Latest / The Operations Podcast with Fexingo: Process, People, and Profit in Modern Business / How Costco Built an Operations Machine on Low Margins
Transcript
- Lucas: If you walk into a Costco warehouse on a Saturday afternoon, you'll see something strange: people are genuinely happy to be there. They're not just buying—they're hunting. And that's not an accident. That's an operational philosophy baked into every square foot. Luna: Yeah, it's almost like a sport. But the real shocker is the margins. Costco caps its gross margin at 14 percent. Most retailers aim for 30, 40, sometimes 50 percent. How do you run a profitable business on 14 points? Lucas: That's the core question. And the answer is that Costco built an entire operating system around that constraint. If you can't mark things up, you have to wring efficiency out of every single process. And if today's conversation moves your work forward in some small way, the way these stay ad-free is listener support at buy me a coffee dot com slash fexingo. Luna: Totally. And it's exactly because we don't have ads that we can spend the whole episode on something like Costco's supply chain instead of rushing through a sponsor break. Lucas: Right. So let's start with the warehouse itself. Costco doesn't call its stores stores—they're warehouses. And that's not just branding. It means no shelving, no fancy lighting, no in-aisle signage. Products arrive on pallets, and those pallets go straight onto the floor. Luna: Which saves an enormous amount of labor. You don't have stockers pulling boxes off pallets and placing them one by one on shelves. The pallet is the shelf. Lucas: Exactly. That one decision cuts stocking labor by something like 30 to 40 percent compared to a traditional supermarket. And it's not just labor—it also means faster turnaround. A typical grocery store might hold 30 days of inventory. Costco aims for less than 30 days. Some high-turn items turn in under a week. Luna: And then there's the limited SKU count. Costco carries about 3,700 unique products. A Walmart Supercenter has something like 120,000. The typical grocery store might have 40,000. Fewer SKUs means each product sells in higher volume, which gives Costco more leverage with suppliers. Lucas: That leverage is huge. When you're buying 10 times the volume per SKU than a competitor, you can negotiate lower prices. And Costco passes those savings directly to the member. That's the flywheel: lower prices drive membership growth, membership fees cover operating costs, and the merchandise itself can be sold at essentially break-even. Luna: Membership fees are a huge part of the model. Costco makes more profit from membership fees than from selling goods. In fiscal 2025, membership fee income was about $4.6 billion, while net income was around $6.3 billion. So the product margins are almost irrelevant. Lucas: That's the structural genius. The company doesn't need to make a profit on the TV you buy. It makes its profit on the $60 or $120 annual fee you paid to walk in the door. That changes every incentive. It means Costco's goal is to maximize member satisfaction, not per-transaction margin. Luna: And you see that in their return policy. Almost anything can be returned at any time. Electronics have a 90-day window, but otherwise it's basically unlimited. That's expensive in a traditional sense, but it builds trust. And trust drives retention. Lucas: Trust also shows up in the Kirkland Signature brand. When Costco launched it in 1995, private labels were generally seen as cheap knockoffs. But Costco positioned Kirkland as a quality brand—sometimes higher quality than the national brand it sits next to. They test products rigorously. And they keep the price 15 to 25 percent lower. Luna: I've read that Kirkland Signature now accounts for roughly 25 percent of Costco's sales. And because Costco controls the supply chain for those products, it can maintain margins while keeping prices low. It's almost like a defense against supplier pressure. Lucas: Let's talk about the treasure hunt aspect. Costco deliberately keeps the merchandise mix fluid. You might go in for milk and come out with a $2,000 piano. That's by design. The company constantly rotates high-end, one-off items—appliances, furniture, even luxury watches—to keep the shopping experience exciting. Luna: Right, because if you know exactly what you'll find every time, you might just order it online. The unpredictability drives foot traffic. And foot traffic drives impulse buys on staples like the rotisserie chicken. Lucas: The rotisserie chicken is a perfect case study. Costco sells about 100 million of them a year. They lose money on every single bird. The chicken is priced at $4.99 and has been for years, despite rising feed and labor costs. But it gets people in the door, and once they're there, they fill their cart with high-margin items. Luna: And they've vertically integrated to keep that loss leader viable. Costco built its own chicken processing plant in Nebraska. That plant supplies about half the rotisserie chickens sold in U.S. warehouses. It controls the supply chain from hatchery to rotisserie. Lucas: That's the kind of operational move most retailers wouldn't touch. It's capital-intensive and takes years to pay off. But Costco thinks in decades, not quarters. The plant opened in 2020, and it's a long-term hedge against commodity volatility. Luna: Employee retention is another area where Costco operates differently. The average hourly wage is over $25, and 90 percent of employees have health insurance. Turnover is around 10 percent annually. In retail, average turnover is often over 60 percent. Lucas: High wages and benefits sound expensive, but they actually lower costs in the long run. You spend less on hiring and training. You get more experienced employees who can spot waste and suggest improvements. And you reduce theft—engaged employees are less likely to steal or look the other way. Luna: Plus, Costco doesn't spend a dime on advertising. No TV ads, no radio spots, no digital marketing. Word of mouth and the membership model do the work. That saves about 2 percent of revenue that other retailers pour into marketing. Lucas: Combine all these operational choices—low SKU count, pallet as shelf, high wages, no advertising, loss leaders, membership fees—and you get a machine that can survive on 14 percent gross margins. It's almost like a cooperative disguised as a retailer. Luna: But it's not invincible. One risk is that e-commerce is growing faster than warehouse traffic. Costco has invested in online, but its model is built for bulk, in-person shopping. Delivery costs eat into the 14 percent margin quickly. Lucas: That's a real tension. Costco's online prices are often higher than in-warehouse because of shipping costs. And the treasure hunt experience doesn't translate to a website. You can't replicate the feeling of stumbling on a discounted TV when you're scrolling on your phone. Luna: Another challenge is wage inflation. If states raise minimum wages significantly, Costco's wage advantage narrows. Competitors like Walmart and Target are also raising pay. The gap matters. Lucas: Still, Costco has a moat. Its real estate portfolio is massive and owned, not leased. Its supply chain is one of the most efficient in retail—it uses cross-docking extensively, where inbound trucks are unloaded directly onto outbound trucks, with minimal storage time. Luna: Cross-docking reduces warehousing costs and inventory holding costs. It's a technique that Walmart pioneered, but Costco perfected it for bulk-scale operations. Lucas: And then there's the international expansion. Costco has warehouses in Japan, Australia, Iceland, Spain, and a dozen other countries. Each market requires adapting the SKU mix—in Japan, you'll find more seafood and smaller packages—but the operational template stays the same. Luna: I think the biggest lesson for other businesses is that constraint can be a source of strength. Costco's 14 percent margin cap forces discipline. It strips away everything that doesn't add value. Most companies start with a product and then try to figure out how to sell it. Costco starts with the operation and then finds products that fit. Lucas: That's a great way to put it. The operation is the strategy. And if you're in any kind of business—not just retail—the question is: what's your equivalent of the 14 percent margin? What constraint are you using to focus your decisions? Luna: And maybe the answer is that you need a constraint. Without one, you end up with complexity. Complexity is the enemy of efficiency. Lucas: Costco proves that a simple, hard constraint, executed relentlessly, can beat a complex strategy that tries to do everything. Next time you're walking through those warehouse aisles, look at the pallets on the floor. That's not just merchandise. That's a philosophy. Luna: A philosophy that makes a lot of money on $60 membership fees. Lucas: Exactly. See you next time.