Executive Summary

Warehouse clubs have been one of the fastest growing retail formats in the US.  A distinct feature of this retail format is its membership fees.  There have been several explanations as to why membership fees are charged by the warehouse clubs.  One of the primary arguments presents the membership fee as the retailer’s major revenue source.  In 2004, Costco’s yearly revenue excluding the membership fee was $47.1 billion, whereas its revenue from the membership fee was mere $961 million.  Those figures for Sam’s Club are $37.1 billion and $881 million, respectively.   The membership fee revenues are just around 2% of the total revenue. 

            Consider that about half the US households are non-members of warehouse clubs, and a recent survey found that about 30% of them cite the membership fee as the major reason for not joining a club.  A quick thinking suggests that, by eliminating the membership fee, the warehouse clubs can add 15% of the US households in their membership base.  It seems that these additional shoppers would be more than enough to recover the lost revenue from the membership fee.  If that’s the case, the clubs’ own claimthat the membership fee provides a means of covering part of their operating costs is insufficient to explain the phenomenon.

            One can find other justifications of the membership fee, including consumer segmentation by non-linear pricing and boosting customer loyalty by providing exclusiveness of shopping privileges.  In this paper, we provide another rationale for the existence of membership fees: it functions as a competitive tool for the warehouse clubs against supermarkets’ price-discount promotions.  Price promotions can be initiated either by manufacturers or supermarkets, and may have various reasons.  By offering promotions, however, supermarkets can attract buyers who otherwise would not make the particular trip to the stores.  Among these buyers are those who make regular purchases at a warehouse club.  We call these store switchers the “cherry-pickers.”  They are the competitive front between the two retail formats, whereas each format has its own hinterland customers who make most purchases in one format or the other. 

            Using a Nash equilibrium concept to model competition between the two retail formats, we find that as long as the cherry picker segment exists, a positive membership fee is optimal for the warehouse club.  That is, the membership fee, combined with lower prices, will lock in the warehouse club’s loyal customers, and make the cherry pickers shop at the club only when there is no price promotion at the supermarket.  This minimizes price competition between the two retail formats, and makes both formats more profitable.  If there were no membership fee, all consumers will become cherry-pickers, resulting in a price war that is disadvantageous for both formats.  The equilibrium solution and the comparative statics to investigate the effects of the model parameters on pricing decisions provide managers several guidelines on yearly fee and retail price decisions.