Here's Why Costco Could, but Probably Won't, Raise Prices

By Daniel B. Kline Markets Fool.com

Costco (NASDAQ: COST) does not make most of its money from people shopping in its stores. Instead, membership fees -- people paying either $55 a year for a regular membership or $110 for an Executive Gold Star membership -- amount to about 75% of its profit.

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Thus the chain's chief goal is not inching prices up in order to increase its bottom line. Instead, the company puts its efforts into making sure people sign up and renew their memberships. That means that even when Costco can raise prices on its products and still be cheaper than its rivals, it may not do that.

CFO Richard Galanti called his company's stand on pricing "more extreme probably than others," and explained during the chain's Q1 2017 earnings cal how the warehouse club works to keep prices low l. He also laid out his thoughts on margins during the call, which was transcribed by Seeking Alpha (registration required).

"As it relates to some different types of competition out there the competitive pricing moat has gotten wider which is good," he said. "We haven't used that to improve our margins consciously in that regard, the wider the better."

Basically that's Galanti saying that his company has room to increase its margins, but has chosen not to.

Costco makes most of its money from membership fees. Image source: author.

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What is Costco's pricing strategy?

The warehouse club consciously pushes its suppliers to lower prices by dangling the promise of bigger orders.

"We are constantly going back to every supplier with our purchasing power, with our buying power ... and competition itself with private label to figure out how can we bring the quantity up, the quality up, and the price down," Galanti explained.

That's a strategy used by all big retailers. Wal-Mart, for example regularly goes back to its vendors and asks for price cuts under the idea that cheaper prices will increase sales. The difference with Costco and other retailers is that instead of using some of the savings to lower prices and some to increase profits, Costco generally uses its savings to push prices down as a way to increase sales, which in theory raises customer satisfaction leading to more membership renewals.

"We're certainly not going to benefit from every extra dollar of income," said Galanti, explaining what happens after a vendor lowers prices. "We're going to figure out how to use it to drive that competitive spirit and to drive our sales."

Costco takes a long view

Costco has chosen a business model driven by membership. Because of that, the chain has to make what must sometimes be difficult decisions to forgo increasing its margins in favor of passing on the savings to its customers. That's a behind-the-scenes thing that shoppers don't see, but which subtly impacts their decision to renew their memberships.

Costco could probably raise prices and make more money in the short term, but by playing a longer game, the chain builds loyalty.

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Daniel Kline has no position in any stocks mentioned. He has no interest in seeing La La Land. The Motley Fool owns shares of and recommends Costco Wholesale. The Motley Fool has a disclosure policy.