Costco: Weaving a Rope of Cost Efficiency

How Costco’s relentless search for cost reduction—shared with its members—makes for a devastating combination against would-be competitors.

The Philosophy

Costco thrives because it sticks to a simple philosophy: create value for customers, employees, and suppliers. Membership fees represent a $4.8 billion revenue stream that is nearly all profit and serves as an asymmetry allowing Costco to keep prices low. Costco pays its employees well, with a starting wage at $19.50 per hour; its average hourly rate is $31.50, implying long tenure and low turnover. Costco’s average hourly rate is almost 5x minimum wage. It also offers health benefits and 401(k)s. Given labor and benefits represent 80% of a retailer’s operating costs, this investment in employees directly impacts service quality and retention.

The Intelligent Loss of Sales

Costco intentionally limits its product selection, a philosophy pioneered by Sol Price, who founded FedMart and later Price Club. Sol called this “The Intelligent Loss of Sales”—the idea that customer demand is most sensitive to price, not selection. Rather than stocking three sizes of an item, Costco stocks the largest one that represents the best value. While not every customer will buy the biggest one, most do, and the best value often comes with the highest selling price. Costco carries about 4,000 SKUs—a fraction of a supermarket (30,000) or Walmart (140,000). The cost of dealing with 4,000 SKUs is dramatically less than 50,000.

Costco only purchases items that are simple to ship, receive, and put on the floor. The company calls this the “Six Rights”: the right merchandise, right place, right time, right quantity, right customer, and the right price. Before it even receives merchandise, Costco keeps distribution costs low by directly receiving most merchandise at the store or routing it to cross-docking depots, giving it freight volume and handling efficiencies rather than using a multi-step distribution chain.

Consider the warehouses themselves: each is about 147,000 square feet, with mature warehouses generating average revenues of $250 million. Large revenues per store combined with bare-bone warehouses—basic lighting, concrete floors, items stacked on pallets—makes Costco a self-service operation.

Rather than targeting a high percentage margin, Costco marks up each item 0–14% on general merchandise and 15% on Kirkland Signature. Even with its highly profitable membership revenue, Costco operates on gross margins of only 11%. In 2024, it turned its inventory 13 times a year and could sell a product in a week while not paying for it for another 30 days. Low margin does not mean unprofitable. In 2024, Costco did $7 billion in net income. Sol Price labeled Price Club a “low margin” retailer and felt he needed to be a fiduciary to the customer—you shouldn’t make too much profit.

Weaving a Rope of Cost Advantages

If raising prices is the easy way, what is the hard way? Costco is assiduously attacking its own cost structure, looking for ways to lower costs and then prices. Jim Sinegal, its former CEO, once said raising prices is “like heroin—you do it a little bit, and you want a little more.”

The search for cost reduction takes multiple forms. With 137 million members, Costco certainly negotiates good prices with suppliers. But it doesn’t rest—it continually speaks with suppliers to ensure it’s getting the best possible price. If it is, they search for ways to make items unique or make pack sizes larger. The Company will ask vendors questions like: what is the cheapest way to get the product into the warehouse, not how you typically do it with others? If Costco feels it’s not getting the lowest price, it will ask a vendor to manufacture under Kirkland Signature. For instance, Kirkland batteries are made by Duracell but priced 40% lower, with most savings from eliminating advertising spend. Costco’s willingness to develop Kirkland products serves as strong leverage.

If there is no viable way to reduce cost with a third party, Costco will vertically integrate. Consider how it keeps rotisserie chicken at $4.99: in 2019, Costco built its own feed mill, hatchery, and slaughter plant in Nebraska, contracting nearby farmers to raise over 100 million birds each year, saving up to 35 cents per bird.

In another instance, Costco changed the shape of its mixed nut container from round jars to square jars, fitting 44 additional units per pallet at the same freight price. It changed rotisserie chicken packaging from plastic containers to bags, reducing plastic by 17 million pounds per year and taking 1,000 trucks off the road. This mentality is embedded deeply in the Company. Employees know prices to the penny; they use the other side of a piece of paper rather than taking a new one. Executives take modest salaries. These are cultural reinforcers that keep Costco on the search for cost reductions.

Because of its 11% gross margins, cost reductions at Costco result in reduced prices—89% of the benefit flows to members. Jeff Bezos once said about Amazon: “We don’t have a single big advantage, so we have to weave a rope of many small advantages.” Like Amazon, Costco keeps weaving that rope.