Latest / Business Strategy Talks with Fexingo: Competitive Advantage, Market Positioning, and Growth Planning / How Costco Defied Inflation With Its Moat Model
Transcript
- Lucas: So you walk into a Costco in July 2026. A rotisserie chicken is still $4.99. A hot dog and soda combo, still $1.50. Same as they were in 2015, same as they were in 2005. And you have to ask—how? Inflation ran at 7 percent in 2022. Egg prices hit records in 2024. Every other grocery chain raised prices. Costco didn't. Luna: I think most people assume Costco just operates on thin margins and absorbs the pain. But that can't be the whole story, right? Lucas: Right, it's not charity. Costco's net profit margin is about 2.5 percent. That's razor thin. But here's the key—that profit doesn't come from selling stuff. It comes from membership fees. In fiscal 2025, membership revenue was roughly $4.6 billion, while net income was about $6.3 billion. So membership fees alone covered about 73 percent of their profit. Luna: Wow. So the merchandise is almost a break-even operation. That gives them a completely different incentive structure compared to a traditional grocer. Lucas: Exactly. A typical supermarket needs a 30 to 40 percent gross margin to cover rent, labor, and still make money. Costco caps its merchandise markup at 14 percent. That's not a rule they advertise—it's a structural commitment. They literally train buyers not to exceed that threshold. So when inflation hits, they can't just pass higher costs through. They have to work with suppliers to find efficiencies, or they walk away. Luna: And that's where the moat really lives, isn't it? The supplier relationship. Lucas: That's the core. Costco carries only about 3,700 SKUs in a typical warehouse. Target carries maybe 80,000. Walmart over 120,000. By being ruthlessly selective, Costco becomes a massive customer for each supplier. If you're a pickle maker and you lose your Costco slot, you lose a huge chunk of volume. So when Costco says 'we need you to hold the price', the supplier has real incentive to figure out how to do that. Luna: And that limited selection also shapes the customer experience. It forces a treasure-hunt dynamic. You go in for milk, you leave with a kayak. Lucas: That's the second piece. The treasure hunt creates urgency and reduces the need for advertising. Costco spends almost nothing on marketing. Their entire promotional budget is the thrill of discovery. And that low overhead feeds back into keeping prices low. It's a virtuous cycle. Luna: Let's talk about the Kirkland Signature brand. That's another layer. How does that play into the moat? Lucas: Kirkland Signature now accounts for about 28 percent of Costco's sales. And it's not just cheap generic stuff. It's often made by the same premium manufacturers—Duracell batteries, Ocean Spray cranberry juice, Starbucks coffee beans. Costco essentially licenses the production, slaps its own label on, and sells it at a discount. That gives them an alternative if a national brand tries to raise prices. Luna: Right, because if Kraft wants to hike the price of its mac and cheese, Costco can just say 'fine, we'll do a Kirkland version'. That's a credible threat. Lucas: And they've done it. In 2024, when egg prices spiked, some suppliers tried to pass through double-digit increases. Costco responded by leaning heavily on its own egg supply chain—they've got massive in-house egg processing at some warehouses. They kept prices lower than competitors for months. Luna: But does that scale? I mean, Costco can do that for eggs and rotisserie chickens, but what about electronics or apparel where they don't have a private-label alternative? Lucas: That's the limit. In categories where Kirkland can't compete—like iPhones or Sony TVs—Costco's price advantage is narrower. They still cap markup at 14 percent, so they're usually cheaper than Best Buy, but the delta is smaller. The moat is deepest where private label is credible. Luna: So the moat is really a composite of several things—membership model, limited SKUs, private label, low overhead, supplier leverage. But can it be copied? Lucas: Walmart tried with Sam's Club. It's roughly the same model, but Sam's Club has never matched Costco's execution. Sam's carries more SKUs—about 5,500—and its private label isn't as strong. Costco's average inventory turnover is 12 times per year. Sam's is around 10. The industry average for general merchandisers is about 6. That turnover speed is a massive efficiency advantage. Luna: And inventory turnover ties directly to working capital. Faster turnover means less cash tied up on shelves. That's a financial moat as much as an operational one. Lucas: Exactly. Costco generates about $20 billion in operating cash flow annually. They spend around $4 billion on capital expenditures. The rest goes back to shareholders through dividends and buybacks. But here's the thing—they reinvest heavily in warehouse growth. They opened about 30 new warehouses in 2025. Each one generates roughly $250 million in annual revenue on average. The return on invested capital is consistently above 15 percent. Luna: So the moat is widening, not shrinking. But let me push back on one thing—e-commerce. Costco's online sales are still a small part of the business, maybe 8 percent. Amazon and Walmart are eating the world online. Doesn't that threaten the model eventually? Lucas: It's a real risk. But Costco's moat is physical in a way that's hard to replicate digitally. The treasure hunt experience doesn't translate perfectly to a website. And Costco's online prices often include a markup to cover shipping, which undermines the value proposition. They're aware of it—they've been improving their app and click and collect. But I think the moat remains primarily brick and mortar. Luna: That's a fair point. I've also read that Costco's member retention rates are over 90 percent globally. That's insane loyalty. And it's not just about price—there's an emotional component, a sense of belonging. Lucas: Yeah, you're part of a club. The membership fee is a sunk cost that psychologically commits you to shop there. Behavioral economists call it the 'membership effect'. Once you've paid $60 or $120, you want to justify it by buying more at Costco. That's a moat in itself—a behavioral lock-in. Luna: And that's probably why they've been able to raise the fee only occasionally. The last increase was in 2024, from $60 to $65 for the basic plan. And hardly anyone blinked. Lucas: Right. And that's the beauty—the fee increase drops straight to profit. If you raise the fee by $5 across 130 million members, that's $650 million in additional revenue, almost all of it margin. It's a pricing power that most retailers would kill for. Luna: But here's my last question—is this moat truly defensible in a world where labor costs are rising, and younger consumers prefer convenience over bulk? I mean, Gen Z is all about delivery and small portions. Lucas: That's the existential question. Costco's average shopper is still a suburban homeowner with a car and a pantry. Millennials and Gen Z are more urban, more transient, more likely to use DoorDash. Costco has tried to adapt—they've expanded delivery via Instacart, and they're testing smaller-format stores in cities. But if the demographic base shifts, the moat could erode. It's not permanent. Luna: So the moat is strong but not eternal. It's built on a specific set of behaviors and economics that could change. Lucas: Exactly. And that's what makes studying moats so interesting. They're not static. Costco's moat today is wider than it was in 2020—inflation actually proved its resilience. But the next decade might bring different pressures. Luna: Speaking of resilience—and I don't want to break the flow here—but a quick honest thing. This show exists because of listeners like you. A handful of folks chip in monthly through buy me a coffee dot com slash fexingo, and that literally funds us making as many of these as we do. No ads, no sponsors, just people who find these conversations useful. Lucas: Yeah, and we genuinely appreciate it. It allows us to pick topics like this and go deep without worrying about commercial breaks. So thank you if you're one of those supporters. Luna: Alright, back to moats. So we've established Costco's is formidable. But let's zoom out—what can other businesses learn from this model? Lucas: I think the big lesson is: design your business so that your profit center is separate from your customer-facing price. For Costco, the profit is the membership. For a software company, it might be the subscription. That separation gives you freedom to compete on value without destroying your margins. Luna: And the second lesson: constraint as a strategy. Having fewer SKUs, fewer promotions, fewer price changes—it forces discipline. Lucas: Right. Most retailers think more choice is better. Costco proves that less choice, when executed well, creates a better experience and a stronger competitive position. It's counterintuitive, but it works. Luna: So the next time I'm walking through a Costco and I see that $4.99 chicken, I'll know it's not magic. It's a carefully constructed moat. Lucas: Exactly. And it's been working for 40 years. The question is whether it can work for 40 more.