Latest / Pricing Power Podcast with Fexingo: How Businesses Set Prices, Raise Margins, and Win Customers / How Costco Packs Pricing Power Into a Membership Fee
Transcript
- Lucas: So Costco sells a hot dog and a soda for a dollar fifty. They have done that since 1985. In a world where literally everything else has tripled in price, that combo has not budged. Luna: And it's not some tiny side business. They sell something like two hundred million of those combos a year. Lucas: Right, about two hundred million units. That's a lot of hot dogs. And the conventional wisdom says: why would you anchor your brand to a loss leader when you could just raise the price to two bucks and pocket an extra hundred million a year? Luna: I assume the answer is not 'because they love hot dogs.' It's about signaling something bigger. Lucas: Exactly. That dollar fifty combo is a price anchor for the entire store. When a member walks in and sees that the hot dog hasn't changed price in forty-one years, the implicit message is: we don't gouge you on anything. It's a trust signal that justifies the sixty-dollar membership fee. Luna: And that membership fee is the real product. The store is almost a loss leader for the membership. Lucas: That's the Costco insight that most retailers miss. Costco's gross margin is capped at roughly 14 percent on any branded item. Compare that to a typical grocery store running 25 to 30 percent, or a department store pushing 40-plus. Costco explicitly tells suppliers: you give us your best price, we add 14 percent, and that's the shelf price. Luna: So they're almost acting like a buying cooperative for the member. The profit comes from the annual fee, not from the stuff on the shelves. Lucas: Exactly. In Costco's most recent fiscal year, membership fees brought in about four point six billion dollars. Net income was about six point three billion. So roughly seventy percent of their profit comes straight from those fees. The merchandise operations basically break even. Luna: That is a completely different business model than Walmart. Walmart makes money on the spread between what they pay and what they charge. Costco makes money on the subscription. Lucas: And that flips the incentive structure entirely. Walmart has an incentive to push prices up where they can. Costco has an incentive to keep prices as low as possible, because every dollar they save the member makes the membership more valuable. Luna: So the membership fee is not just a revenue stream. It's the mechanism that aligns Costco's interest with the shopper's interest. Lucas: Right. And the renewal rate reflects that alignment. In North America, it's over ninety percent. That's unheard of in retail. People don't just shop at Costco; they subscribe to Costco. Luna: How does Kirkland Signature fit into this? Because that's a huge part of the pricing story. Lucas: Kirkland is the enforcement mechanism for the 14 percent cap. Let's say Costco sells a premium olive oil from Italy at a 14 percent markup. If the supplier tries to raise the wholesale price, Costco can't just pass it through—that would break the cap. So they threaten to launch a Kirkland version at a lower cost. Luna: So Kirkland is basically a price ceiling for branded suppliers. Lucas: Exactly. It's not about having the cheapest private label. It's about disciplining the branded vendors. If your price gets too high, Costco will replace you with a Kirkland product that meets the same quality standard but costs less. And they control the production, so they control the margin. Luna: There's a famous story about a major coffee brand. Costco wanted to lower the price per pound, the brand refused, and Costco launched Kirkland coffee. Within a year, Kirkland was the top-selling coffee in their stores. Lucas: That story is true, and it's played out in categories from diapers to batteries. The Kirkland brand now accounts for about 28 percent of Costco's sales. That gives them enormous leverage. Luna: But isn't there a risk that Kirkland cannibalizes the branded goods and reduces the overall assortment appeal? Lucas: Costco manages that by keeping Kirkland SKU count low relative to the total. They have about four thousand SKUs in a typical warehouse. A Walmart Supercenter might have a hundred twenty thousand. Costco deliberately curates—they want you to find a treasure, not browse a catalog. Luna: The treasure hunt. That's another pricing lever, right? Lucas: Yes. About a quarter of the inventory changes every month. They bring in seasonal items, closeout deals, one-off luxury goods. You might go in for a five-dollar rotisserie chicken and walk out with a two-thousand-dollar wine cabinet. Luna: Because you can't price compare that wine cabinet. There's no Amazon listing for the exact same model from three months ago. Lucas: Exactly. The scarcity and the limited-time nature kill the comparison shopping reflex. Costco doesn't want you to pull out your phone and check prices. They want you to trust that the price is fair—and to buy now because it might be gone next week. Luna: And that trust is reinforced by the membership. You've already paid sixty bucks. You want to feel like you're getting value from that investment. So you're psychologically primed to buy. Lucas: It's a beautiful flywheel. The membership fee creates an upfront commitment. That commitment drives trip frequency and basket size. The treasure hunt model creates urgency. The 14 percent cap builds trust. And Kirkland keeps the branded suppliers honest. Luna: But the hot dog remains the symbol of the whole thing. Lucas: The hot dog is the promise. Costco's co-founder Jim Sinegal reportedly told a CEO who suggested raising the hot dog price: 'If you raise the damn hot dog, I'll kill you.' And they've held that line even through the recent inflation spike when beef prices jumped. Luna: They actually built their own hot dog plant to keep costs down, didn't they? Lucas: They did. In 2009, they built a hot dog manufacturing facility in California. They now produce about 300 million hot dogs a year there. That vertical integration lets them control the cost structure so they can absorb commodity swings. Luna: So the dollar fifty is not a loss leader in the traditional sense. They've engineered the supply chain to make it profitable at that price. Lucas: That's a subtle but important point. It's not a loss leader; it's a sustainably low price enabled by operational excellence. Same with the rotisserie chicken. They lost money on it for years, then built their own poultry plant. Now it's breakeven or slightly positive. Luna: Which reinforces the trust signal. The member sees a price that hasn't changed, assumes Costco is taking a hit for them, and feels loyal. In reality, Costco has engineered the system so that the price is viable. Lucas: Right. And loyalty shows up in the renewal rate. That ninety-plus percent renewal means members are voting with their wallets year after year. The average Costco member spends about three thousand dollars a year there. Luna: That's a lot of hot dogs. Lucas: A hundred and forty million hot dogs, actually. Luna: So what happens when a competitor tries to copy this model? Sam's Club has memberships, but they don't have the same pricing discipline. Lucas: Sam's Club markups are higher, around 18 to 20 percent. And their private label, Member's Mark, doesn't have the same premium positioning as Kirkland. Costco has a thirty-year head start on building that trust. Luna: And the treasure hunt? Sam's Club has more predictable inventory. Lucas: Exactly. Costco's buying team is famous for finding one-off deals. They bought a massive lot of premium Italian olive oil when the supplier overproduced. They bought a container of high-end watches from a bankrupt jeweler. That's hard to replicate. Luna: So the moat is really the combination of membership pricing discipline, private label leverage, treasure hunt curation, and operational efficiency. It's not just one thing. Lucas: It's a system. And the system works because every element reinforces the others. If you weaken the markup cap, trust erodes. If you weaken the treasure hunt, urgency drops. If you weaken Kirkland, supplier discipline fades. Luna: One thing that's always struck me about Costco is how they treat their warehouse as a marketing tool. The layout, the sample stations, the massive pallets—it all communicates abundance and value. Lucas: It's a psychological environment designed to signal 'we are on your side.' The pallets are often still on the steel shelves—no fancy displays. That says 'we don't waste money on frills, so you don't pay for them.' Luna: And the samples are a form of social proof. If you taste a product and see other people buying it, you're more likely to add it to your cart. Lucas: Absolutely. And they rotate samples to align with the treasure hunt. You might try a new snack that's only available for two weeks. That creates FOMO and impulse buying. Luna: So the pricing strategy is deeply intertwined with the entire shopping experience. It's not just about numbers on a shelf tag. Lucas: It's a holistic value proposition. And the member is paying sixty bucks a year to be part of it. That fee is the filter that ensures the customer is committed, and it's the profit engine that lets Costco operate on razor-thin margins. Luna: I think that's the key lesson for any business: if you can align your pricing model with your customer's long-term interest, you build a relationship that's hard to break. Lucas: And the hot dog is just the most delicious reminder of that alignment. Luna: I'm getting hungry. Maybe I'll go get one. Lucas: If these conversations have moved your work forward in some small way, a handful of listeners chip in monthly through buy me a coffee dot com slash fexingo, and that's literally what funds making this many episodes. No ads, no sponsors—just people who find value in the show. It keeps the whole thing going. Luna: Yeah, it's a small group, but it makes a big difference. Keeps the podcast ad-free and focused on the stories. Lucas: So anyway, back to Costco. There's a question I've been thinking about: can this model survive as e-commerce grows? Costco's e-commerce sales are still only about 6 percent of total revenue. Luna: That seems low compared to Walmart or Amazon. But Costco's whole model is built on the physical warehouse experience. Lucas: Right. The treasure hunt doesn't work online as well. You can't create the same scarcity and impulse buying when the customer just searches for a product. Costco has been investing in its app and two-day delivery, but it's a challenge. Luna: And the membership fee is harder to justify if you're not walking through the warehouse. The value of the fee is tied to the in-store experience. Lucas: True. But Costco's renewal rates among online-only members are still high, around 85 percent. So people do find value even without the full treasure hunt. But the long-term challenge is real. Amazon is getting faster and cheaper at delivery. Luna: And Walmart is combining its store network with online fulfillment. So Costco's pricing power moat isn't invincible. Lucas: No moat is forever. But for now, Costco has something most retailers envy: customers who pay for the privilege of shopping there. And that's a pretty strong foundation. Luna: And a dollar fifty hot dog. Lucas: Always the hot dog.