Is Costco Worth Paying The 2011 Annual Membership Fee Hike? A Business Model Analysis

Costco CardsCostco just announced that they are raising their annual membership fee 10% in the US and Canada as of November 1st, 2011. This makes the Gold Star and Business memberships $55 and the Executive membership $110 per year. The maximum 2% cashback reward that comes with Executive Membership will increase from $500 to $750. The last price hike was in 2006, so the membership fee has actually been rising less than inflation. See Costco press release, WSJ article.

Is Costco worth it? As someone who shops at Costco regularly, I’ve asked Is the Executive Membership upgrade worth it? (You can’t lose money by trying it out.) This time, I thought it would be interesting to look at how the Costco business model itself affects the value to customers. There are various articles about the Costco business strategy, for example here, here, and here. This is a quick and dirty summary:

  • Costco tries to make a low but constant profit margin, combined with large volume. Two metrics for this are operating margin, and sales per square feet. Costco keeps around a 3% operating margin, which means for every dollar in sales they get 3 cents of profit before things like interest and taxes. They don’t want this number higher (more room for competitors), or lower (race to zero). Costco has more sales per square feet than Wal-mart, Home Depot, or Nordstroms. They keep this high with low prices, bulk packaging, and limiting selection.
  • Instead, most of the profit can be seen as coming from membership fees. Roughly half of the 22 million members in US and Canada are Gold Star/Business members paying $50 a year, and the other half are Executive members paying a $100 a year but with a 2% cash back check. Simple math says that Executive members should be spending $2,500 a year at Costco for this to be a good idea ($2,500 x 2% = $50). Spend $5,000 a year, and your membership is “free”.
  • They treat their employees better with higher pay and benefits than say Wal-mart or Sam’s Club, as well having better stats for upward mobility. One number given was Costco pays 40% higher than Sam’s Club. I think this makes for a more stable operation and less employee turnover.
  • They treat their customers better with a generous lifetime return policy. They’ve had to tighten it up with customers abusing the policy by returning TVs every year before the Super Bowl and buying a new one (now limited to 90 days on electronics), but it’s still very customer-friendly. I’ve seen people return empty wine bottles.

What’s the result? I like to look at it this way – at the two extremes:

  • If you buy nothing and they can’t make any profit on markups, they’ll still charge you the $50 membership fee.
  • If you buy $5,000 of stuff and get the 2% cashback, your membership fee is basically free ($100 minus $100). If you remove membership fees, you’ll find their retail profit margin is actually a thin 1%. I visualize this as the 3% overall margin minus 2% cashback. That leaves them with 1% of $5,000 = $50 again. Coincidence?

In the end, Costco makes money even with such low profit margins, as long as they keep you as a happy customer. Over 90% of people renew membership every year. This leaves Costco only concerned about expansion of members. In fact, they have a rule that they never charge more than 15% of the cost of any product. That’s tiny in the retail world. Remember, they still need to pay for the building, worker wages, and so on. As a result, Costco prices will always be “very good”, but it can be beat by short-term sale prices of an aggressive competitor or “extreme couponing” at grocery stores.

For some perspective, Wal-mart’s operating margin is around 6%, and Target’s is almost 8%. Since the basic membership fee is $55 a year soon, your only hurdle is to buy enough stuff to make the $55 worth it. Assuming based on the operating margins that Costco prices are 3% cheaper than Wal-mart, you’d have to spend $1,833 a year (about $150 a month) at Costco instead of Wal-mart to pay for the $55 membership fee.

Based on these assumptions, if you are someone who is satisfied with all-around competitive prices and doesn’t want to hunt for the best deal all the time, and would be spending more than $150 a month at Costco, then the new membership fee should be still worth it. Our family got $88 cash back last year.

If you do go for it, you can get 3% cash back on gas, 2% cashback on restaurants, 2% back on travel, and 1% back on everything else with the TrueEarnings Card from Costco and American Express, which also replaces your Costco membership card.

Comments

  1. One caveat to this is that if you have the Executive Membership and do not spend enough to cover the additional $55, they will actually reimburse you for the difference.

    So basically, you should always go for the Executive Membership.

  2. There is not other company that I feel gives me the value and quality that Costco does. It’s the only company that I feel is actually looking out for my best interest. How many companies would you say that about?

    We upgraded to the executive membership a few years ago and have come out ahead every year. We also use the Costco American Express card and usually get around $400 back each year. Thanks Costco!!

  3. Sarah in Iowa says:

    There are no Costcos around here, but I recently heard one is being built in a town nearby. So now I’ll get to see what the hullabaloo is all about!

  4. Please note that cash back for executive membership does not include the gas charges.

  5. Money Beagle says:

    It always sucks to see an increase, but even with the extra $5, there’s still a great benefit to us in shopping at Costco. We love the fact that they offer coupons, and we save at least that much by using their coupons on products we would buy anyways, so as long as they continue those, it’s a no brainer.

    But if Costco happens to be reading these comments then the answer is ‘No, no, you must lower the in fact!’

    Never hurts to try, I guess :)

  6. Hi there. Great analytical article.

    I try to stay away from low costers and mega malls. I simply enjoy my produce fresh and buy little every time.

    I have been running and publishing our family budget last four years and groceries are only fractional amount of overall cost. Even by squeezing additional 100 a month, wont make much difference, but will take out much fun.

  7. Now that we have a child (growing bigger by the minute), we may soon be checking out Costco as an option. I agree with Financial Independence some though. We’ve stopped shopping at WalMart almost entirely because their selection has become far too limited, forcing us to routinely visit a traditional grocery store anyways. I fear that Costco won’t offer much more in the way of selection, just savings.

  8. hawks5999 says:

    You’ve hit the nail on the head. About 10 years ago, I did a stint at the Costco HQ and internally at the time, the messaging was “We make our money $45 at a time.” Meaning that memberships were their bread and butter.
    On the flip side, I worked for a supplier to Costco and that’s a tough relationship. Returns to Costco get sent back to the supplier no matter the condition and the sale is considered reverse to the supplier.
    It seems that at one point A LOT of Compaq Presarios got returned by people upgrading (buy a computer, use it a year, return it for refund, buy newer faster computer for same money, rinse, repeat). In this instance, Compaq said “forget it, we aren’t taking thousands of year old computers back.” So for one refresh cycle, Costco had consumer version Presario computers deployed to everyone’s desktop. Shortly after, the 90-day return on electronics appeared.

  9. I personally love costco but there is phsycological issue that they employ that Jonathan overlooked. Buying items in bulk is better for the producers and suppliers because you the consumer have to wharehouse(store) that item. YOu buy more and save because of cost of storage. This is fine if you ahve the space and for items that you use in a fixed amount, like toilet paper, paper towels, laudry soap. But when it comes to buying food and drinks or other items like hand-warmers you dont save as much money as you think. The problem is that when you see that you have an abundence of those items you do not ration your consumption as you normally would have if you only had a few. For instance, I have a desire for strawberries, I would be forced to buy 4 pounds of strawberries at Costco and then force myself to eat them in a greater quatity then I normally would have if I went a bought a pound at Safeway. If you are increasing your consumption of something just because you have it in your house then are you really saving any money?

  10. Wow, a lot of love for Costco among your readers! Being a frugal Vanguard Diehard, I feel like I should too, but I don’t. Oh gawd no…

    About once a year a friend who is a Costco member drags me along in preparation for some picnic or office party or other event. Honestly, there is nowhere on the planet I dread shopping more.

    * Crowds! Have to skip work to avoid them
    * No credit cards? YGTBFSM! Thus, no cashback…
    * Buy more stuff, but no bags! Instead, Costco offers you the most poorly designed boxes for carrying groceries ever conceived. What the hell is that about.
    * Membership fee
    * Parking, parcel pickup situation is insane
    * I have a small house, and you expect me to store a three-month supply of anything?

    Anyway, that’s my $0.02. I shop at Asian markets all the time, and I’m pretty sure my unit costs are competitive with what Costco charges.

  11. Not sure about returning empty wine bottles.. We buy wine quite often from Costco. Once, the wine was spoilt (ie. had turned vinegarish), so we went to return the bottle within a few days of purchase with most of it still undrank. The return was refused; the person said that it was Costco policy that opened wine bottles cannot be returned regardless of reason. I was surprised given Costco’s usually liberal return policies and felt that this was rather unreasonable; spoilt wine should be accepted just like any defective product – particularly when most of the bottle has not been drunk and the spoilage can be confirmed.

  12. One thing overlooked so far in this discussion is Costco’s Pharmacy. I am on a maintenance drug that I have to take everyday for the rest of my life. There is no generic equivalent and because of the specifics of my condition there probably never will be. A 90 day supply through my insurance is $105 ($35 per 30 days). 100 day supply from Costco is $75 without my insurance getting charged. That annual difference more then pays for my membership every year, anything else after that is bonus. Costco publishes the cost for many common maintenance medications on their web site. If, like me, you’re on such a drug and have a high co-pay you should check into it.

  13. Your calculations are wrong on the profit on the executive membership. If you pay $100 for membership and then get $100 in cashback then you are even, but Costco got your $100 plus sales with profit of $150 (total $250) then gave you back $100 leaving them with $150.

  14. We share an executive membership. Since I don’t need to carry a card, my wife has a card and so does our married daughter. We each pay $50 and easily make it back.

  15. You forgot to mention Costco gas. This tends to be cheaper than most and coupled with the Costco Amex credit card, is a great deal. We are a two member household who only buy odds n ends in Costco. So we don’t end up with free membership, but usually rake in around $60 to $75 executive rewards and about $250 on the credit card (by using it solely for gas n dining out)

  16. @W – I could easily be wrong about the ability to return wine, but I definitely saw empty bottles in people’s carts in the return line. I can understand returning spoilt wine, but if I was returning something I would just have corked that baby up like you did.

    @Robert – You’re right, I had it wrong, but the result is correct. Costco’s 3% margins as a company include the membership fees. If you exclude them, their retail operating margins are only 1%. $5,000 x 1% = $50.

    @Dennis, Haha – It correct in that Costco gas does not get the 2% back from Executive membership, but you do get the 3% back from the Costco American Express card. Not bad, since my PenFed gas card is not an American Express.

    http://shop.costco.com/en/Serv.....tions.aspx

  17. * Crowds! Have to skip work to avoid them

    true

    * No credit cards? YGTBFSM! Thus, no cashback…

    they do allow the Costco AmEx. 1% cashback on general items.

    * Buy more stuff, but no bags! Instead, Costco offers you the most poorly designed boxes for carrying groceries ever conceived. What the hell is that about.

    yes, very annoying. My theory is that they do this on purpose to give you a more warehouse experience. It makes you feel that they are skimping on the luxuries (painted walls, bags, decorations, etc) to pass the savings on to you. I’m sure it does save them some money, but I’ll bet it’s more for the psychological effect.

  18. Regarding the no credit cards = no cash back.

    A little work, but you can buy Costco cash cards on their website with a credit card of your choice. Doesn’t have to be Amex. Then use the Costco cash card at the store.

  19. Who said Costco doesn’t take credit? They take Amex. All Amexes.

    Boxes and bags? What do you need boxes and bags for? Seriously.

    We go almost once a week to costco. We buy fresh veggies/fruits, a few fresh types of fish, tofu, and other bulk odds and ends (tp, bread, milk every two weeks, pinenuts, grape seed oil). When it’s all said and done we spend over $300 a month there (not including maybe 1-2 fillups a month). We can’t get fresh salmon at our local san diego markets even near the same price; most markets have shoddy looking seafood locally too and certainly nothing like the clams, mussels, etc that Costco often has for their road shows. Cheeses at local markets are outrageously priced (though we will indulge in Whole Foods’ cheeses as the selection is awesome). Likewise the bulk fruits and veggies (spinach, broccoli, peppers, hearts of romaine, etc) at most local markets are quite pricey. 3 of us and we easily blow through fresh meats/veggies every week. Unlike most Americans we tend to avoid potatoes/rices/noodles (save for quinoa/brown rice) so maybe if we relied on these items we’d see savings from local shopping. Anyway, when it’s all said and done if we ever step into regular markets we’re shocked at how little you can get for you money and how little is actually in there. Asian and Indian markets we do love and frequent but that’s because we can’t find the ingredients we want for the dishes we make (hell at the local market they charge several dollars for basil or lemon grass – insanity – try even finding thai eggplant in a local market). Unless you plan and shop with coupons local super markets tend to be really expensive.

    Obviously we get our money back on our costco executive card every year and the 5000 in points or so pretty much gives us half a hotel room for a night on our Starwood Amex. Probably would make more sense to get a Costco cash back amex but it’s just easier to use one amex for 90% of our purchases.

    Love our local costcos (several within a few miles) and unlike Walmart we do not feel guilt or icky going in there: great products, good prices and friendly staff. They’re the opposite of Walmart.

  20. Gas doesn’t count? I’ll have to check out expenses at Costco but I know this august we got a check for over $100 on our executive card. Shrug.

  21. I don’t think you can include the 2% cash back when deciding if a membership is worth it. I have a Fidelity Amex with 2% no annual fee. I will get the 2% if I use it at Walmart or Costco. I think you have to look at the savings exclusive of rewards.

  22. I have been a member for several years now. We buy bulk things we use a lot of like paper towels, tissues, toilet paper, etc. I also buy meat there; frozen scallops, shrimp, chicken, etc. are all very cheap per gram of protein. And I know that Costco sources their food responsibly, for example the only buy tilapia from U.S. producers whereas Walmart gets theirs from China. They sell three racks of baby back ribs for the cost of two at my local supermarket. They have good deals on electronics.

    We also use the pharmacy and save enough annually to more than pay for our membership. To Brad, above, in many states (including mind) Costco is required or chooses to allow non-members to use their pharmacy as a public service. So call your local warehouse and if you are only using them for drugs you may be able to do so and save the membership fee. You just tell the person at the door you are there to use the pharmacy and they will let you in. They may give you a pass to scan when you pay for your prescription or the cashier will scan a store membership card to check you out.

  23. Anonymous says:

    >One thing overlooked so far in this discussion is Costco’s Pharmacy.

    In most states you can use the Costco Pharmacy without a Costco membership… Just inform the store you are there for the pharmacy and they will direct you over without the need to show a membership ID. Same with certain liquor sales, which is why some Costco’s have a sepereate entrance to the liqor section as they can’t require membership for those types of purchases.

  24. Costco makes you fat.

    You didn’t figure in how much money you lose by:

    - buying bigger quantities than you really want

    - the health care costs from being encouraged to consume more than is healthy.

  25. I really don’t understand all the fuss about Costco. I go for the pharmacy every once in a while, and have browsed the aisles while waiting. Their prices are roughly the same as grocery stores or Walmart if you know how to do proportional math. If you can figure out the unit price (per pound/ounce) you’d see how there really is no savings, and plus you have to buy such large quantities and the membership. I really think the popularity with Costco is from the “group mentality” of everyone else is going, so I should too.

    I live in CA so I don’t know whether there’s actual savings elsewhere. Maybe if you live in a small town without so many stores to compete with, then costco prices may be better. Out here there’s so much competition between stores they outprice each other. I’ve been able to find way better deals than Walmart even! Especially in the spanish neighborhoods. 99cent Only Stores are a big deal here.

  26. @Marie:
    It is not that you can only buy big boxes of cookies and junk food in Costco. Self control is always more important. We enjoy our daily fresh fruits and vegetables bought from Costco weekly. We buy cans of tomatoes to make our own marinara sauce and freeze them in containers for busy weeknights. We only buy some sweet goods when they go on sale once in a blue moon and we keep them in the freezer so we only have a bit each day. We freeze the meat in parts as well. I never feel the obesity rate among costco shoppers is worse than people in the local grocery store or as high as customers in Wal-mart. We actually save about $50 each year just from buying (1%) milk. (Averagely we need 3 gallons every 2 weeks.)

  27. @marie – lack of self control and lack of exercise makes people fat. You don’t need to buy carb heavy junk. Most of what we buy = fruit, veggies and proteins. Avoid rice, potato, noodles and it’s quite a bit easier to stay lean.

    And yes, milk is significantly cheaper at costco. Not even close to the local stores. Same with yogurt (weekly purchase of non-fat greek yogurt – easy 140 calorie, high protein, low sugar, no fat breakfast).

  28. i am a costco member. however i recently got into “extreme” couponing for RiteAid/CVS/Walgreens/Walmart, and i never had to pay for toothpaste and toothbrushes (literally!). most personal care and household items can be bought for less than a dollar each (dove, pantene, neutrogena, etc) although i can’t seem to get a good deal on toilet paper or paper towel, so for that, we may have to renew our membership. biggest caveat with “extreme” couponing is the time spent preparing for these weekly deals. I worked it out now that I’ll only spend a lot of time only on really good deals – like free stuff or shampoos/conditioner that are .50 or less.

  29. Anonymous says:

    The Fidelity Amex+Penfed Visa is a better deal that the Costco Amex. The Fidelity Amex pays 2% on everything including Costco purchases, where the true earnings card only pays 1% on costco sales (plus you get the 2% extra from Costco with executive membership for a total of 4%). Plus the fidelity Amex gives you the cash every month your rewards hits $50. The True earnings cards only pays out the cash back once a year, and you have to redeem the coupon at Costco if you want the cash. If your close the card and/or Costco membership early you forfiet the cash.

  30. Costco’s prices are far more than 3% lower than Wal-Mart’s. Your assumption overlooks the fact that Costco’s expense structure is much smaller than Wal-Mart’s, which enables them to price lower than the 3% operating margin gap would suggest. Despite paying their employees more, the actual operating costs of running a store (per dollar of sales) is far lower due to the warehouse nature of the store and much, mcuh higher productivity. On average, each Costco location averages more than $100 million per year, which is a heck of a lot.

  31. Costco allows non-costco Amex credit cards? Wow, I didn’t realize that. I’m using my new Fidelity Amex at costco from now on.

  32. I don’t care about Costco’s stock holders. I care about my pocket book. After being an executive member for years, I am not going to renew any kind of membership at Costco even though I love their stores and their quality of products, as a matter of principle. I feel that persons who were prior members before the membership increase should have been grandfathered in. It has been my experience dealing with Costco. They don’t listen to their membership and they don’t care what we think. I am blind, have MS, and live on a disability check, and these rate increases are just to much for me to handle. I won’t be joining Sams Club either because of their low quality merchandise. I am checking out Trader Joe’s since I need more Organic and chemically free items, which Costco also refuses to sell. I hope their business takes a nose dive! Merry Christmas to all. Cheryl

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