Costco: A Case Study

Misti Walker

Costco: A Case Study 1

Business Model
Costcos business model depends on high sales volume coupled with quick inventory turnover, made possible by low prices and limited product selection among a wide variety of branded and private label products. This business model is appropriate for this chain and has many benefits. For one, by gearing the business approach to rapidly turning over inventory, the company is often able to sell new merchandise and pay suppliers before the invoice is due, even when the company pays early to benefit from early payment discounts. This frees up capital, as Costco finances most new inventory purchases with supplier payment terms. Fittingly, the company passes these savings on to consumers in the form of low prices. Another benefit of this model is that the company is not required to maintain high levels of working capital or take out loans, with interest to pay suppliers.

Strategy
The generic competitive strategy employed by Costco is that of the best-cost provider in the wholesale club category. The best-cost provider strategy is a mix of low-cost provider and differentiation. This strategy is aligned with Costcos abilities and resources. That is, a streamlined supply chain, purchasing power, good supplier relationships, high sales volumes, quick inventory turnover, and excellent customer service. The three components of the companys strategy are low pricing, limited product selection and what the company calls treasure-hunt merchandising, or highend products acquired in closeouts and liquidations. This approach works well with the companys target market CEO Sinegal signaled that he intends to keep this strategy during his tenure, arguing that low price, high value products are precisely what it takes to achieve staying power in this industry. A long-term strategy is recommended and he hopes to heed this advice, being especially careful not to differentiate to the point of losing its price competitiveness. While Costco strives to beat the competitions pricing, it also delivers exceptional value in its high-end offerings and customer service, giving consumers more for their money. This strategy works well for Costco, given its customers are the most affluent of all the warehouse clubs, with average incomes around $75,000. However, these customers are also value conscious, as evidenced by the members who opt for executive memberships, although it costs more per year, to take advantage of a 2% discount on most purchases. While this group only accounts for about a fourth of the companys memberships, they represent nearly half of its net sales.

Leadership and Strategy Making

The process of crafting and executing strategy is done in 5 steps. Below, I will discuss the different steps and evaluate the performance of this companys CEO, Jim Senegal in the process of strategy making, as well as discuss areas for improvement. Phase 1 During this phase, the CEO and other senior management meet to discuss and draft a strategic vision for the company. The strategic vision lies out the path the 2

company will take in the future to improve its market position. Good strategic visions reveal where the company is going in the future and provide reasons for that particular path. Vision statements should be written and distributed to employees at all levels of the organization. This is why it important to include the reasoning for the chosen path. Employees must find the vision both reasonable and beneficial; after all, they have a lot to lose. When a company shares a well-crafted, well-thought-out vision statement throughout the organization, the benefits are palpable. Motivation and productivity go up and it steers the course for the entire organization to be working towards the same goal. I did not find any evidence of a strategic vision, or where the company plans to go in the future. However, the companys growth strategy shows that the company has been steadily expanding the number of warehouses each year, with some stores overseas. The second growth strategy was that the company opened two test stores, Costco Home. While these two spots are steadily increasing revenue and profits, the company has decided to instead add extra space to new storefronts and essentially combine these two operations. A third way the company intends to grow is by expanding its private label brand from 400 items to 600 items over the next five years. From a pure math standpoint, this will prove effective incrementally, as the markup on the private label is 1% higher than other goods. As for the direction the company is heading and why, Sinegal receives a C. Recommended action is to call a meeting of senior management to draft an exceptional vision statement with the direction the company is heading in the future to gain market share. The benefits are immeasurable. Phase 2 This phase is setting objectives, whereby the company determines the steps to take in order to reach its vision and sets specific, measurable goals accordingly. Considering Costco does not have an outlined strategic vision, Sinegal would receive an F in this area. Although Costcos stated strategy includes low prices and its mission statement claims that the company is committed to selling its products at the lowest possible price, no specific sales goals were discovered. A remedy to this problem can be sought upon creating the vision. This involves setting SMART goals or specific, measurable, attainable, realistic goals with a timeline for completion. Once this is done, the company will not only know where it is going, but will also know the steps to take in order to get there. Phase 3 Crafting a strategy that aligns with the stated vision and objectives is the third step in this process. The strategy of a company is all about how the company will achieve its objectives for growth. It is never acceptable to simply do business the way it has always been done because the market changes, the industry evolves, and numerous other external factors make it absolutely necessary for a business to evolve to retain or gain market share. This is particularly important in industries with high growth, such as this one. Sinegal should incorporate managers from all levels in the strategic process, emphasizing value in regard to its competitive strategy. Until this time, Sinegal receives a D on this phase. Phase 4 & 5 These steps are executing the strategy and evaluating its progress, accordingly. Sinegal will not receive a grade in these areas until the strategy creation process is complete. Keep in mind that evaluation of the strategy must be ongoing to ensure the company is headed in the right direction. 3

Financial Measure gross profit margin return on stockholder equity current ratio debt to equity ratio inventory turnover working capital (in millions)

2006 10.5% 5.6% 1.05 0.02 11.42 413

2005 10.6% 11.1% 1.22 0.09 11.45 1477

2004 10.7% 11.4% 1.18 0.13 11.41 1099

Financial Perspective

The gross profit margin falls into the normal range for this industry. However, it should be trending upward and as you can see it is actually decreasing slightly. If this trend continues, steps will need to be taken to correct the problem. Another probability indicator, return on stockholder equity indicates that the company has a problem. Average returns are around 12%, which Costco was nearing in 2004 and 2005. In 2006, the company experienced a sharp decline which is cause for concern. Investigate this decline. It could be due to low profits after taxes. If the pricing is too low, this can happen. Currently, Sinegal, admittedly, tries to sell products at the lowest price possible for longevity. However, if the investors in the firm are not making appropriate returns for the risk, they will invest elsewhere. The current ratio figure is in the average range but on the decline. The debt to equity shows a strong balance sheet and low levels of debt. It is trending downward. The inventory turnover rate is slightly higher than average, indicating that Costco is outperforming competitors in moving product. Also cause for concern is the fact that the working capital is shrinking. This might indicate the inability to expand without a loan.

Competitive Outlook
When an industry is experiencing high growth, a company must determine what makes it unique to its competitors and draw on the differences to gain competitive advantage. As mentioned previously, the three components of the companys strategy are low pricing, limited product selection and what the company calls treasure-hunt merchandising, or high-end products acquired in closeouts and liquidations. These practices do little to address the future prospects or unique capabilities of the firm. As a matter of fact, it is very similar to Sams Clubs way of doing business. Costco is beating both Sams Club and BJs Wholesale in net sales and market share. However, Sams Club has launched an aggressive campaign to increase its market share. BJs Wholesale differs from the other two wholesale clubs, in that its product offering is nearly twice as large. The company also has a broader selection of products, sometimes offering products in three price categories, good, deluxe, and luxury. One other differentiating factor is that it places a premium on a comfortable shopping experience with aisle markers, self checkout, express lane and video sales aids. However, BJs has similar efficient operating capabilities with cross-docking facilities and around a 24 hour processing time. 4

Costcos overseas performance is mixed. The last four years, the return on sales remained constant at 3% in the U.S., 4% in Canada, and other foreign operations show a 1% return in 2003 and an increase to 2% in the last three years. This ratio shows the profitability of the different geographic locations of the firm, without taking into account interest or taxes. Since 2004, the return on sales from international endeavors has been equal to the U.S. return on sales. This indicates that national and international ventures are equal in profitability of current operations. Market research indicates that the mean income of a Costco consumer is $75,000, with 30% of its members making $100,000 or more. This means that Costco consumers are more affluent than the members of the other clubs. This is an excellent opportunity for differentiation. As new competitors are bound to emerge, Costco should stress the value it provides to consumers, as opposed to low costs. After all, Sams Club offers its customers low prices, with similar store layouts and less expensive membership costs. Also, the company can charge a higher price yet be the best cost provider because of additional value it offers its customers, such as well-paid, well-trained staff. If the company invests heavily in its human capital, it must capitalize on the added value and pass the cost onto the consumer, or shareholders interests are not being protected. Being the best cost provider means that the company can charge a higher price for an item with more value-add. In order to differentiate from Sams Club, this would be well advised. A good strategy means being different in a good way. Given the demographics and preferences of members, the best cost provider is ideal.