(MONEY Magazine) – Do you remember the first time you visited a Costco? I do.

It was five years ago in Brooklyn, not long after the company opened a warehouse store in the wake of a storm of local protests. I was prepared to hate the place: a discount box store that was sure to blight the neighborhood, harm local store owners and tie traffic in knots. Who needed it? On the other hand, I had been dispatched to buy diapers, and I'd been told to buy them fast, cheap and in extraordinary quantities. So I went, I parked, I entered. And I quickly found my fire of hatred dimming--first to a simmer as I walked through the doors and flashed my wife's membership card, then to a dull glow as I saw the rows of wooden pallets stacked with amazing stuff at terrific prices. A voice in my head--apparently an inner Costco voice I didn't know existed--said things like Hey, I need that. Or Hey, I want that. Long before I made it to the cash register with a full cart--whether it was near the televisions or French roast coffee, I'm not sure--that hate turned to love. Costco, I had decided, was actually a lot of fun.

I was recalling this in late June when I visited Joe Portera, Costco's COO for its eastern and Canadian divisions, in his office in Sterling, Va. On Portera's wall hangs a framed newspaper commemorating the store's triumphant Brooklyn opening, but that's just one of many decorative items that point to the company's string of recent successes. Indeed, as Costco marked its 20th anniversary last month, consumer sentiment has remained warm and fuzzy--even if the investment community has been showing some skepticism (see the box on page 128). At the moment, the company has $41 billion in annual revenue and nearly 23 million member households. It has consistently outpaced its competition, inspiring levels of customer satisfaction, as measured by annual University of Michigan surveys, that place it among the most trusted names in retailing. More and more, it seems, we are relying on our local Costco branches for gas, groceries, household staples, clothing and hardware. And more and more, I would add, we are listening to our inner Costco voice when we visit.

But how, precisely, is Costco wooing us? Up the road from Portera's office is the company's Sterling branch, and that was what I asked as I walked through the cavernous store on a weekday morning with Portera and his deputy, Jeff Long, the company's Northeast chief. It was easy to get distracted. At the Sterling Costco, much like many of the other 418 Costco branches around the world, you can buy pricey Bordeaux and a lifetime supply of Cheerios. You can buy resplendent Waterford crystal and megaboxes of muffins. You can buy sleek Movado watches and buckets of cashews. The cartoon character Marge Simpson once rejoiced at finding a great price on a 12-pound drum of nutmeg at a store like this. It was a comic exaggeration. But only a slight one.

"We do simple very well," Portera agreed as we made our way through the store. Big quantities at low prices, he added, are the company's mainstay. Yet what Portera strenuously pointed out as we breezed past $1,500 wide-screen TVs, kiosks displaying $2,000 chandeliers and tables overflowing with Calvin Klein shirts is that Costco also does luxury items better than anyone. When I asked Long whether Costco rules out carrying things that are too expensive, he gave me a what-planet-are-you-on kind of look. "Never," he said, shaking his head. "I can never remember something being too high end for us."

In fact, high-end items are the key to understanding Costco's cultish national appeal. Costco is good--indeed, Costco is exceptional--at knowing what middle-class Americans need: peanut butter, paper towels, Snickers bars and lots and lots of toilet paper. But more important, Costco has refined the art of understanding what we dream about. And then, once Costco figures out what those dreams are, the store prices them at an irresistible discount. In doing so Costco is not only altering the way American consumers pursue luxury; Costco is altering the way American consumers perceive value.

TRADING UP AND DOWN

Jim Sinegal, the plainspoken CEO of Costco, likes to be frank about his Issaquah, Wash.-based company. "When you go to Costco, you don't find crap," he told a radio interviewer in Seattle not long ago in response to a question about the store's philosophy. When I caught up with Sinegal in early July, he was getting ready for a new store opening in Naperville, outside Chicago. This year, he says, Costco will open 23 new branches around the country, and none of them will sell crap either. "I hate to sound so simple," he told me, "but all we're trying to do is sell the best quality merchandise for a better value than anyone else." Sinegal makes the claim that it is Costco's deftness with luxury goods that puts it in front of competitors like BJ's and Sam's Club.

There's little doubt that the company's steady expansion over the past 20 years is also due in large part to being in the right place at the right time. In other words, as American consumers have come to seek higher-priced goods, Costco has benefited from giving people not only what they want but what they can increasingly afford. The recent economic skid has dimmed the company's appeal only slightly. While lean times leave consumers with less discretionary income, they also make them focus more on bargains and value. To its good fortune, Costco seems to have been well positioned for the boom as well as the bust.

In the meantime the company has exerted a unique effect on the dynamics of the marketplace. Warren Buffett recently called attention to the "Wal-Mart effect"--a tag that's been used to describe the billions in extra cash that consumers pocket thanks to the Arkansas retailer's low prices. But whereas a Wal-Mart effect might be seen in economic terms, a Costco effect might be viewed as cultural. Not long ago the Harvard Business Review ran an excerpt of a forthcoming book by Michael Silverstein and Neil Fiske entitled Trading Up--The New American Luxury. The authors--Silverstein is an executive with Boston Consulting Group and Fiske is CEO of Bath & Body Works--note that "new luxury," or "masstige products that occupy a sweet spot between mass and class," has recently begun to sell in enormous numbers despite their relatively high prices.

And Costco is a prime mover in this new order. Silverstein told me that Costco allows its members to simultaneously trade up into luxury and trade down into bargains. Indeed, says Silverstein, such trading down actually creates the opportunity for trading up. "The savings customers reap while buying the value goods allow them to splurge on quality name-brand stuff," he explains. I suggest that perhaps this kind of mental accounting--now that I've saved on that 24-pack of Bounty paper towels, I can buy the Starbucks coffee over the Maxwell House--goes on at a subconscious level. Silverstein disagrees. "I believe that every one of these purchases in the trading-up category is a planned purchase, and the consumer is deciding to buy the better good," he says. "And this is something that we think of as a revolution in the U.S."

SCOUTING THE HIGH END

He may well be on to something. By capitalizing on Silverstein's high/low dynamic, Costco has arguably benefited from this revolution more than any other retailer. But why have BJ's or Sam's Club, Costco's largest competitors, lagged behind? And why do the large department store chains that dominated America's retail sector for decades look so stale in comparison? I think part of the answer is that Costco presents its high-end and low-end choices to us with such precision and finesse.

One assumption about warehouse clubs is that their merchandise comes from a production overrun by a pants manufacturer, for instance, or a glut from an appliance producer that is destined for an everything-must-go table. In truth, most everything at Costco has been scouted, sampled, reviewed, tested and then preordered by the company, usually many months or years before we see it. Nothing is accidental. Items like Starbucks coffee and Similac baby formula reflect longstanding contracts; they also reflect the retailer's savvy grasp of how certain high-end brands appeal to aspirational consumers.

Even the "surprise" items are the result of a surprising amount of calculation. Of the 4,200 products regularly sold at any given Costco (a typical Wal-Mart, by comparison, carries upwards of 50,000), about one-third are rotated. Sometimes seasonal, sometimes not, these things seem to just show up in big piles, get snapped up fast and disappear from the store in weeks or days. Shearling jackets, Polo sweaters and camping tents all fall into this category.

The cut-rate prices and high-end sheen make this stuff look like it must have fallen off the proverbial truck. But where does it really come from? In many cases, it's created. Take Costco's annual lineup of camping equipment. Every year the company invites a dozen or so tent manufacturers to set up their latest designs on the lawn of its headquarters in Issaquah. Buyers spend a couple of days crawling in and out of tents--and then pick two or three and take them camping. When they get back, they contact the manufacturers to ask for improvements, and because Costco can move such an extraordinary number of tents, the manufacturers always hasten to comply. By the time a tent makes it onto the shelves, it is arguably the best on the market being sold for the best price.

THE TREASURE HUNT

Yet the way it's all displayed--piled high on pallets and heaped haphazardly on table displays--betrays none of what went on behind the scenes. This is intentional. The presentation is meant to suggest, accurately in many cases, that if you don't jump at the purchase today, you're not likely to get another chance. The flea-market aspect of Costco--what Portera calls "the treasure-hunt atmosphere for wow items"--has an unmistakable touch of theater.

Should Americans care if their favorite warehouse store mixes so much hucksterism into the soft sell? I found myself thinking about this often as I visited one Costco store after another and fought the recurring temptation to buy. On one hand, it's all concocted to sweeten the bottom line. Company managers never let the numbers out of their sight: Customers, on average, currently visit about once every 10 days and spend roughly $115 a visit. These metrics have steadily improved over the years, and continuing that trend is crucial to Costco's future success. If the company's store managers can persuade you to buy one more can of premium tuna (see the box on page 127) or snap up a treasure-hunt item that you would not have bought otherwise, they've boosted the company's bottom line.

On the other hand, Costco never offers loss leaders, never marks up anything more than 14% over cost, never asks a question if you want to return something. And its executives' claim that they hold quality to be their top priority appears to be borne out by the merchandise on the shelves. Wall Street has expressed some skepticism about Costco's ability to hold the line on its consumer-friendly policies and still be competitive in the cutthroat warehouse club business. But for now those policies remain part of Costco's core identity--and I think it's at least arguable that they've helped the store exploit an unmet demand in the marketplace more than they've exploited any of their members. What's more, this demand is pretty simple: Sell the best stuff for the least amount. No consumer will have any regrets--and none will resent your tactics. You almost certainly didn't come to Costco expecting to buy a shearling jacket or a tent, and you probably ended up spending more than you had planned, but you don't regret the visit. This was money well spent.

A NEW KIND OF BARGAIN

If the past few years have taught us anything, they've shown that even as the economy continues to sputter, vast numbers of middle earners have declined to relinquish the trappings of luxury. It may be coffee or it may be Cabernet, or it may be foreign travel or plasma-screen TVs (both of which Costco now sells), but there are concrete expectations about being middle class in America in 2003, and DVD players and good patio umbrellas are part of them. Some social critics have made the case that a plasma TV or a brand-name suede coat isn't by definition real luxury if you can buy it at a discount at Costco--an indication that the item has already moved beyond the trendy boutiques and elite department stores. But even if that's so, does it really matter? "All it means is that you're living only slightly behind the curve," says James Twitchell, the author of several books on luxury and consumerism. "You're also being rewarded for living slightly behind the curve. All these images that only yesterday were out of middle-class reach are now being stacked to the rafters."

Of course, this is not exactly what Sinegal had on his mind 20 years ago when he teamed up with an investor named Jeffrey Brotman and opened the first Seattle store. But Sinegal has always kept an eye on the high end, and what we see today is a natural progression from his founding vision. "Our business was originally aimed at the entrepreneur," says Sinegal, "and if anyone was going to buy a Movado watch or Waterford crystal, it was that customer. People who own businesses are at the top end of the demographic scale. So it makes sense that if you're targeting that customer, you should sell that kind of merchandise."

On the day the store opened, Sinegal remembers, the first customer bought about 25 Michelin tires. And so, while that first Costco in Seattle did not carry the fresh farmed salmon or diamond gemstones that members have come to expect, it did carry Dom Perignon Champagne, in addition to all the things a small businessman might need. Ever since, Sinegal has tried to push the upscale formula further and further along.

And maybe it's as simple as that--giving us the high-end products we yearn for while keeping the shelves well stocked with cheap peanut butter and paper towels. Yet the idea has effectively moved mass consumer culture to a new level. As Sol Price, Sinegal's former boss and the man generally credited with inventing the membership club in the 1970s, explains: "It used to be that people were embarrassed by the fact that they looked for bargains. That's no longer the case." Maybe that's because bargains are so different from what they once were. We used to think of a good value as an inexpensive product. Now value can apply to anything Costco decides to carry: wine, chandeliers, diamonds, fine furniture--you name it. It's no longer the case that the sale and the splurge are separate ideas. We can buy into the lush life and the not-so-lush life at the same time. And in the same place.