The Costco Concept

Are customers prepared to pay a membership fee of US$45 or even US$ 100 a year to shop in a warehouse where they can purchase large quantities of a limited assortment? Costco thinks so. The company is confident that its concept of large quantity, high quality goods and low prices is working - not just in North America but in Central America, Europe and Asia.
Elsevier Food International, Vol. 4, Number 3, September 2001
Pascal Kuipers

"We know our concept works and that there is plenty of opportunity out there. We think now is the time. There are short-term profitability implications but we plan to be here for the long term." So said Richard Galanti, chief financial officer of Costco, in last June's edition of the US newspaper Seattle Post-lntelligencer. Increased costs due to Costcos aggressive business expansion, plus the soaring energy prices in California (where over a fourth of Costco's stores are located), have had an impact on the profitability of this US$32 billion warehouse club retailer. One month before Galanti's comments, Costco experienced a dramatic plunge in its stock price, which reached a low of US$24.95 on 24 May after having traded a week earlier at US$51.31.
Costco had faced stickier situations in its past, however, most notably in late 1993 to early 1994 after its merger with Price Club, which was announced in June 1993 and became effective in October 1993. Both warehouse club retailers faced fierce competition from Wal-Mart's Sam's Club and knew that they had to merge to stay in business and avoid acquisition. Despite the many benefits that the new company PriceCostco enjoyed - leveraged buying power; increased capital base for expansion; knowledge transfer and the expanded manufacturing and private label packaging to increase gross margin - the merger had two significant drawbacks.
First, PriceCostco was unable to combine back office operations efficiently because it still operated dual headquarters in Washington and California. Secondly, senior management could not agree on the company's future strategy. Jim Sinegal, president and CEO of the new merger company PriceCostco, had worked for Price Club before leaving the company to establish Costco in 1983. Ten years later, this defection remains a sore point with Price Club's top management. Robert Price - former chairman and CEO of Price Club - became PriceCostco's chairman, but did not share the vision of Sinegal and other former Costco executives. Merger frictions in the highly competitive warehouse club business resulted in soaring costs. The 1994 financial results showed a huge increase in revenues, but despite the benefits of the merger, PriceCostco's bottom line revealed a US$112 million net loss.
After spinning off the former Price Club organisation into the real estate investment company Price Enterprises in 1994, PriceCostco - under the helm of Jim Sinegal - could concentrate once again on growing its business. In the years that followed, the company's net results increased steadily.

Expand to grow
Expansion has been key to Costco from the very start and is the first of the three elements of the Costco Concept. A base of locations, and therefore volume, provides plenty of buying clout and enables Costco to spread out fixed costs. If the sales volume of a particular club reaches its maximum level, Costco will open up another one nearby to cannibalise on the sales of the existing store. This takes the pressure off the high volume club, while at the same time reinforcing Costco's dominance in the local market and deterring competitors from setting up shop. On the other hand, however, Costco has been straightforwardly closing underperforming outlets, thereby keeping its store base healthy. Despite cutting out the underperformers, store numbers should still rise. At the company's annual meeting in January 2001, Costco's president and CEO Jim Sinegal said that Costco will spend more than ever on new store openings, both in the US and abroad. After opening 14 and 20 stores in fiscal 1999 and 2000 respectively, Costco aims to add an ambitious 36 locations to its store base in fiscal 2001, and 35 to 40 annually at least up until 2005. Sinegal clearly understands that early warnings are needed after the May 2000 stock value plunge: "We have informed our shareholders that this growth may impact our short term returns, but we're confident this will payoff and that we need to grow now."
CFO Galanti refers to company research indicating that one Cost co Warehouse per 250,000 people is realistic. To cater to all 276 million Americans, then, over 1,100 stores are needed. With its US store base of 260 warehouses (as of June 6, 2001) Costco covers only 24 per cent of the company's alleged domestic potential. Nevertheless it has expanded its warehouse club format abroad. First Costco set up shop in Canada (1986) and Mexico (1992) and then, in 1993, it expanded overseas to the UK (with the support of the French retailer Carrefour, which then held a 20 per cent stake in Costco). Then Asia was on the menu, with South Korea (1994), Taiwan (1997) and Japan (1999).
From 1994 to 2000, Costcos international operations have shown growth rates that are above the total company average. Canada represents the lion's share of Costen's international operations, which in its FY 2000 accounted for 18.6 per cent of total revenues and 18.2 per cent of operating income. Costco is still eying expansion into Puerto Rico, where it is expected to open two locations in 2001, and into Ireland, and China, where Costco has a retail partner called Normart with whom it has been working on starting a warehouse club business since 1999. In 1995 the company also announced its interest in the southern European markets of Spain, Portugal and Italy, but these plans have yet to become a reality. Carrefour's 1996 decision to sell its stake in PriceCostco (as the company was called before it changed its name to Costco Companies a year later) may well have contributed to the US management's decision to postpone expansion into southern Europe. With this sale the French also vacated their position on Costco’s advisory board.

Reduce costs
The second pillar supporting the Costco Concept is its buying and operational principles, which have the overall goal of translating cost reductions into low prices.
The guidelines that Costco buyers must bear in mind are as follows:

• Be creative in selecting products.

• Purchase an item early in that item's life cycle and sell it before that cycle hits a peak.

• Research and stock regional items.

• Products should arrive at the clubs ready to be sold, and warehouse employees should handle products as little as possible.

• Follow strict margin requirements. Do not sell an item below cost, or price an item above 15 per cent margin.

• Reflect all deals in the cost of goods and reduce the retail price.

• Abide by an intelligent loss of sales. If a competitor is selling an item below cost, delete the item, replace the item or purchase the item from that competitor.

• Be the first retailer to stock seasonal merchandise and be the first retailer to be out of stock on seasonal merchandise. This will reduce markdowns.

• Constantly try to increase the quality of a product without adding to its cost structure.

Source: Warehouse Club Industry Guide (Warehouse Club Focus)

One of the principles is not to sell an item below cost price or above a 15 per cent margin. In its 1999 and 2000 business year, Costco worked on a hair-thin 10.4 per cent gross margin, which means that, without membership fees, its net result would be an US$83 million loss in 1999 and a profit of just US$88 million for the fiscal year ending 3 September, 2000. This is of course extremely modest for a company with total net sales of US$31.6 billion in its fiscal year ending 3 September, 2000. Given the low margins, costs need cutting where possible. On average, the Costco Warehouse Clubs store some 3,800 items, which is some ten per cent of the sku's of an average supermarket. Furthermore, these are all top selling items that are offered in the largest possible package sizes. This optimises both inventory turnover and cost levels.
Costco is active in limiting costs of packaging, handling and shrinkage. It wants its merchandise delivered in a condition that is ready for sale. Warehouse employees don't have to cut cases, mark products or stack shelves. They only need to cut the shrink-wrap and the products are ready for sale. This keeps handling costs low. Average shrinkage costs at Costco are about 0.5 per cent of sales, which is very low when compared to the industry average of between 1.5 per cent and two per cent of sales. In 1995 Costco even managed to cut shrinkage costs to 0.25 per cent of sales. That year, Costco was testing a preferred supplier programme in which it collaborated with selected vendors in streamlining logistics, analysing categories and expanding business delivery support. This forerunner of what is currently branded CPFR included a review of ED!, volume forecasting and supply contracts.
Logistics are organised on a 'just in time' basis, aimed at cross-docking the goods via Costco's distribution centres. Only full trucks are allowed to deliver to the stores, and on their way back they further streamline logistics by backhauling return goods from suppliers that are on their route.

Invest and innovate
The third element in the Costco Concept is upgrading the offer by introducing fresh foods departments and pushing forward its private label. Costco started selling fresh foods in the early 1990s and this was a risky decision given the low cost/low price/low margin nature of Costco's operations and positioning in the market. But it paid off very well, as it turned in higher margins and increased members visits and total company sales. Fresh foods - which in the second half of the 1990s also came under Costco's private label Kirkland Signature - and added services such as optical and pharmacy departments enabled Cost co to differentiate itself from others and gave it a reputation for being the industry's innovator. In 1998 Costen's Kirkland Signature label was printed on Tyson frozen poultry products, thereby associating Costco's private label with the perceived quality of a well known brand. Costco follows the same strategy in non food, aligning its Kirkland Signature brand with Whirlpool (household appliances), and its private label tyres with Michelin. Since November 1999 the Costco membership cards have been co-branded with American Express and, in co-operation with Microsoft, Costco offers unlimited Internet access via its website for US$1l.99 per month. This will also stimulate Costco's E-commerce sales, which are expected to surpass the US$100 million level. Its new On-line Business Center, where small and medium sized businesses can order their office supplies, is also supposed to push Costco's E-commerce sales forward.
Fresh and packaged foods account for some 30 per cent of Costco's sales, and food service has also developed into an interesting ancillary business worth some US$250 million. Future developments may well include the Food Factory, an instore venue where employees roast and pack coffee beans, make burritos and tortillas, squeeze fresh orange juice and so on. Customers can see, smell, taste and purchase, and return visits are frequent. Back in 1988 Costco had planned to test a non-member store in Washington, with some 15,000 sku's combining food and general merchandise and with a targeted margin of 20 per cent. But this never happened because Costco had to concentrate on expanding its successfully introduced fresh food offer to its Warehouse Clubs. In 1995 PriceCostco acquired property in Manhattan, where it planned to open a Warehouse Club on four levels. This illustrates PriceCostco's aggressiveness in finding and purchasing highly visible urban locations. However, this venture also failed to become a reality (the property was later sold), as did the 1998 "fresh product concept," as Costco's chairman Jeff Brotman called an intended two storey-6,500 square metres location in New York City, where Cost co wanted to offer fresh meats and produce in large quantities. This time it was the local authorities that put a stop to the plans. This large volume foodstore within a Manhattan retail environment would have featured all kinds of innovative concepts for merchandising fresh foods and could possibly have inspired Costco to keep the fresh foods departments in all of its locations up to date. Despite its low cost focus, Costco has always been keen on investing in people - and not only at board level. According to Warehouse Club Focus, by 1989 Costco employees were the highest paid in the industry. Cost co clearly believes that higher salaries not only mean better productivity, they can also help to diminish employee interest in trade unions.