The Fee Is Not the Business: How Costco Built a $4.8B Revenue Stream That Doesn't Behave Like Retail
Costco Wholesale Corporation collects approximately $4.8 billion in annual membership fees. Its merchandise operations — the warehouses, the pallets, the buying power — produce almost no operating profit on their own. The fees are not subsidizing the merchandise. The merchandise is justifying the fees.
This episode traces how that inversion accumulated — through decisions that looked, at the time, like operational discipline. Thin margins. Limited product selection. Above-market wages for retail workers. No advertising. Each of these looked like a constraint the company had accepted. What they were actually doing, in combination and over time, was building a membership asset that competitors could not replicate — not because the structure was secret, but because replication required accepting years of sub-market returns while waiting for something that only time could produce.
What this episode covers:
- How the warehouse club model worked and what condition it required to function
- Why Costco's margin discipline held through thirty years of public market pressure — and through multiple leadership generations
- Why Sam's Club has operated the same format since 1983 and still trails Costco's renewal rate by a significant margin
- The three reinforcing mechanisms that compounded the membership asset through the 2000s and 2010s
- What the 2024 fee increase — the first in seven years — revealed about the structural durability of the model
Full written analysis at deliberatedrift.com
Transcript
This is deliberate drift.
Speaker A:I'm Dawn Porthouse.
Speaker A:Today's episode is about Costco.
Speaker A:Not the hot dogs, not the parking lot, not the samples.
Speaker A:Here's the thing about Costco that most coverage misses.
Speaker A:The warehouses, the pallets, the buying power.
Speaker A:None of that is the structural advantage.
Speaker A:The structural advantage is something quieter, something that took decades to build.
Speaker A:And by the time it was visible, it was already too late for any competitor to replicate.
Speaker A:The question this episode is asking is not why Costco succeeded.
Speaker A:It is when the membership fee stopped being a funding mechanism and started being the business itself.
Speaker A: In: Speaker A:The fee was $25 a year.
Speaker A:The idea was not new.
Speaker A: same model in San Diego since: Speaker A:The logic was straightforward.
Speaker A:Charge members up front, use the revenue to subsidize lower prices.
Speaker A:Give members a reason to come back.
Speaker A:It was a funding mechanism, a way to make the math work.
Speaker A:To keep prices low enough to justify the fee, Costco had to keep merchandise margins thin in the range of 10 to 14%.
Speaker A:For context, conventional grocery stores run 25 to 30%.
Speaker A:Department retail runs higher still.
Speaker A:Costco was not failing to extract margin from its suppliers.
Speaker A:It was choosing not to.
Speaker A:The margin a conventional retailer would have kept was being returned to members in the form of lower prices.
Speaker A:The model required one condition to function.
Speaker A:Members had to believe the fee was worth paying.
Speaker A:As long as that belief held, fee revenue was stable.
Speaker A:And stable fee revenue made the thin merchandise margins viable.
Speaker A:The whole structure rested on member satisfaction, not as a nice to have, but as a load bearing element.
Speaker A:Now, here is where it gets structurally interesting.
Speaker A:So what happened when members renewed?
Speaker A:Any member who paid $25 in year one and came back in year two had already decided the exchange was worth it.
Speaker A:The second renewal required less persuasion than the first, the third less than the second.
Speaker A:Each renewal cycle, the decision to pay shifted incrementally, quietly, from an evaluation to a habit.
Speaker A:The fee became a standing commitment rather than an annual deliberation.
Speaker A:This dynamic was present from the beginning.
Speaker A:It was not yet understood as the structural core of the business.
Speaker A: In October: Speaker A:The combined entity, Price Costco, had more than 200 warehouse locations across the United States, Canada and several international markets.
Speaker A:Jim Sinegal became chief executive.
Speaker A:The Price family exited management within a year.
Speaker A: By: Speaker A:The merger mattered, but not primarily for the scale it created.
Speaker A:What it created was a new kind of pressure.
Speaker A:Price Costco was publicly traded from the moment of its formation.
Speaker A:That meant quarterly earnings expectations.
Speaker A:That meant analysts and analysts could see something that looked like an obvious opportunity.
Speaker A:Costco was sitting on a merchandising scale.
Speaker A:It was not monetizing.
Speaker A: s and into the: Speaker A:Why not expand the margins?
Speaker A:Sinegal's answer was always the expanding merchandise margins would damage the value proposition members were paying to access.
Speaker A:If prices moved towards conventional retail levels, the fee stopped making sense.
Speaker A:Members who stopped believing the fee was worth it would not renew.
Speaker A:And if they did not renew the fee revenue that made the thin margins viable would erode.
Speaker A:This was not a complicated argument, but it required thinking about the membership base as an asset.
Speaker A:Something with long term value that did not show up cleanly in a quarterly earnings report.
Speaker A:Margin cap held below 15% and most years well below.
Speaker A:And here's what makes this analytically significant.
Speaker A:The discipline outlives Senegal.
Speaker A:The 14 to 15% margin ceiling had been in place for years.
Speaker A:Did Costco intend to maintain it backer centered without equivocation?
Speaker A:That ceiling, he said, had been part of how Costco measured return for many years.
Speaker A:There were no plans to move it.
Speaker A:The question had been asked in various forms for three decades.
Speaker A:The answer had not changed.
Speaker A:What was shifting during this period, Largely beneath the surface of the financial reporting, was the quality of the membership base.
Speaker A:Each year that a member renewed was a year in which the renewal decision moved further from a price comparison and closer to an automatic commitment.
Speaker A:The base was not just growing, it was maturing.
Speaker A:Competitors watched Costco's growth and drew the obvious conclusion.
Speaker A:The warehouse club format worked.
Speaker A:Scale was the route to competing in it.
Speaker A: s and: Speaker A:BJ's Wholesale Club established a reasonable presence in the Northeast.
Speaker A:Both followed the same basic template.
Speaker A:Large format, warehouse membership fee limit product selection, bulk merchandise.
Speaker A:Neither closed the gap with Costco on the metric that mattered most.
Speaker A: By the mid: Speaker A:Sam's Club's renewal rate trailed by a significant and persistent margin, a gap documented in analyst and industry coverage across multiple decades.
Speaker A:The structural reason is not difficult to identify.
Speaker A:Stan's Club operates within Walmart.
Speaker A:Its financial performance is reported as part of a consolidated enterprise with its own earnings expectations.
Speaker A:Holding merchandise margins at Costco's floor, accepting near zero merchandise profit in exchange for membership.
Speaker A:Asset accumulation is a commitment that a standalone operator can sustain more easily than a Division of a publicly traded conglomerate whose shareholders are measuring consolidated returns.
Speaker A:Sam's club could replicate Costco's format.
Speaker A:It could not fully replicate Costco's incentive structure.
Speaker A:BJ's faced a different version of the same problem.
Speaker A: ship base from scratch in the: Speaker A:It was competing against the cumulative renewal history of a membership base that had been renewing for 20 years.
Speaker A:A new member at BJ's was making a first year decision.
Speaker A:A member renewing at Costco for the 15th time was not.
Speaker A:The responses confirmed rather than disrupted Costco's position.
Speaker A:Format replication without operational replication produced a weaker version of the model.
Speaker A:And operational replication without temporal replication, without the years of renewal history that produce habituated behavior produce a membership base that had not yet developed the inertia that Costco's had.
Speaker A: Through the: Speaker A:Each one was compounding the others.
Speaker A:First was the renewal flywheel.
Speaker A:Then merchandise margins delivered genuine value.
Speaker A:Genuine value produced high renewal rates.
Speaker A:High renewal rates produce stable fee revenue.
Speaker A:Stable fee revenue funded continued investment in buying power and employee quality.
Speaker A:That investment sustained the value that produced high renewal rates.
Speaker A:Each cycle of this fluke did not just maintain the position, it deepened it.
Speaker A:Members who had renewed multiple times were not evaluating Costco against alternatives each year.
Speaker A:The evaluation had already occurred repeatedly and the answer had been the same each time.
Speaker A:The renewal was becoming automatic.
Speaker A:The second mechanism runs through product selection, what I'll call the SKU Trust loop.
Speaker A:SKU just means individual product line.
Speaker A:Costco's warehouses carry fewer than 4,000 of them.
Speaker A:A conventional supermarket carries tens of thousands.
Speaker A:The constraint is also a service because Costco selects so few products that selection itself is a curation signal.
Speaker A:A member who trusts Costco's judgment about which olive oil or which mattress to carry does not need to comparison shop.
Speaker A:That trust accumulates with each satisfactory purchase.
Speaker A:The Kirkland Signature private label Deepen the loop further.
Speaker A:A household that relies on Kirkland for a meaningful portion of its regular purchasing has built a dependency that does not dissolve when the membership fee increases by $5.
Speaker A:The third mechanism was the employee quality loop.
Speaker A:Costco has paid above market wages for retail workers since its founding.
Speaker A:This drew consistent analyst criticism, the argument being that inflated operating costs unnecessarily.
Speaker A:Management defended it on retention grounds.
Speaker A: The third quarter fiscal: Speaker A:The structural consequence of above market compensation is lower turnover.
Speaker A:Lower turnover produces more experienced warehouse staff.
Speaker A:More experienced staff produces more consistent member experience.
Speaker A:Consistent member experience is a component of the renewal value proposition.
Speaker A:This loop operates on a longer cycle than the others, but its output, the institutional knowledge and customer consistency embedded in a stable workforce is the hardest element of the model for a competitor to replicate because it requires sustained above market labor investment for years before the benefit compounds into a measurable renewal behavior.
Speaker A: By fiscal year: Speaker A:The structural consequence of these three loops running simultaneously for two decades was visible in Costco's income statement.
Speaker A:Membership fee revenue approximately $2.3 billion operating income approximately $2.8 billion.
Speaker A:The merchandise operations, the warehouses, the inventory, the supply chain.
Speaker A:The employees produced operating profit of roughly $500 million, net sales exceeding 100 billion.
Speaker A:The fee revenue was not supplementing the merchandise profit.
Speaker A:It was the profit the merchandise existed to justify the renewal.
Speaker A:The temporal barrier is the one that cannot be purchased.
Speaker A: the warehouse club market in: Speaker A:What it could not do was compress the years required for membership base to mature from deliberate evaluation to habitual renewal.
Speaker A:That compression is not available at any price.
Speaker A:The other requirements follow from it.
Speaker A:Establishing a sufficient initial membership base to fund operations at thin merchandise margins.
Speaker A:Delivering enough value, consistently enough over enough renewal cycles to begin producing habituated behavior.
Speaker A:Sustaining above market labor costs before the retention benefit appears in the service quality data.
Speaker A:Building a private label brand from zero against a Kirkland signature that had been a household staple in millions of homes for 15 or 20 years.
Speaker A:None of these are individually impossible.
Speaker A:In combination, over the time horizon required, they constitute a commitment that no publicly traded competitor has demonstrated the organizational capacity to sustain.
Speaker A:The barrier is not the capital.
Speaker A:It is time and the organizational discipline required to accept below market returns.
Speaker A:While time does its work.
Speaker A:The membership asset is not a list of names and credit card numbers.
Speaker A:It's a behavioral state, the accumulated habit of renewal across millions of households.
Speaker A:A member renewing for the first time is making a deliberate cost benefit evaluation.
Speaker A:A member renewing for the 12th time is largely not.
Speaker A:The fee has been absorbed into the household budget.
Speaker A:The shopping pattern has been established.
Speaker A:The switching cost is not the annual membership fee.
Speaker A:It is the disruption of a deeply embedded routine.
Speaker A: opened its first location in: Speaker A:They have operated the same warehouse club format for as long.
Speaker A: In fiscal year: Speaker A:The gap between the two companies is not a gap in execution.
Speaker A:It's a gap in accumulated time, organizational incentive, alignment and the depth of habituated renewal behavior.
Speaker A: o things produce In September: Speaker A:The goal membership went from 60 to $65, executive membership from 120 to $130.
Speaker A:A fee increase is an explicit request for members to reaffirm the value proposition.
Speaker A:A membership base renewing out of habit absorbs the increase without significant attrition.
Speaker A:A membership base still making annual price comparisons does not.
Speaker A: The fourth quarter fiscal: Speaker A:US and Canada renewal rate 92.9% worldwide 90.5% CFO Gary Millichip, responding to analysts questions about member attrition, stated that the company had not seen a significant member reaction.
Speaker A:Renewal rates remained stable.
Speaker A: attributed specifically to a: Speaker A:Digital promotions attracting younger, less habituated cohort that renews at a lower initial rate.
Speaker A:As that cohort entered the renewal calculation, it dragged the aggregate rate down marginally.
Speaker A:The underlying renewal behavior of the established base was unchanged.
Speaker A:The fee increase is not just a revenue event, it's a measurement.
Speaker A:Each time Costco raises the fee and absorption is confirmed, the structural durability of the membership asset is documented.
Speaker A: The: Speaker A: The: Speaker A: The: Speaker A: The: Speaker A:The patent is not a coincidence.
Speaker A:It's the accumulated result of two decades of delivered value compounding into behavioral lock in.
Speaker A: Costco entered fiscal year: Speaker A:At current fee levels, the annual fee revenue run rate exceeds $4 billion.
Speaker A:That revenue is largely independent of merchandise sales fluctuations, largely immune to the margin compression dynamics that govern conventional retail competition, and largely secured by behavioral inertia that has been compounding for 40 years.
Speaker A:Three framings of Costco position are common.
Speaker A:All three miss the structural point.
Speaker A:The first, Costco succeeds because of scale.
Speaker A:Scale matters.
Speaker A:Purchasing leverage is real, but scale alone does not explain a 92.9% renewal rate.
Speaker A:Walmart has more scale than Costco.
Speaker A:Sam's Club has been running the same format for as Long scale is a necessary condition for the model.
Speaker A:It is not the structural advantage.
Speaker A:The second Costco succeeds because of operational discipline.
Speaker A:The margin cap, the limited product selection, the refusal to advertise the discipline is real.
Speaker A:It has been maintained against persistent pressure for three decades.
Speaker A:But discipline is a behavior, not an asset.
Speaker A:What the discipline produced over time the membership base whose renewal behavior has become habitual, that is the asset.
Speaker A:Costco is not valuable because its management is disciplined.
Speaker A:Its management has been disciplined long enough that the result of the discipline has become self sustaining.
Speaker A:Third, Costco succeeds because members love it.
Speaker A:Customer satisfaction scores are consistently high.
Speaker A:The brand generates genuine affection.
Speaker A:But affection is not a structural position.
Speaker A:What looks like affection from the outside is, in structural terms, the behavioral expression of accumulated switching costs.
Speaker A:Members do not renew at 92.9% because they are enthusiastic.
Speaker A:They renew because the renewal has become automatic, because the shopping pattern is established, the private label dependencies are real, and the disruption and cost of switching exceeds any plausible benefit from doing so.
Speaker A:What Costco actually built is a revenue stream that does not behave like retail revenue.
Speaker A:It does not fluctuate with consumer sentiment the way merchandise sales do.
Speaker A:It does not compress under competitive pricing pressure.
Speaker A:It does not require quarterly promotional investment to sustain.
Speaker A:It compounds not dramatically, not visibly, but year over year, renewal cycle by renewal cycle, as the membership base matures and the habit deepens.
Speaker A: The: Speaker A:Costco renewal rates held.
Speaker A:The second quarter.
Speaker A: Fiscal: Speaker A:Merchandise sales decline.
Speaker A:Fee revenue did not.
Speaker A:Durability is not a product feature.
Speaker A:It is the structural output of 25 years of operational decisions that, taken individually, look like restraint and taken together, builds something that conventional retail analysis had no framework to value.
Speaker A:Costco's renewal rates have held above 90% through recessions, fee increases and the expansion of digital retail alternatives.
Speaker A:The warehouse experience, the limited selection, the discovery dynamic, the physical scale continues to justify the fee for the overwhelmingly majority of members who encounter it.
Speaker A:But the experience that produces renewal is a physical one.
Speaker A:It depends on members showing up, navigating the warehouse, encountering products they did not plan to buy.
Speaker A:That is what the Kirkland brand is built on.
Speaker A:It is what makes Costco structurally different from a subscription service that delivers boxes to your door.
Speaker A:The question I want to leave you with is at what point does the shift in consumer behavior towards digital purchasing begin to erode the warehouse visit frequency that renewal motivation depends on and where the Costco's response to that shift, when it becomes necessary, will require changes to the model that the model's own incentive structure makes difficult to make.
Speaker A:That's the episode.
Speaker A:If you want to go deeper, the full analysis is@deliberatedrift.com subscribe for the next one and I'll see you there.
