Learning Team Project Selection

STR/581

August 26thth, 2014

Alfonso Rodriguez

Table of Contents

Executive Summary

Costco Wholesale Corporation started as Costco Companies Inc. in 1976 in Washington State and began as a corporation in 1983. Costco has 555 warehouses around the world with about 142,000 full and part-time employees. The company has about 54.5 million cardholders worldwide. Costco offers their members competitive low prices on a limited selection of products that include a wide range of national and private label brands. Costco’s operating efficiencies are accomplished with volume purchasing, warehouses, and distribution of products to these warehouses. Volume purchasing allows Costco to purchase their products at a lower price, which in turn they can pass off to their members. Efficient distribution of their products to these warehouses allows Costco to properly distribute their products where customers are more drawn to them. Costco’s fast turnover ratio and operating efficiencies give them a lower gross margin compared to their competitors. In order for Costco to be even more successful or survive unexpected economical events, they must come up with strategy to strive for in the future. In the past Costco’s organizational company has pushed them above their competitors and to be known as a household name. For Costco to understand what to change in their organizational strategy in the future, they must understand the industry they’re in and how their internal environment is operating. Costco must analyze how their industry is doing and in which direction it is moving so they can tailor a strategy to fit the external elements. Costco must also analyze their internal environment operations so they understand if they are operating to their fullest potential, and if they aren’t they can tailor their strategy to fit their internal operation goals. When understanding both the external and internal environments the company can then create an organizational strategy that will help them succeed and survive unexpected economical events.

Strategic Plan and Presentation

Access to Costco Warehouses is restricted to members who pay a small annual fee for access. Started primarily as a small business supply company, Costco’s inventory focus has grown to include high-end consumer goods including home electronics and luxury items. Costco has succeeded by focusing on the demands a specific customer group while continues to provide for other profitable customers.

The vision of Costco founder, Jim Sinegal, is to give the customer the best value that they can. Costco strives to be a company that’s on a first-name basis with everyone. The company is committed to treating people with respect.

Costco’s mission: "To continually provide our members with quality goods and services at the lowest possible prices." Costco doesn't have a vision statement, but it runs on a Code of Ethics: "Costco runs its business according to its Code of Ethics: to obey the law; take care of its members; take care of its employees; respect its suppliers; and reward its shareholders."

The values at Costco have helped to create a culture of fairness, transparency and respect for the consumer that shapes not just how Costco does business, but how its work force sees itself, and how customers experience the brand. One of the best-known is ‘the 14 percent rule,’ which states that no Costco product will be marked up more than 14 per cent over wholesale – regardless of how it’s selling or what competitors are doing.

Environmental Scan

We will compare Costco’s values versus Sam’s Club values. The Kirkland brand has the Costco expectation to be equivalent or better than national brands. A continual product improvement is the exact objective for the maximum competing goal. Product quality and price comparison is continuously revisited by the internal Costco research team. Sam’s club is a division from the Wal-Mart Corporation. Although Sam’s and Costco have a close race, there is an outstanding difference when considering the research that goes into product expectations and supplier preference. Costco is very similar to Sam’s, but in resent comparison Costco has beat out many companies in the same bulk market. Costco and Sam’s have excellent programs for their employees and team effort climate has both companies at an outstanding stance to overall organizational performance.

Costco is known as the anti-Wal-Mart. As of 2005 research demonstrates that Wal-Mart was unstoppable and created strife for small local businesses and destroyed many small businesses. Wal-Mart is an unstoppable force and revenues of $247 billion with a growth of 15% a year. Costco’s is approximately 30% the size of Wal-Mart and Costco competes against Sam’s approach to bulk sales. During the past 20 years Sam’s has had more than 5 CEO’s and has incorporated many strategies in order to try to gain control of the top position. All these ploys have been smothered by Costco’s array of visual space and prestigious options. Consider some figures. Sam's Club has 71% more U.S. stores than Costco (532 to 312), yet for the year ended Aug. 31, Costco had 5% more sales ($34.4 billion vs. an estimated $32.9 billion). The average Costco store generates nearly double the revenue of a Sam's Club ($112 million vs. $63 million), (Helyar, 2003).

When considering the Political, Economic, Social, and Technological aspects to Costco and Sam’s Clubs; there are applications and dues that apply to both organizations. If there is any violation to a customer’s legal liberties, the Better Business Bureau can step in and provide help for paying back any dues or compensations. Services must also fall under the ethical and humane way of treating anything or anyone with rights. Recalls are available through many options into a righteous resolution of matters. The Food and Drug Administration will step in to apply righteous and ethical behavior to products, such as food and all types of medications. Regulations in place are always to be followed by both companies. In some instances, companies such as Costco and Sam’s club may be vulnerable to contaminated foods, such as vegetables, fruits, and processed meats. Over the years, Costco has held a responsible advantage over Sam’s when choosing their provider of such items. As with all businesses offering consumable goods; Costco and Sam’s have to comply with the health inspection section of individual states. Because of their stature in business proceedings, both organizations have avoided problems in matters of this nature. James D. Senegal CEO for Costco remains adamant that mistakes will happen but then to recuperate a team effort to improve must be made. This is what has set the progressive result and rising for Costco’s future. According to Senegal (2003), “We think when you take care of your customer and your employees, your shareholders are going to be rewarded in the long run. And I'm one of them [the shareholders]; I care about the stock price. But we're not going to do something for the sake of one quarter that's going to destroy the fabric of our company and what we stand for."

Some Costco practices are often criticized; Costco has proven to survive through customer research and meeting their needs and wants. Moreover, even while Costco was critiqued on certain decisions Senegal decided to meet the challenge by analyzing, improving the product and advertisement of services. Small decisions and strategies of this nature proved to elevate Costco over Sam’s. Rather than the recommended wage reduction, a decision toward improving the stakeholder, shareholder, and employee treatment was placed in motion. Therefore, visible, and internal improvements to every Costco aspect are evident by proof of costumer surveyed satisfaction.

The core assets/activities of this industry are primarily the facilities (geographic location included), the contracts with suppliers, buyer power, and the barriers to entry.

The factor affecting rivalry among existing competitors is a significant concentration within the industry that has left five or six main competitors capturing major market share. Competing on price at high volumes is the winning strategy within this industry. The firms competing in this industry are very sensitive to costs and capacity utilization. The majority of the facilities in this industry are often around 140,000 square feet, and they are sparsely located based of consumer population within that area. There is a high industry price elasticity of demand. Overall, rivalry is determined by the price and cost structure of the firms operating within the industry, thus rivalry is low or high relative to the price per product.

The factor affecting the threat of entry is brand loyalty. Brand loyalty has been created by some firms impacting the purchase decision. Entrant’s access to distribution channels is not easy. Entrant’s access to raw materials and technology/know-how is easy due to the advancements over the years (especially in operations management). There is an experience-based advantage to the current firms. Overall, threat to entry is relatively low given these circumstances.

The factor affecting or reflecting pressure from substitute products and support from compliments is close substitutes that are readily available. Overall, substitute products are not competitive based on the pricing strategy.

The factor affecting or reflecting power of suppliers is concentration of the suppliers to this industry is minimal at best. Firms in the industry do not purchase relatively small volumes and as such they are able to negotiate volume discounts and strip the power of the supplier. Many suppliers can guarantee sales levels by negotiating contracts with these firms. Overall, supplier power is minimal.

The factor affecting or reflecting power of buyers is buyers’ industry is not more concentrated than the industry it purchases from because buyer’s can go anywhere. Typical buyers purchase large volumes, and they purchase individual items in bulk. There is some negotiation of prices in this industry between buyers and sellers on each individual transaction, but most transactions are a “take-it-or-leave-it” price application. Overall buyer power is high given buyer options.

This industry has limited rivalry, a few enormous barriers to entry, very little supplier power, strong buyer power, and little threat from substitutes.

Internal Environment

Costco’s mission statement in the membership warehouse business reads, “To continually provide our members with quality goods and services at the lowest possible prices.” The companies basic business model is too generate high sales volumes and rapid inventory turnover by offering members low prices on a limited selection of branded and private label products in a wide range of merchandise categories. Costco has a simple but differentiated business strategy that works. Their strategy is low prices, bulk buying, limited selection, and a treasure-hunt shopping environment. Costco is known for selling top-quality national and regional branded products consistently below traditional wholesale or retail outlets. Costco also abides by a strict pricing rule to cap its markup on brand-name merchandise at 14 percent compared to competitors at 20 to 50 percent markups. Yet another price strategy is Costco’s Kirkland Signature products which are a private label designed to be of equal or better quality than national brands, but priced some 20 percent below competing brands. Product selection is another main aspect of Costco’s business model. Companies such as Wal-Mart and Target may stock some 150,000 different items to give shoppers a wide selection to choose from. However Costco’s strategy is to provide members with a selection of only about 4,000 different items.

Finally, the part everyone likes, treasure-hunt shopping. Costco’s product line may only consist of approximately 4,000 items, however, about 25 percent of those are constantly changing. Also, since approximately 1,000 items are constantly changing members know they had better buy now, because the product may not be their next time. When looking at the cross-sectional financial analysis between Costco and Wal-Mart between 2005 and 2008, Wal-Mart has had a larger profit margin compared to Costco’s over those years. Costco’s profit margin has ranged from 13.38% to 13.17%, while Wal-Mart’s profit margin has gradually increased from 24.43% to 25.29%. Costco’s average profit margin from 2005 to 2008 was 13.27% compared to Wal-Mart’s 24.80%. This shows that Wal-Mart has better control over their cost. In order for Costco to improve their profit margin, they must control their cost as well as Wal-Mart. In the cross sectional analysis, Costco’s total asset turnover has been higher than Wal-Mart’s. Wal-Mart’s total asset turnover has ranged from 2.43 to 2.60, while Costco’s total asset turnover has ranged from 3.18 to 3.50. Wal-Mart’s average total asset turn over from 2005 to 2008 was 2.29 compared to Costco’s 3.35. This shows that Costco is doing a better job at turning their assets into revenue than Wal-Mart is. When comparing each company’s equity multiplier, Wal-Mart tended to have the higher equity multiplier from 2005 to 2008 compared to Costco’s. Costco’s equity multiplier ranged from 1.88 to 2.27, while Wal-Mart’s ranged from 2.43 to 2.60. Costco’s average equity multiplier from 2005 to 2008 was 2.08 compared to Wal-Mart’s average of 2.51. This shows that Wal-Mart is relying more on stockholder’s equity or debt to finance its assets. In order for Costco to increase their equity multiplier they must use more debt to finance their assets. Costco’s return on equity from 2005 to 2008 is lower compared to Wal-Mart’s. Costco’s return on equity ranged from .80 to 1.05, while Wal-Mart’s ranged from 1.41 to 1.46. The average return on equity was .92 compared to Wal-Mart’s 1.43. In order for Costco to increase their return on equity to Wal-Mart’s they must increase their profit margin and equity multiplier. Costco must control cost and use more debt to finance their assets to increase their return on equity. The average sales for Costco between 2005 and 2008 were $62 billion, while Wal-Mart had average sales of $328 billion. Costco’s average sales growth of 11.07% between 2005 and 2008 is higher than Wal-Mart’s 9.52%. Even though Costco’s sales are not as large as Wal-Mart’s, their sales growth has been growing. The average income for Costco between 2005 and 2008 was 1.13 billion, while Wal-Mart had average income of 11.37 billion. Costco’s average income growth of 6.80% between 2005 and 2008 is lower than Wal-Mart’s 7.56%. Both companies took a hit to their income in 2007, but Costco had a negative growth compared to Wal-Mart’s. Costco’s return on assets from 2005 to 2008 is lower than Wal-Mart’s. Costco’s return on assets ranged from 5.52% to 6.38% in this time frame, while Wal-Mart had a range from 7.44% to 8.54%. The average return on assets for Costco was 6.10% compared to Wal-Mart’s 7.98%. This tells us that Wal-Mart is doing a better job at taking their assets and generating earnings. When competing with Wal-Mart, Costco should look into more efficient ways of using their assets so that more earnings can be generated. When doing a longitudinal financial analysis on Costco, Costco’s profit margin has been slightly increasing between 1999 and 2008. It had a profit margin of 12.79% in 1999 to 13.29% in 2008. This gives the company an average profit margin of 13.16% compared to the industry average of 20.40%. This shows that even though Costco has been gradually increasing its profit margin, it is still below the industry average. The company needs to control costs in order to increase their profit margin. Costco’s total asset turnover has stayed relatively the same from 1999 to 2008. The average total asset turnover in that time period was 3.40 compared to the industry average of 2.85. Compared to the industry Costco has a moderately high total asset turn over. This means that Costco is doing a very efficient job in using its assets in creating sales. Costco’s equity multiplier has ranged from 1.88 to 2.27 from 1999 to 2008. The average equity multiplier in this time period was 2.06 compared to the industry average of2.34. Costco is slightly lower than the industry average. To increase their financial performance the company should increase their financial leverage and rely on more debt to finance their assets. The average return on equity for Costco between 1999 and 2008 was .92 compared to the industry average of 1.19. Costco’s below average return on equity is mainly because of its profit margin. In order for Costco to improve on their financial performance, the company needs to handle their cost associated with their operations. Costco has had gradually increasing sales from 1999 to 2008. The sales growth shows an average growth of 11.43% for Costco compared to the industry average of 10.48%. This shows that Costco is above average in the industry with its sales growth. The average sales for Costco between 1999 and 2008 were 47.38 billion compared to the industry average of 88.53 billion. Costco’s averages sales puts the company in third place for the largest sales right behind Wal-Mart and BJ’s. Costco also has had a gradually increasing net income from 1999 to 2008. The net income growth shows an average of 15.2% for Costco compared to the industry average of 13.68%. This shows that Costco is above average in the industry with its net income growth. The average net income for Costco between 1999 and 2008 were 846 million compared to the industry average of 2.8 billion. Even though Costco’s net income is below the industry average, it is slightly growing every year. Costco has been generating below average profit margins compared to the industry average. At the same time Costco isn’t controlling their cost which is hurting their profit margins. The company gives generous pay to their employees higher than the average believing that this will result in lower turnover and saving cost on new hires and training. Another cost for Costco is their inventory and markup on products. They make less per sale but make more with higher number of sales. If this is the case then Costco is generating more cost with their inventory decreasing profit margins. The key elements of Costco’s strategy and drivers of performance are low prices, bulk buying, limited selection, and a treasure-hunt shopping environment. Another reason Costco has been generating below average profit margins is because they are doing it on purpose. Sinegal was quoted saying the following about Wall Street, “Those people are in the business of making money between now and next Tuesday. We’re trying to build an organization that’s going to be here 50 years from now.” Sinegal is saying that by keeping prices low they are driving out competitors. If Costco was to raise prices a new competitor may be able to enter the market and beat them.

Strategic Recommendations

When looking towards the next 2 to 5 years, Costco must make sure that it understands where the industry is heading. Based on the external environment and industry analysis conducted above, Costco must make sure that it can cut costs as much as possible. As mentioned above in the Key Success Factors, the most successful company within the discount, variety stores industry is a company that is able to keep prices low. Customers have very low switching costs; therefore, Costco needs to constantly remain on its toes in order to compete and sustain its position in the industry. Because Costco needs to maintain very low prices, a lot of pressure is put on the profit margin of the company. In the past, Costco has kept relatively low profit margin levels versus other competitors within the industry. Table 3 below compares Costco’s average profit margin to that of its competitors over the past ten years. Table 3

Costco’s profit margin above is significantly less than Walmart’s and Target’s. This shows that either Costco is trying to compete with the other competitors too severely and jeopardizing profits or they have large costs. In order to increase its profit margin and remain a viable player in this industry, it is strongly recommended that Costco finds a way to decrease costs while maintaining low prices.

One way for Costco to cut their cost would be in their wages. "From the perspective of investors, Costco's benefits are overly generous," says Bill Dreher, retailing analyst with Deutsche Bank Securities Inc. "Public companies need to care for shareholders first. Costco runs its business like it is a private company. (Zimmerman)" Costco’s generous wages and benefits to their employees are one of the reasons for their below industry average profit margins. One of our recommendations would be for Costco to reduce the amount of employees’ health-insurance premiums they pay by at least 6%. Costco in 2004 paid about 92% of their employees’ health-insurance premiums compared to the top U.S. companies paying on average 80% (Zimmerman). By cutting the amount Costco pays for their employees’ insurance premiums by at least 6%, Costco will still be above average compared to the top U.S. companies and still be semi-generous to employees while at the same time increasing their profits margin. One thing that has been hurting Costco and many other retailers has been the inflation cost on food. There has been a rise in cost for many of the products that Costco carries, and the company has been having a hard time passing those cost increases to their customers. This is because the costs of their products are rising to fast not giving them enough time to pass the increase to consumers. “Consumers have felt the pinch of rising prices, but Costco and other retailers have often resisted passing along all their cost increases to avoid losing sales to rivals (McWilliams )”. Costco is stuck in a corner with the rising cost of their products, because if they choose to raise prices they face the threat of losing customers and if they decide to keep prices the same they are losing profits and increasing cost. Our recommendation would be for Costco to raise prices slightly below their competitors. This is an economic condition that many retailers are facing and in order for them to survive they must increase prices as well. With the belief that many retailers are going to raise their prices as well, Costco should do the same. The price increases should be proportionate to how much the cost is rising for the product but to also try to keep the price within the 14% markup that Costco has compared to their competitors. This in turn will keep cost for Costco under control while keeping customers and still being a price competitor. With the current economic times and massive Government spending any company needs to financially and strategically place themselves for success in the future. Simple economics tells us that with huge amounts of spending and Government debt comes inflation. This is a viable outlook for the economy and to place oneself to benefit during inflationary times one needs to increase debt. Costco should do as the Government does and issued debt, take out loans, or do whatever it takes to increase the amount of debt on their balance sheet. Then during the inflationary times Costco will be able to repay that debt with a cheaper dollar instead of having their asset purchasing power devalued.

References

Costco Investor Realtions, (2014). Retrieved via the world wide web: http://phx.corporate-ir.net/phoenix.zhtml?c=83830&p=irol-irhome&cm_re=1_en-_-Bottom_Nav-_-Bottom_investor&lang=en-US.

Helyar, J. (2003). The Only Company Wal-Mart Fears Nobody runs warehouse clubs better than Costco, where shoppers can't resist luxury products at bargain prices. Retrieved from