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Written Case Analysis: Costco

Costco is a membership only warehouse club that in 2012 had 598 warehouses in 433
U.S. locations, 82 locations in Canada, and the rest scattered throughout the world. It is the
second largest retailer in the U.S. and the seventh largest in the world. Revenues in 2011 were
$88.9 billion and net income was $1.46 billion. The following is a written case analysis of the
company focusing on its business strategy, management, financial performance, and competition,
ending with a few recommendations to sustain the company's growth and improve financial
performance.
Business Model
Costco's business model is summarized in the 2013 annual report. It states, "We operate
membership warehouses based on the concept that offering our members low prices on a limited
selection of nationally branded and select private-label products in a wide range of merchandise
categories will produce high sales volumes and rapid inventory turnover. This turnover, when
combined with the operating efficiencies achieved by volume purchasing, efficient distribution
and reduced handling of merchandise in no-frills, self-service warehouse facilities, enables us to
operate profitably at significantly lower gross margins than traditional wholesalers, mass
merchandisers, supermarkets, and supercenters" (Annual Report, 2013). The main
characteristics of this model are paid memberships, low prices, high quality, rapid turnover, and
low margins.
These elements combine to contribute to another important factor in the business model
mentioned in the textbook Crafting & Executing Strategy: often goods are turned over so fast
that they can be paid for with the cash received from sales, resulting in vendors themselves
providing the financing for payment and requiring less working capital (Thompson, 2014, p C-
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9). This business model is appealing for several reasons. First, the financing model makes it less
capital-intensive then its competition. Second, is that their competitive advantages are very
difficult to replicate, requiring a lot of experience and specialized systems and procedures in
order to capitalize on the low prices and high turnover enough to compensate for the low
margins. This leads to the third, related advantage, of there being relatively few direct
competitors of Costco, even though there are several competitors that overlap into parts of the
same big box retail market. It is a relatively unique business model, client base, and competitive
landscape.
Business Strategy
According to Crafting & Executing Strategy there are five chief elements of Costco's
business strategy (Thompson, 2014, p. C-9). The first is ultra-low prices. The company's
markup for most products is capped at around 15% while supermarkets markup about 25% and
department stores can be as much as 50% on some items. The business is constantly receiving
pressure from Wall Street executives and others to raise membership fees and markup
percentages, but their strategy is almost the opposite: lower prices to the absolute breaking point.
The next strategy point is to maintain a limited product selection - both in the number of brands
and the number of choices within the brands. Costco has an average of 3,600 items for sale in its
locations, while a Wal-Mart Supercenter might have 150,000 different items.
Another element of the Costco strategy is treasure-hunt merchandising. This is a
relatively unique strategy that consists of having 20-25% of the stocked items constantly rotating
and filled with low-priced special items of all price ranges that will be appealing to the typical
Costco shopper. One article summarized this strategy this way: "Unlike many mass-market
retailers, Costco tries to act as a curator of great values. This makes customers feel like they're on
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a 'treasure hunt' and are pleasantly surprised by the new items they find there" (Lutz, 2013). An
emphasis on low costs is another strategic element. Everything about the corporation is designed
for efficiency. The last chief element is Costco's growth strategy. This includes increasing sales
at existing stores by 5% annually, as well as opening new stores in the U.S. and internationally.
The strategy is very good as witnessed by the financial numbers. The company is now the
second-largest retailer in the U.S., and is "An anomaly in an age marked by turmoil and
downsizing" (Stone, 2013). Sales have grown 39% and the stock price has doubled since 2009.
Jim Sinegal as CEO
Jim Sinegal founded Costco with Jeff Brotman, the current chairman of the company's
Board of Directors in 1983, the same year that Wal-Mart launched Sam's Club. Sinegal became
CEO of the company in 1993, when it merged with Price Club, and continued in that position
until last year, when he stepped down at his own request and was replaced with Craig Jelinek.
During his tenure, Jim Sinegal was definitely an effective CEO and deserved an A grade in
crafting and executing Costco's business strategy. A strategic plans consists of the strategic
vision that will set the direction of the company, a series of objectives that will help it reach its
goal, a coordinated plan to achieve the strategy, and then the execution and constant evaluation
of the strategy itself. Sinegal was involved in every aspect of this from formulating the vision,
coming up with the plan, and insuring its execution. The vision that he had of where the
company would grow came from his background in working with Sol Price at Price Club, and
his down to earth business principles related in Crafting & Executing Strategy (Thompson, 2014,
p. C-18). These include obedience to the law, taking care of the customers or members, taking
care of employees, respecting suppliers, and rewarding shareholders. An overarching value can
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be seen in all of these principles: never cutting corners when it comes to people or
responsibilities, but only when it comes to prices.
Sinegal insured that this strategic vision would be spread throughout the entire company
by having strict hiring and training policies. Managers were promoted from within and only
after they had bought into the vision and shown requisite skill in merchandising. Once this
happened, they were well compensated so that they never wanted to leave the company. Then
they could continue to impart the company to vision others as well. Sinegal was also
instrumental in the development of Costco's key competitive advantages in pricing, efficiency,
product selection, and growth. These in turn, contributed to the company's functional-area
strategies such as marketing and customer service, and operating strategies such as internet sales.
Crafting & Executing Strategy states, "Developing a strategic vision and mission, setting
objectives, and crafting a strategy are basic direction-setting tasks. They map out where a
company is headed, its purpose, the targeted strategic and financial outcomes, the basic business
model, and the competitive moves and internal action approaches to be used in achieving the
desired business results" (Thompson, 2014, p. 35). This describes the leadership that Sinegal
provided Costco from its beginnings in 1983. The only thing keeping Sinegal from receiving an
A+ grade is that he and the rest of the upper-level leadership did not do a great job in raising up
the next group of corporate leaders. The current executive team are almost all in their 60s or
older, and the company needs to quickly identify and develop the next wave of leaders (Stone,
2013).
Financial Analysis
Costco's financials reflect its business model and strategy. In general, the company is
performing well, both year after year and in comparison with its competitors. However, in some
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of the commonly-used ratios, it lags behind the competition because of its strategic placement.
Longitudinal analysis shows that return on assets, return on equity, free cash flow, earnings per
share, dividends per share, and dividend yield are all improving annually since 2009 when the
global recession caused a dip in almost every company's year over year numbers worldwide
(S&P, 2014). Other metrics such as the price to earnings ratio and sales growth per store also
indicate good health, as the P/E ratio has fluctuated between $20 and $25, showing confidence in
the company's future outlook and earnings growth. Internal store sales growth has hit its target
of being above 5% every year except 2009.
Table 1 - Costco Financial Summary
($ in millions)
2008 2009 2010 2011 2012 2013
ROA 6.2% 4.9% 5.5% 5.5% 6.3% 6.7%
ROE 14.0% 10.8% 12.0% 12.2% 13.8% 18.8%
FCF $1,070 $1,773 $2,206 $2,092 $2,780 $3,198
EPS $2.89 $2.47 $2.92 $3.30 $3.89 $4.63
Div/share $0.61 $0.68 $0.77 $0.89 $1.03 $8.15
Yield 0.9% 1.3% 1.4% 1.1% 1.1%
P/E ratio 23.2 20.6 19.3 23.8 25.2 24.2
Store sales
growth
8% -4% 7% 10%
Data from S&P Compustat Company Research and Thompson, 2014.
Cross-sectionally Costco also compares well to its competitors and the industry as a
whole, in almost every category except its margins. Because their business model is focused on
keeping margins incredibly low, they do not compare well to their competitors in terms of gross
margin or profit margin. In almost every other category, however, the company financials fall in
the 50% range and up, with many categories falling in the top quartile for the industry. Costco,
because of its sheer size, will not always compare favorably with the industry financial averages,
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but in comparison with similarly-sized companies it stack up well. Additionally, it is a mature
company, which is impossible to grow as quickly as others in the industry that are more recent
start-ups.
Table 2 - Current Costco Financials vs. Industry Average
Costco Industry Average Percentile
P/E ratio 26.2 18.8 70%
Gross margin 13.5% 23.6% 15%
Profit margin 2.8% 4.9% 44%
ROA 6.2% 7.0% 66%
ROE 17.4% 16.5% 76%
Inventory turnover 11.2x 9.8x 50%
EPS growth -3.0% 1.3% 54%
Data from S&P Compustat Company Research and Thompson, 2014.
Costco Financials vs. Competitors
Comparing just the data available in Exhibits 1 and 4 for Costco, Exhibit 5 for Sam's
Club, and Exhibit 6 for BJ's Wholesale Club from Case 2 in Crafting & Executing Strategy,
Costco's financial performance is superior to these two competitors. From the raw numbers
below it is difficult to see this because Costco and Sam's are much bigger companies than BJ's,
however the average sales per location and sales growth per location figures are reflective of
Costco's superior performance due to its efficiencies and low-cost model.
Table 3 - Competitor Comparison Financial Summary
($ in millions)
2005 2007 2008 2009 2010 2011
Sales
Costco $51,862 $70,977 $69,889 $76,255 $87,048
Sam's $44,336 $47,976 $47,806 $49,459 $53,795
BJ's $8,792 $9,802 $9,954 $10,633
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Operating
income

Costco $1,474 $1,969 $1,777 $2,077 $2,439
Sam's $1,648 $1,649 $1,515 $1,711 $1,865
BJ's $195 $221 $224 $208
Assets
Costco $16,514 $20,682 $21,979 $23,815 $26,761
Sam's $11,722 $12,388 $12,073 $12,531 $12,823
BJ's $2,047 $2,021 $2,166 $2,322
Locations
Costco 433 512 527 540 592
Sam's 713 727 729 746 751
BJ's 177 180 187 189
Sales per
location

Costco $119.8 $138.6 $132.6 $141.3 $147.1
Sam's $73.9 $78.5 $79.0 $81.2 $88.0
BJ's $49.7 $54.6 $53.2 $56.3
Sales
Growth

Costco 7% 8% -4% 7% 10%
Sam's 4.9% 4.9% -1.4% 3.7% 8.4%
BJ's 3.7% 9.4% -1.9% 4.4%
Data from Thompson, 2014.
International Expansion
The data in from Exhibit 4 in Case 2 of Crafting & Executing Strategy definitely
indicates that Costco's expansion outside the U.S. has been financially successful. It also points
towards future financial success and growth as this expansion continues. This can be seen only
when setting aside the raw total revenue and operating income numbers and breaking down those
same numbers per warehouse for U.S., Canadian, and other international operations.
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Table 4 - Costco Per Warehouse Financial Summary
($ in millions)
U.S.A. Canada International Total
2011
Revenue $151.29 $170.98 $123.35 $150.19
Operating
income
$3.25 $7.57 $5.22 $4.12
Capital
Expenditures
$2.04 $1.76 $3.33 $2.18
2005
Revenue $127.41 $103.57 $105.17 $122.29
Operating
income
$3.46 $3.72 $2.17 $3.40
Capital
Expenditures
$2.17 $2.15 $4.07 $2.30
Data computed from Thompson, 2014.
This chart shows the tremendous growth in efficiency and overall revenues that Costco
has seen from 2005 through 2011 in its overseas locations. By 2011, Canadian operations were
beating U.S. operations in both revenue and operating income per store. Other international
operations were lagging behind the U.S. per store revenue numbers, but beating them in
operating income per location. It seems clear that there is still room for efficiencies to increase
in these international operations as well, which means that further expansion outside the U.S.
could bring up the total revenue and income numbers even further.
Competitive Advantages
The key aspects of Costco's strategy have already been identified as ultra-low prices,
limited product selection, treasure-hunt merchandising, low-cost emphasis geared towards
efficiency, and its long-term growth strategy. Since these are the foundations of the company's
strategic plan which has seen it grow to number 19 on the 2014 Fortune 500 list from its
beginnings in 1983, it should be safe to say that Costco does have a winning strategy. It is a
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winning strategy because the company is still healthy and growing, even when some of its
competitors have recently struggled. It has massive room and opportunity for expansion, both
domestically and internationally, as has already been addressed. One particularly amazing proof
that it has a winning strategy is that its strategy has not changed at all since the first store was
opened. Most large retailers have undergone turmoil, restructuring, rebranding, or wholesale re-
organization in the last decade, including K-Mart, Best Buy, Circuit City, Pet Smart, Sears,
JCPenney, and Staples. Costco has not wavered from its strategic plan or its competitive
advantages.
Costco's competitive advantages over Sam's Club and BJ's Wholesale Club were seen
previously in the figures comparing the companies' average sales per location as well as their
annual sales growth per location. It is clear from Costco's dominance in those categories that its
emphasis on efficiency and keeping operating costs at a bare minimum is a competitive
advantage over all its competitors. Another competitive advantage that the company has is its
commitment to good compensation of its employees. Costco trounces its competitors when it
comes to salary and benefits. Sinegal has stated, "It absolutely makes good business sense.
Most people agree that we're the lowest-cost producer. Yet we pay the highest wages. So it
must mean we get better productivity" (Thompson, 2014, p.C-17). Taking good care of
employees not only means higher productivity, but also good publicity. Costco rarely gets
hammered in the press as most of its competitors do, especially Wal-Mart.
Low Prices
Despite low price being a central part of Costco's business model, many argue that its
prices are too low. However, this is not true because their business strategy is not dependent on
the markup of its products, but on membership dues. In fact, its ultra-low prices are a
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competitive advantage compared to similar stores. If the company was dependent on product
markup for a good percentage of its revenues, then it would be fair to say that Costco's prices are
too low. But their management believe that even small increases in markup could hurt their
membership and volume purchasing strategies, thereby turning the price markup into a net loss.
It is a strategic decision to keep prices as low as they are with markups limited to 14-15%.
With that said, there is a significant community, especially among Wall Street and larger
shareholders, that think Costco could easily raise prices without any other negative
consequences. A New York Times article quoted a Deutsche Bank analyst saying of Costco,
"It's better to be an employee or a customer than a shareholder" (Greenhouse, 2005). Sinegal
defends the company against this claim saying, "When I started, Sears and Roebuck was the
Costco of the country, but they allowed someone else to come in under them. We don't want to
be one of the casualties. We don't want to turn around and say, 'We got so fancy we've raised our
prices,' and all of a sudden a new competitor comes in and beats our prices" (Greenhouse, 2005).
Another analyst said, "They could probably get more money for a lot of items they sell" but
Sinegal warns that if Costco increased markups even to 16 or 18 percent, the company might slip
down a dangerous slope and lose discipline in minimizing costs and prices (Greenhouse, 2005).
In other words, the company could lose the competitive advantage that they have built so
carefully over the years.
Generous Compensation
A concept closely related to the question of whether Costco's prices are too low is the
question of whether they compensate their employees too well. Costco leadership and
management again would say that their compensation of employees is one of their competitive
advantages and therefore it makes perfect sense for it to be so high. The practice results in
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120,000 "loyal ambassadors" of the company who are constantly promoting it to everyone that
they meet because they are pleased with the company in general and their compensation in
particular (Thompson, 2014, p. C-17). The practice also results in very low turnover in
comparison to their competition - under 6 to 7% after the first year of employment. Since the
company works hard at recruiting the right employees to begin with, the high compensation
makes it a more difficult decision for employees to leave the company. This leads to the high
employer approval ratings that are consistently quoted in articles about the company. Another
reason that this practice makes sense that has been mentioned previously, is that the consistency
in the strategic plan and upper-level management of the company is a good indication of
happiness and agreement between company employees, management, and shareholders as well.
However, just as with the practice of ultra-low prices, the company has detractors in Wall
Street that argue Costco is too generous to its employees. In regards to employees paying a
larger percentage of their own health care costs, one analyst says, "He (Sinegal) has been too
benevolent. He's right that a happy employee is a productive long-term employee, but he could
force employees to pick up a little more of the burden" (Greenhouse, 2005). Despite this feeling,
the company has shunned Wall Street pressure to be less generous to his workers. One aspect of
the high employee compensation overlooked by these detractors is that Costco's executive
compensation is much lower than other Fortune 500 companies. Sinegal explains the reasoning
behind this: "I figured that if I was making something like 12 times more than the typical person
working on the floor, that that was a fair salary.... I've been very well rewarded. I don't require a
salary that's 100 times more than the people who work on the sales floor" (Thompson, 2014, p.
C-18).
Recommendations
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Given Costco's relatively quick growth to emerge as one of the world's largest and most
successful companies, any recommendations given here should be read with the knowledge that
they are given without any first-hand experience and limited research. The company obviously
knows who it is, what it is doing, and where it wants to go. Having said that, however, several
recommendations are here offered. The first is based on anecdotal observation. Many of the
things written in the short summary found in Case 2 of Crafting & Executing Strategy are not
commonly known to American consumers. So while 2% of the company's budget is saved each
year by doing minimal advertising, having one intensive marketing campaign each year for each
warehouse location could easily more than make up for any funds spent by the enlisting of new
members. Membership advantages that few people know about could be highlighted. Key
differences between Costco and Sam's Club and other competitors could also be stressed, as the
general public thinks they are very similar stores.
Another recommendation is to increase the speed of expansion into new markets,
especially domestically, but internationally as well. The key to Costco's outperformance in
comparison to Sam's Club and other competitors is its dominance in average per warehouse
revenues and profit. This means that every warehouse that Costco opens helps it to beat Sam's
Club for market share. There are still many larger metropolitan areas throughout the U.S. that do
not have a single Costco warehouse. At the end of the year 2011 Costco had 592 warehouses
worldwide compared to Sam's Club's 751 (Thompson, 2014). There is much room for growth,
even in areas that Sam's Club has already proven effective.
Finally, the only other recommendation is for Mr. Sinegal to withdraw from an active
part of company leadership more quickly than he has to this point. For Costco to continue to
succeed, management must feel like they have a free hand to pursue strategies in any way that
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they feel lead. Sinegal could impart his years of wisdom in an informal mentoring type of
setting, or even through a formal leadership development program. Sinegal's influence comes
through in every article written about Costco, but this problem is especially noted in Stone's
article in Bloomberg Business Week: "Another challenge for Jelinek is making his voice heard
over Sinegals. Even after his official retirement in early 2012, the co-founder stuck around as an
adviser for another year, sitting in on meetings and surreptitiously funneling questions through
other executives" (Stone, 2013).
References
Annual Report 2013. (2014, January 30). Costco Wholesale. Retrieved from phx.corporate-
ir.net/External.File?item=UGFyZW50SUQ9NTI4MzE1fENoaWxkSUQ9M
jE1NjQ0fFR5cGU9MQ==&t=1
Costco Wholesale Corp. (2014, August 1). Standard & Poor's - Compustat Company Research.
McGraw-Hill. Retrieved from Fidelity Investments Research.
Greenhouse, Steven. (2005, July 17). How Costco Became the Anti-Wal-Mart. The New York
Times. Retrieved from http://www.nytimes.com/2005/07/17/business/yourmoney/17
costco.html?pagewanted=all&_r=2&
Lutz, Ashley. (2013, March 7). Costco's Unorthodox Strategy To Survive The Big Box
Apocalypse. Business Insider. Retrieved from http://www.businessinsider.com/costcos-
unorthodox-business-strategy-2013-3?op=1
Stone, Brad. (2013, June 6). Costco CEO Craig Jelinek Leads the Cheapest, Happiest Company
in the World. Bloomberg Businessweek. Retrieved from http://www.businessweek.com
/printer/articles/123856-costco-ceo-craig-jelinek-leads-the-cheapest-happiest-company-
in-the-world