BLL

September 8, 2008
Costco Case

Costco, a discount warehouse based in Issaquah, Washington,

specializes in selling quality products at low prices. The company operates

as a membership retailer, focusing its business on small businesses and

consumers with incomes averaging $75,000 a year. While the company has

strong competition with Sam’s Club and BJ’s Warehouse, net income for

Costco surpasses $1.6 billion in 2006, $100 million more than Sam’s Club.

By focusing on competitive pricing, a sizeable selection of products, and

treasure-hunt merchandising, Costco has developed a franchise that has

surpassed its competition.

The pricing strategy that Costco has implemented focuses on the

price-sensitivity of its consumers. The company has excelled in keeping its

prices low by capping the markup on its merchandise. By keeping the

markup 6% lower than its competitors, Costco has provided its customers

with deep discounts on over 4000 products within its stores. Sam’s Club,

which offers the same number of products within its stores, earns half the

income that Costco does at each store. Though Sam’s Club has more than

200 additional stores than Costco, Costco generated almost $20 million more

in revenue in 2006. Sales per location at Costco are triple that at BJ’s

Warehouse, which stocks 3500 additional products. Sales per square foot at

Costco in 2006 were almost $920, while BJ’s and Sam’s Club lagged behind

by more than $450 per square foot. Costco has been very efficient at
utilizing its floor space, generating high revenues from its products within its

stores.

Merchandise at Costco includes a “broad spectrum” of products

ranging from groceries, to media, to appliances. The company sold 96,000

carats of diamonds in 2006, focusing on upper-middle class consumers.

Though Costco sells products spanning 5 product categories, the percentage

of sales per category has been stagnant or decreasing. Costco has

successfully entered another market, creating two furniture stores, which

saw an increase in sales of 132% between 2004 and 2005. The company

has successfully offered diverse services compared to Sam’s Club and BJ’s,

introducing more ancillary businesses before its competition. Costco

increased the number of food courts, vision centers and pharmacies by 20

each year between 2004 and 2006. Almost every store now includes a food

court and photo center, providing an opportunity for Costco to increase its

sales within this category of items. Costco has ignored many of its

customers’ requests to stock certain goods in order to only sell products that

will sell quickly. Though the company does say that it focuses on its

customers’ demands, it has disregarded demands of certain items. It is

understandable that the company would do this, since products are sold at

low margins, allowing consumers to purchase more during each visit.

Costco has been very successful in opening stores more frequently

than its competitors. The company has opened an average of 20 to 25

stores each year, while BJ’s Warehouse and Sam’s Club have only managed
to open about 10 stores annually. Costco has successfully kept their

property taxes low, focusing on real estate which is located in areas more

secluded from other retailers. BJ’s Warehouse, however, builds its stores

closer to each other and closer to other retailers, where property costs are

much higher.

While the company has taken a bold strategy to keep prices low by

having a high turnover of inventory, some financials have been counter-

intuitive of the company’s goal. The company saw a significant drop in the

growth of net income from 2005 to 2006. Growth between those years was

slightly over 3%, when prior years had seen growth of more than 20%. One

factor that this can be attributed to is the 33% increase in income taxes

Costco paid in 2006. The prior year, Costco was able to decrease its net

income taxes by more than 6%. Changes in total revenue have seen

increases of at least 10% during the past several years. Though revenues

are increasing, increasing taxes and overhead have prevented Costco from

significantly increasing net income. Costco has been very inconsistent in

keeping its cash flows stable, with cash flows increasing only 3% in 2006, but

fell 15% in 2005. Though some of the high variance has to do with

investments in its furniture business, Costco has not developed a steady

increase in cash flows to appease shareholders.

Costco values its treasure-hunt merchandising strategy by selling

products that are expected to be sold quickly. This high inventory turnover

has allowed the company to stabilize its current assets between 2005 and
2006. Costco has increased its inventories by more than 10%, yet has

maintained its current assets at its current level. The company sells high-

end products which appeal to its upper-class consumers. The luxury

products keep consumers coming back to the store, knowing that a new

product may be available at an unbelievable discount. Even if the consumer

does not purchase the treasurer items, they will be enticed to purchase other

products that are regularly sold at Costco.

Costs at the warehouse are consistently paid off by Costco, allowing

the company to avoid extensive interest expenses. Since 2004, interest

expenses have decreased $24 million due to the company’s strategy to

quickly pay off all short-term debt. Costco has been able to take advantage

of payment discounts by paying its suppliers immediately. The company has

become more efficient in paying its invoices, decreasing the growth rate

since 2004. Working capital has significantly decreased since 2005, falling

$1 billion. This has decreased the amount of capital the company can use to

invest in its products and stores.

Costco has strong ethics within its business, developing a motivating

workplace for its employees to flourish within the company. Though the

ethics are strong, Costco has a weak mission statement that is not unique.

Within the company’s five principles, employees are seen as a priority in

order to be successful. Costco offers its employees very competitive

benefits and salaries, allowing employees to have satisfaction in their work

while working. The company focuses on providing strong benefits, which

allow its employees to feel as though they can work at Costco until they

retire. Though competitive packages are offered, the company prefers to

develop their employees within the company. When doing this, they have

turned down outsiders who may be able to bring in new innovations which

can propel the company further ahead of its competitors. Jim Sinegal

mentions that if a Harvard MBA graduate was looking for a job, he would tell

him that he would begin at the bottom of the company. This strategy deters

the company from accepting outside viewpoints, which could bring greater

profits. Sinegal instead wants to instill only his values without any outside

opinions, even if they may propel growth within the company.

While the company has surpassed its competition many levels, the

growth of income has slowed drastically. One of the largest problems the

company has faced is the significant increase in tax payments. As Costco

has decreased its interest paid, it has less debt to write-off to taxes. This

was caused by the company’s desire to keep debt low, and pay vendors

quickly to take advantage of discounts.

Though this method has been very successful, the company should

increase its liabilities and purchase more goods to sell in its stores. Costco

currently offers 4000 products, 1000 of which are continuously changing.

The company has a distinct advantage by knowing how to increase its

turnover of inventory rapidly. During the past several years, consumers

have requested products which the store does not carry. These consumers

could easily go to BJ’s Warehouse, which offers 7500 products. Costco has a
strong policy of keeping its customers happy, and by stocking their shelves

with highly requested products, consumers will gain a stronger loyalty to the

company. As consumers come into the store for one-time discounts on

luxury products, a wider selection of products will be available to them. In

order to keep inventory turnover high, Costco does not need to sell an

excessive amount of new products. By offering an additional 500 to 1000

products in its stores, Costco will have a larger selection than Sam’s Club,

while catering to its customers desires.

Though management at Costco has been efficient for many years, new

recruits and experienced businesspeople have been overlooked. Costco’s

policy of promoting its employees into management positions has been

effective for many years. As the world becomes more globalized, the

company has passed up many intelligent people who can have a significant

impact on the company. Costco needs to look into hiring graduate students

who have little to no work experience, giving them the opportunity to mold

them into the managers they desire. These students have a lot of theoretical

knowledge and motivation to lead a successful organization, while providing

innovative ideas that could lead the company to success. By offering a fast-

track program for recent graduates, Costco can expose its graduates to all

aspects of the business, allowing them to gain an inside knowledge of how to

further the success of Costco.

The company should not turn down outsiders who have experience in

other fields; these individuals bring a fresh perspective to the company.

Though Jim Sinegal wants his managers to be price-efficient, he prevents

future business leaders from entering. Sinegal preaches only one method,

but by allowing more outside leaders into the company, new pricing

strategies can be developed. As these leaders further develop the company,

Costco can continue to serve its employees and customers, while generating

a profit which will suit its stakeholders.

By adhering to these strategies, Costco can outlast its competitors and

become a greater threat to supermarket chains. These strategies fall into

the business model by only expanding its product line at a small degree.

The company can continue to generate high sales volumes and rapid

inventory turnover. Costco already has a successful strategy in place;

however, as net income begins to slow, investors will become weary of the

company’s future. With an improved strategy in place, Costco can continue

to service its customers, while satisfying the needs of its shareholders.