expenditures with internal resources.

In the first quarter of fiscal 2020, Costco had already opened four net new warehouses—including one relocation. The company plans to spend $0.7 billion on capex in the quarter.

Costco stock performance

So far this year, Costco stock (COST) is up 44.4%, as of December 27, 2019. The rise is due to the company’s industry-leading comparable sales growth. Moreover, double-digit EPS growth over the past several quarters drove the stock even higher. 

In comparison, shares of Walmart and Target Corporation are up 28.4% and 95.5%, respectively. Want to learn more about investing in the ever-changing consumer sector? Check out our overview of the now-private Panera Bread and our investor’s guide to Chipotle Mexican Grill.

First published here: How Costco Manages Its Inventory and Supply Chain