Playing the Long Game: Risk Management Lessons from Costco and Charlie Munger
Costco operates with the lowest gross margins among major US retailers but boasts the highest returns on invested capital. This impressive profitability, coupled with operating margins similar to competitors, stems from Costco’s efficient operating and business model.
The late Charlie Munger, a longtime Costco board member (from 1997 to his death in 2023) used to call Costco the perfect business.
It’s seemingly simple business model rests on five key pillars:
At its core lies the membership model. Customers pay a fee, fostering loyalty and providing predictable revenue that allows Costco to offer unbeatable prices.
The company strategically limits its product selection, focusing on top-selling items bought in bulk. This drives volume discounts from suppliers and simplifies logistics, reducing operating costs.
No-frills warehouses and minimal advertising further cut expenses. These savings translate directly to lower prices for shoppers.
Costco’s Kirkland Signature brand amplifies this value proposition, offering quality at competitive prices.
Finally, Costco invests in its employees. Higher pay and benefits create a loyal, knowledgeable workforce. This translates to better customer service and encourages repeat business.
Business’s profitability is mainly driven from its membership system. Membership fees (totaling USD 4.6 billion in 2023) contribute directly to the bottom line with no added costs and account for more than half of the net profit. These fees historically comprise around 2% of merchandise sales revenue.
In a recent knowledge project podcast with Shane Parrish, Chris Davis, a Berkshire board member recalled a conversation Charlie Munger on these membership fees and argues that if Costco raised prices by 2% and eliminated the membership requirement, it would likely remain the most price-competitive retailer, given the vast difference in the gross margins compared to other retailers. On top of that, with the membership requirement lifted, Costco should see an increase in revenue as the customer base expands to include non-members. In response, Charlie Munger told Chris that the people Costco keeps out by requiring membership likely hesitate to provide basic identification. Further, they’re also the type who might struggle to understand the long-term value of the membership, and who might even be more inclined towards shoplifting.
The response offers deeper insights and embodies a core principle of risk management: deal only with people and businesses you trust and understand. In both life and business, risk management is a simple concept. It centers around proactive identification, assessment and mitigation of potential losses that could threaten long-term viability of an investment, a relationship, our integrity, or reputation. It’s about knowing what could go wrong, how likely it is to happen, and taking steps to minimize the potential damage.
While risk management textbooks discuss numerous techniques, all strategies center around four key strategies and Munger’s strategy of only dealing with people and businesses you trust and understand cuts across all of them:
Avoidance: The simplest approach – like choosing not to drive in a storm to prevent an accident. Businesses might avoid risks by declining to enter uncertain markets or launch risky products. Costco’s membership fee discourages customers unlikely to appreciate its value proposition, potentially avoiding problematic customers (avoidance).
Mitigation: Reducing the potential impact of risk, like wearing a seatbelt for safety. Businesses might mitigate risk with safety protocols, insurance, or by carefully vetting partners. By selecting customers who value membership and have a history of responsible shopping, Costco mitigates risks like shoplifting and theft (mitigation).
Transfer: Sharing the risk burden, often through contracts or insurance. A business might outsource risky operations or purchase liability insurance. Munger’s strategy might be seen as a form of risk transfer in a broader sense. By carefully selecting members, Costco transfers some responsibility for customer behavior to the customer base itself. They are essentially relying on members to self-police and uphold a certain standard of conduct.
Acceptance: Some risks may be too small or costly to fully address. In these cases, businesses make a calculated decision to accept them, like ignoring minor car scratches. Even with a screened membership base, there will always be a residual level of risk. Costco accepts this by focusing on building trust and loyalty with its members, aiming to minimize the likelihood and impact of such incidents.
While risk management can become complex, and there is place for managing risks in business through hedges and insurance, but this approach forms the bedrock of any effective risk management strategy. Our strategy focuses on a core idea that can protect us from significant losses. We can view any area of our life through its lens, be it our business, investments, relationships, or career. It’s all about carefully framing our decisions and understanding the potential consequences.
Work with Integrity
Imagine being offered a job at a company that seems wildly successful. But the more we learn, the more we realize their practices are shady, maybe even illegal. While the immediate paycheck might be tempting, the long-term risk to our reputation could be devastating. Choosing employers who operate ethically and where we understand how the business makes money reduces this risk of being caught in a scandal that could stain our career for years to come.
Understand our Investments
Before investing in the latest hot stock or complex financial product, take a step back. Can we easily explain how that investment is going to make money? If not, we’re essentially gambling. There might be hidden risks we haven’t considered. Instead, focus on investments whose risks and returns we clearly understand. This is our best protection against unpleasant surprises and financial losses.
Choose Relationships Wisely
We sometimes maintain friendships or relationships for status, convenience, or perceived benefits. But if trust is missing, and if it feels like everyone is looking for what they can get out of the situation, the potential for future hurt is high. Prioritizing relationships built on trust and mutual respect offers a sense of security and protects your emotional well-being in the long run, even if it means forgoing some fleeting short-term gains.
This approach isn’t about eliminating risk entirely. Life, business, and investing are inherently uncertain. Instead, it’s about making informed choices, always considering the long-term view, and prioritizing lasting value over temporary gains. It’s about favoring substance over flash.
Think back to Costco. They could easily boost short-term profits by ditching the membership model, opening their doors to everyone, and raising prices. But this would likely erode their core strengths – a loyal customer base, streamlined operations, and the price leader image. Their success stems from a long-term commitment to a business model that, while unconventional, carefully balances risk and reward.
Much like Costco carefully chooses which products and customers fill its warehouse shelves, this method of risk management encourages us to be selective in our own lives. Whether it’s the job we accept, the investments we make, or the company we keep, do we truly understand the potential downsides? Are we prioritizing long-term well-being over the temptation of a quick, but potentially risky, win?
References:
Sol Price Retail Revolutionary & Social Innovator by Robert E Price
The Complete History and Strategy of Costco covered by Acquired podcast