Business Case Studies #3: Costco's Secret Weapon (Classic)

What's up, everyone. This is Alex Lieberman, co-founder and Executive Chairman of Morning Brew. Welcome back to Founder’s Journal, my personal audio diary, where I give you, the business builder, the tools you need to think better in order to build better, whether that's building a business, a team, or a new product. This week on Founder’s Journal, we're doing things a little differently. We are dropping mini series full of case studies that lay out a number of lessons you can learn from successful businesses. That means instead of just one episode, Monday, Wednesday, and Friday, this week, we're giving you two: a new show that you won't want to miss, plus a classic episode you maybe haven't heard before. In today's classic episode, originally published on September 17th, 2021, I talk about a $200 billion behemoth and the place that I loved frequenting for free food samples growing up, especially loved their meatballs. I'm talking about Costco. Let's hop into it. 

Overview of Costco’s history

So let's set the foundation. The concept of Costco started in 1976 under this guy Sol Price, the original founder, who started the company under the name Price Club and price club was doing business out of a converted airplane hangar in San Diego. Price Club started as what is known as a B2B retailer, basically selling three types of products. One: what businesses used in their business. So think—food for a restaurant or printing supplies for a corporate business. Two: what businesses consume in their business. Think—toilet paper. And three: what business owners used for their own personal consumption. Think—things like TVs. But let's fast forward from the founding. In 1983, Jim Sinegal, who had worked for Sol Price in merchandising, distribution, and marketing, and then this guy, Jeff Brotman, who was an attorney that came from a retail family, they opened the doors to Costco. And Costco drew inspiration from Price Club. It was this concept of something called the Retail Warehouse Club, where customers were members, and because of the wholesale quantities that the store would sell, customers could hunt for bargains or buy in bulk for their businesses.In 1993, Costco ended up merging with Sol Price's, Price Club, and it has gone on to boast $167 billion in revenue. It has more than 800 locations worldwide, and it is the sixth largest retailer in the world behind Walmart, Amazon, Schwartz Group, Aldi, and Alibaba. So what has led to this just wild success over several decades of business? Well, I believe that the strategic advantage that Costco has demonstrated is that it can basically make no money on its product, meaning the stuff that it sells in the store, and by doing so, it will be able to convince members to pay for an annual membership, like a country club, but for retail, which is either $60 a year or $120 a year, and build a super loyal brand.

And the great part about this is because Costco is synonymous with quality and low cost, it retains its customers incredibly well. 91% of its members in the US and Canada stay Costco customers each year. And the fascinating part is it's been able to maintain this crazy retention of 91% while also being able to raise membership fees in recent years because of the loyalty it's built with its audience. At face value, understanding this concept of having super clear product differentiation and making money off of customers, not from the thing that they sell, but access to the thing that they sell is a really valuable mental model that spans many businesses, not just retail clubs.

The Kirkland factor

But for the rest of the episode I want to not just focus on Costco as a business, I want to focus on what I consider to be the secret weapon of Costco. And that is the Kirkland brand. More on Kirkland after this quick break. Let's get back into it. So, as I mentioned, Costco, unbelievable business that was started in the nineties and has grown to be the sixth largest retailer in the world. But I want to talk about Kirkland, which is the private label brand that Costco has been building and nurturing since the early nineties.

I would argue that Kirkland is the most successful private-label brand in the world at a time when private label is incredibly in vogue. And when we think back, why did Costco start creating its own product? Why didn't it just source from all of its partners that continue to fill its stores with product? I think the big reason is because Costco knew the leverage it had with having hundreds of millions of customers paying annual members, and it knew that it could undercut the big guys. It saw that a lot of retailers were raising prices simply because of pressure from Wall Street, as Wall Street increased its expectations of the revenue that retailers did.

And so it knew that if it could keep prices low and simply not increase them like many other retailers, that would be a competitive advantage. And so over the last 20-something years as Jim Senegal and Costco has built up the Kirkland brand, there have always been three things that leadership looks to in order to decide if they should go private label with it. One, is it a product that can be as good or better than the leading national brand? Two, is it a product that can be sold for at least a 15 to 20% discount as a Kirkland brand? And three, is it a product that is important for customers, something that they really want to buy?

But think about how crazy this is. Supposedly Kirkland, the private label brand for Costco, is being manufactured by the exact brands that are placing their product in Costco. Let me just say that again. From Kirkland coffee, which is being created by Starbucks, to Kirkland batteries, which are being created by Duracell, to Kirkland tuna fish, which is being created by Bumblebee, brands are manufacturing, Kirkland products to compete with their very own brands that are sitting on the shelves in Costco store. What that basically means is brands are agreeing to create as quality of a product by Jim Senegal and Costco standards and undercut their own products price, because like I said, they needed to be 15 to 20% cheaper.

For Costco, Kirkland bypasses marketing expenses 

So why would brands do this? Well, one, I think it's because brands actually can make good money by becoming a manufacturer for Costco and effectively white labeling their product. If you think about it, when brands create their product, they need to go and market their product. A marketing expense is a very large expense on a per product or per unit basis. And so by just being the manufacturer for Costco, Costco being the, now the brand that's responsible for building up the Kirkland brand, they bypass the marketing expense, and because that's a significant cost, it makes just selling the white label product to Costco actually a profitable endeavor.

Okay, well, let's, let's say that makes sense that by becoming a manufacturer and moving upstream and not just being the brand saves a company like Starbucks or Bumblebee money, because they don't have to spend on marketing for their own brand. Why would they create competition for themselves? I think there's two reasons. 

Why manufacture Kirkland: Power of brand

One is, I fundamentally believe that brands believe in the power of brand. Right? Like, why is it that people buy Louis Vuitton bags? Why is it that people buy, you know, Ford over Toyota, whatever it may be. Brands believe that customers value brand. And they have confidence that most consumers will pay even a little bit more for something that they associate trust and quality with.

And so I think what they justify to themselves is even if Kirkland stuff is just as quality as their own, consumers wouldn't know that, and so if consumers associate quality with the name brand stuff, they will always buy this. And I think there's actually value to that, especially in things like medicine. When I go to Walgreens or CVS and I'm looking to buy something like Advil or Tylenol, and there's the private label brand sitting right next to it, even though I am 90% sure that it is just as quality, I will continue to buy Advil and Tylenol because of all the brand equity that it's built up over many decades.

Kirkland equals opportunity cost 

I think the second reason that these brands take on competition or create competition for themselves is in thinking about the importance of their relationship with Costco. It's about opportunity cost. I don't think that Costco forces brands to manufacture Kirkland products for them. But I do think that is part of the equation when someone like Starbucks or Duracell is thinking about their relationship with Costco and how important that relationship is. At the end of the day, I compare Costco to a media company. It is one of the greatest distribution channels for a brand on planet earth. Not just because it has so many customers, but because of the number of products it has in the store.

For context, Costco did $148 billion in revenue in 2019. And if you're lucky enough to be a brand on their shelves, you are one of 3,700 skews or product offerings versus, in something like a Walmart, you are one of 100,000 skews. So if you get the privilege to have access to Costco's distribution, you also have way less competition with other products. Not hurting your position with one of your best distribution partners is likely more important than worrying about creating competition within unbranded or private label products like Kirkland. I will say, I think this is going to be tougher and tougher for private brands to justify over the coming years because we've moved into this moment in time where trusting private label brands is becoming normalized.

You have Kroger, which has its private label brand, which is Simple Truth. Target has Good and Gather, shopRite has Bowl & Basket. Amazon has dozens of private label brands, and you probably wouldn't even realize that they are created by Amazon. And we're seeing new startups explore this model in a digital first environment. As I had mentioned before, Italic, a DTC retail membership, is selling luxury goods at cost. Just to bring it back to Kirkland for a second, I don't think people truly appreciate how impactful this private label brand is for an already massive company.

Kirkland’s success: Differentiation 

Kirkland was responsible for $52 billion of revenue last year in 2020, which is about 25% of all of Costco's revenue. Just stop and think about that. Kirkland, a private label brand did more revenue last year than American Express, Pfizer, Coca-Cola, and Nike. We focused for a second on why brands would choose willingly to compete with the exact same product that is Kirkland, but let's talk about Kirkland for a second. Why has Kirkland been so successful? I think we have three reasons. The first is just true differentiation.

The oldest trick in the playbook in business. It's like the old Jeff Bezos quote, which is, "Your margin is my opportunity." Lower price is one of the oldest tried and true differentiators of products in the world. Because of Costco's ability to generate margin through its memberships, which makes up about three and a half billion dollars in revenue per year, the company can afford to sell basically all of its products, including Kirkland, close to cost and undercut pretty much everyone else's product. And it's an interesting exercise to think about, "How can you monetize your customer, in whatever business you work in, in different ways, by selling your core product at cost or a loss and monetizing or creating margin through other means."

The best analogy for this or the best model for this is the razor model. Razor handles are traditionally sold at a loss in order to then be able to sell blades for a profit. And like I said, we're seeing new startups explore this model in a digital first environment. Italic, like I mentioned is a DTC retail membership that sells luxury goods at cost. Its membership is $60 a year, sounds familiar, right? And it sells high quality or luxury goods made by the same manufacturers as Alexander Wang, Giorgio Armani, and other tier one retailers basically at cost.

And it's such a good reminder that you don't have to always make your money in business by charging more, but by simply giving people access to well priced products. So that's the first reason I think Kirkland has just done an amazing job in addition to obviously Costco more broadly. 

Kirkland’s success: Time

The second reason is time. This is the perfect real life example of the last episode of Founder's Journal on hacks and how the best hacks in life aren't really hacks at all. But instead doing the work and putting in the time. Kirkland has been around for 26 years, it has long been a focus of Costco and it spans from clothing, to coffee, to jelly beans, to hearing aids to batteries.

 Kirkland’s success: Distribution  

Costco has put in the work for nearly three decades for Kirkland to deserve the brand equity that it has today. In this world where we expect immediacy, we expect businesses to go from zero to a billion dollar valuation in 12 months because we've seen one or two examples of it. It's an important reminder that putting out a quality product that solves a clear problem for decades and doing it thanklessly is the most tried and true strategy in business. And then there's one last reason that I think Kirkland has been a massive success. And that is because Costco owns distribution.

Costco has 109.8 million card holders across 60.6 million households. It not only owns its audience, but it also owns an audience that is heavily incentivized to visit Costco frequently to recoup the investment of a $60 or $120 a year membership. When you have distribution and you also have data on what your customers like, you can create new products via the Kirkland private label brand at way lower risk because you have this built-in audience that has told you exactly what sort of products they'll buy most. I am sure the Costco strategy around what Kirkland products to go into next isn't an accident or throwing shit at the wall.

All Costco has to do is look at their customer data, understand what sells through well in their store, understand what they can have made just as well by the same brands that are in their store at a lower cost, and just rinse and repeat. That's why Kirkland isn't just focused on one product category, but literally everything from golf clubs to diapers. And that is the story of Costco, the OG retail membership club, and it's 26 year old secret weapon, the private label behemoth that is Kirkland. 

I want to hear from you 

I'd love to hear what resonated with you about the Kirkland story, whether it's the power of differentiating product based on price, building brand slowly and sustainably, or the power of owning your distribution and specifically how this has elevated your own thinking about your job or your business.How can you apply the lessons of Costco and Kirkland to your own company or the business that you work for? I would love to hear your thoughts on it. Shoot me an email to alex@morningbrew.com or DM me on Twitter @businessbarista, with what you've learned from this episode. And finally, if you enjoyed the episode, please share with a friend that you think would love to use Founder's Journal as a tool for thinking better in order to build better.

Credits

Our show is produced and engineered by Dan Bouza, our associate producer is Bella Hutchins, Brian Henry is our executive producer, Alan Haburchak is Morning Brew's Director of Audio. Holly Van Leuven is our fact checker, and I'm your host, Alex Lieberman. Thanks so much for listening and we'll catch you next episode.