Rock Center   |  April 25, 2012

Inside the Box: What’s the secret to Costco’s success?

Costco is famous for turning the experience of warehouse shopping into an adventure. CNBC’s Carl Quintanilla shows how Costco has grown to 600 stores, attracting loyal customers who return for the treasure-hunt thrill of constantly changing inventory, including diamond rings, steaks, wedding dresses and caskets.

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This content comes from a Full-Text Transcript of the program.

BRIAN WILLIAMS: they're known as big box retailers, just for their sheer size. What they lack in the charming old-school shopping experience, they make up for in bulk and volume and low prices. Costco is a big player among big boxes, an addiction to its devoted shoppers. There are 64 million of us, give or take, with Costco membership cards in our wallets, and they have made bulk shopping a science. There really is a trick to getting us buy all that stuff . The people at Costco recently allowed Carl Quintanilla a look at how it's done inside the box.

CARL QUINTANILLA reporting: It's 11 AM , less than 24 hours before the doors to this Costco in Augusta , Georgia , will open to the public for the very first time.

Unidentified Woman #1: And here's your card.

QUINTANILLA: This is the 597th warehouse Costco has built, and all the usual last-minute preparations are for a store that is highly unusual. The floors are bare cement. The ceiling stark skylights to save on electric bills. The merchandise stacked high on industrial pallets, saving millions in labor costs. Costco is a no-frills operation.

Group of People: One, two, three!

QUINTANILLA: And whether they know it or not, these customers are about to join 64 million other Costco members...

Unidentified Woman #2: Welcome to Costco !

Unidentified Woman #3: Thank you.

QUINTANILLA: ...in a retail revolution that has changed not only how people shop but how much they'll buy. Call it the " Costco effect."

Unidentified Woman #4: I thought I would spend about $25, and I ended up spending over $700, which is why my husband never lets me come here.

Unidentified Woman #5: I've never, ever spent less than three digits here. Even if I just come in for one thing, I always end up buying a minimum of $100 worth of stuff .

Unidentified Woman #6: It's going to be 326.94.

QUINTANILLA: No wonder Costco shoppers spend more than they plan. There are no signs or directory. Costco wants shoppers to wander and stumble across items they weren't expecting.

Ms. PARTHIE ORTH: And I do try to go down every aisle just in case.

QUINTANILLA: That sense of discovery and low prices are what draw customers like Parthie Orth , a New York marketing executive and mother of two.

Ms. ORTH: This is like my favorite thing at Costco is the meat lasagna. See, 12.99. I mean, you really can't make it for that little.

QUINTANILLA: Like many shoppers, she tries to stick to her list...

Ms. ORTH: Hand soap.

QUINTANILLA: ...but admits it's difficult to pass up a bargain.

Ms. ORTH: That was not on my list.

QUINTANILLA: Exactly what Costco wants.

Ms. ORTH: I'll sometimes end up with like, you know, three packs of toothpaste because I'll be going by the toothpaste and be like, 'Oh, do I have toothpaste? Oh, well, I should probably just get it just in case.'

Professor BRIAN WANSINK: What's really difficult to do is to not impulse buy . It's amazing. There's stuff there you've never even seen before and you say, 'I don't know what that is but I need three of them.'

QUINTANILLA: Brian Wansink is professor of consumer behavior at Cornell University and an expert on the appeal of Costco and other warehouse clubs .

Prof. WANSINK: Shopping at a warehouse club gives us license to spend like we otherwise wouldn't if we were in a normal store. We are motivated to save money. We are motivated to recoup our membership fee. And, as a result, we might even end up spending a little bit more .

QUINTANILLA: A little bit more adds up. Costco is among the world's biggest purveyors of meat, selling $4 1/2 billion worth a year, another 4 billion in produce, almost 2 billion in TVs . They sell 35 million prescriptions, three million pairs of glasses, and 55 million chickens every year. And spending more is impossible to avoid when everything is sold in bulk. Want waffles? Here's 60 of them. Like eggs? How about 90. Mayonnaise? Here's a tub.

Ms. PAM DANSIGER: It's part of the American psychology that more and bigger is better.

QUINTANILLA: Marketing consultant Pam Dansiger studies what stores do and why they do it.

Ms. DANSIGER: What Costco does is it really understands their consumer. Understanding what's going to excite them and then making sure you have the product that's going to be there to excite them.

QUINTANILLA: Three-quarters of what Costco sells are what it calls "triggers," staples such as cereal, detergent and paper towels . But it's the remaining 25 percent, what Costco calls "treasures," that make shopping here an adventure and create a sense of urgency. Those Sony flat screen TVs , Cartier watches and Prada handbags could be here today and gone tomorrow.

Unidentified Woman #7: I've sold five Prada purses this morning.

QUINTANILLA: Costco shoppers spend so much because they can. The average member is a college educated homeowner earning nearly a hundred grand a year, twice the national average. And they spend despite the fact that Costco actually stocks surprisingly few items, only around 4,000. That's nothing compared to the average supermarket which can carry 40,000 items. Dansiger says Costco 's limited selection is deliberate and counterintuitive. Take for example this ketchup.

Ms. DANSIGER: One ketchup, one choice. You don't have to choose from a variety of other ones.

QUINTANILLA: You've literally paid them to...

Ms. DANSIGER: Exactly. Yes.

QUINTANILLA: ...to do that for you?

Ms. DANSIGER: Yes. They've edited it down.

Unidentified Man #1: Run that down to the end register, please.

QUINTANILLA: Of course, the company does draw complaints.

Unidentified Man #2: The checkout, it's too damn long. It takes a long time to make your purchases.

QUINTANILLA: Another criticism, having to buy items in such large quantities.

Prof. WANSINK: The real perils of warehouse clubs is that, not that you spend too much money, I think it's that you actually waste the food because it goes uneaten or you end up eating way too many calories.

QUINTANILLA: Costco claims buying in bulk is precisely how shoppers save money.

Unidentified Woman #8: Have a wonderful day.

QUINTANILLA: But do they save?

Unidentified Woman #9: I feed seven every night. It makes it real easy to get the volume of food I need.

QUINTANILLA: A recent independent study by Consumers ' Checkbook confirms that Costco 's prices on food alone are about 30 percent lower than those at the largest supermarket chains. The secret? Costco says nothing it sells is marked up more than 15 percent. A typical supermarket has a 25 percent markup, department stores 50 percent. But less expensive doesn't mean cheap. Take its single biggest selling item, toilet paper . In a laboratory near Seattle , Costco technicians treat toilet paper like treasure, testing everything from thickness to strength to softness.

Unidentified Woman #10: You can definitely feel a difference.

QUINTANILLA: I think so.

Woman #10: It takes a lot of training.

QUINTANILLA: If that kind of obsessiveness makes you laugh, well, this staple of the American backside has a huge financial upside for Costco . Doing the little things right over and over again has made Costco 's founder and recently retired CEO, Jim Sinegal , a very wealthy man. I wonder what middle America would think if they knew there were all these complicated benchmarks for something as simple as this?

Mr. JIM SINEGAL: I think to most stories there's always a lot more behind the curtain than you expect. Generally speaking, when people ask, you know, I tell them all we're trying to do is sell stuff cheaper than anybody else, but there's a lot more work that goes into it.

QUINTANILLA: And that work begins long before it's tested in the lab.

Unidentified Man #3: We'll do a little closer look at tissue converting after the lab here.

QUINTANILLA: Toilet paper keeps Costco merchandise managers Russ Decaire and Nancy Griese on the road throughout the year.

Mr. RUSS DECAIRE: As we walk through this mill, we see things that we would suggest to them to improve our quality.

Ms. NANCY GRIESE: We're passionate about everything, but we're really passionate about the bath tissue. Learning how the machines work, learning about the paper and the humidity and the water and everything that's involved in that entire process.

QUINTANILLA: We went along as they inspected a paper mill in Green Bay , Wisconsin .

Mr. DECAIRE: See the spool start to spin on the top? So you're looking for holes or any sort of defects.

QUINTANILLA: On this visit, the Costco team has found a problem. The toilet paper is wrinkling, which will make the rolls look poorly finished.

Ms. GRIESE: This is something that we need to work on getting fixed.

Unidentified Woman #11: It's not getting wrapped up properly, and if the -- these wrinkles kind of get ironed into it with our rollers, so we know we still got some work to do . And that's how...

QUINTANILLA: A minor adjustment that may seem trivial, but one that's typical of the kind of passion and obsessiveness at the core of any success, even if it's toilet paper . Are there lessons from toilet paper , if you looked at the company as a whole?

Mr. SINEGAL: Oh, absolutely. How can you not fall in love with a product that is the number one thing that you sell? I'm sure most people would say, 'Really? Somebody really thinks about this stuff ?' But we do.

QUINTANILLA: Costco isn't the only company trying to think up a better toilet paper , but it has managed to find a new recipe for one of the oldest enterprises in human history -- selling stuff .

WILLIAMS: Fresh from Costco , Carl 's here with us. We've established our love for rotisserie chicken. Pet peeve, however, to add to your list -- bags. If I'm buying enough that requires a flatbed truck to take it to the checkout, hook me up with a couple of complimentary bags.

QUINTANILLA: They've actually thought about it in the past. It's just another item that would require their cost structure to go up, and they'd have to probably charge you more for everything they sell.

WILLIAMS: Oh, and it gets -- slides under the seats of the cars, it's a mess. I was going to bring my card tonight, but my photo looks like the Unabomber in 1985 . Those cards -- those membership cards, you were saying that's most of their profit?

QUINTANILLA: Most of their profit is from the fees themselves. Which means basically they break even on all the stuff they actually sell to you and me. Interestingly, 90 percent of members renew every year. And that includes people who move, who die. It's one of the highest renewal rates in retail, and it's a big reason they -- they're assuming, 'I'm going to make up this cost, this $50 cost in the savings I'm going to get from shopping at Costco .'

WILLIAMS: What could go wrong with their business at this point?

QUINTANILLA: I think the Internet 's a risk. We've seen what the Web can do, what Amazon can do to Best Buy . And I think longer term, you know, baby boomers are retiring, kids are leaving home, households will get smaller. Are you going to need to buy five pounds of cereal at a time? I think long term, demographically, we might begin to see some headwinds down the road.

WILLIAMS: All right, great stuff . Really fascinating look at this company and this store. Carl , thank you very much .

And Carl has an upcoming one-hour documentary, "The Costco Craze: Inside the Warehouse Giant ." It airs tomorrow night, 9 PM Eastern and Pacific on CNBC .