Brief Overview of Costco's Compensation System
Costco has a unique compensation system within its industry. The company competes as a cost leader, where it features low prices as a means of winning business. Cost leaders typically try to have rock bottom costs throughout their operations, from the supply chain to labor and everywhere in between. These competitors will use their bargaining power to get the cheapest labor possible, bargaining down wages, benefits and other perks. This often results in a poor quality labor pool with high levels of turnover, but these companies accept that as part of having a low cost labor pool and account for that is the design of the low cost business model (Lutz, 2013).
The approach that the company has to compensation is therefore counterintuitive to the way that most of its competitors run their human resources, but there is internal logic to Costco's system. Costco is famous for paying its employees a living wage and providing good benefits to its employees. This approach is based on a unique perspective, that the company wants to look at the entire cost-benefit of its workforce, not just its cost.
Evaluation of Costco's Compensation
The underlying logic of the Costco compensation system is that the company will attract better workers if it pays a proper wage and benefits, and it will be able to retain them as well. This is basically the logic of labor unions, but without the union part -- you get professionals, not workers, and you keep them. The higher wages and benefits paid to employees are weighed against a number of other costs that are lowered. The first is that turnover costs are lower. Turnover results in higher costs because of a) the cost of acquiring new employees and b) the cost of onboarding new hires. New hires are also less efficient workers, so having experienced workers is likely to improve the efficiency of the company overall (Gray, 2014). Efficiency is one of the major ways for companies that compete with a cost leadership platform to lower their costs throughout their operations. Costco is essentially operating on the principle that there are subtle benefits throughout their company that arise that will offset the higher upfront costs associated with its pay and benefits policies (Goldberg & Ritter, 2005). Further, the company feels that loyal employees are also going to provide better service. While this might be true, service is not the main thing on which Costco competes, so it does come down to whether or not the Costco compensation strategy delivers a low total cost for the company.
While Costco seems convinced that its strategy works, there is not necessarily any clear evidence to support this. There are a number of measures that could be used to evaluate the effectiveness of the strategy. The first is total profit and market share. On those measures, Costco has performed well. The company earned $1.96 billion last year, and with $105 billion in revenue is the 2nd-largest retailer in the United States (MSN Moneycentral, 2014). On those terms, Costco has become an enormously successful company. A direct comparable is Sam's Club, which is owned by Wal-Mart, and operates with the same warehouse store strategy, but with Wal-Mart compensation policies. Costco is destroying Sam's Club in the market, which is a good sign for the Costco business model. Costco customers are also more loyal, again highlighting that the company is doing something right. The question remains, however, how much role the compensation policy plays in that.
The compensation strategy is designed to improve efficiency. At this point, Costco's net margin is 1.9%, compared with 2.7% at Target and 3.3% at Wal-Mart. While the cost leadership model relies on using slim margins to increase market share, that would only explain why Costco's slimmer margins help it beat Target; it does not explain Wal-Mart, which earns better margins and has a bigger market share. Sam's Club is the best comparable, and has an operating margin of 3.4% (2014 Wal-Mart Annual Report). Costco's operating margin is 2.9%. On that measure it seems that Costco is paying more for something than Sam's Club is, but those slimmer margins should correspond with higher market share in this industry and they do in this case. The data here then is inconclusive. What can be determined for certain is that Costco...
The company's approach is to run against the industry norms, from the front line workers right to the CEO. Costco does not advocate external consistency, and part of this is that the company is not trying to attract the same people. The company wants workers who are better educated, more experienced, and have a lot of loyalty. This is an entirely different type of worker than the ones normally hired by cost leaders, who prefer to hire people that have no education, skills and are prone to turnover. Costco feels that it can get by with fewer workers and that the overall costs will be lower (or at least equivalent) than those of competitors.
It could be argued that at the higher levels, some degree of external consistency is important. Costco recognizes that it will need to compete with other companies in retail for senior management talent. This is why the company emphasizes internal hiring, because it knows that its own people are highly motivated and loyal, so that they want to stay at Costco. The company does not want to get into bidding wars for executive level talent -- it believes that the challenges associated with running a $100 billion business should allow it to attract some considerable talent, and they are right. This approach has worked well, and Costco is one of the best-run companies as a result, without overpaying for executives.
Internal consistency is very important at Costco. The company typically bases its internal consistency on tenure and job performance, which is a bit old-fashioned in some circles, especially the tenure part. But many of the company's workers are comfortable staying in their jobs for years, and the tenure increases are not massive. The workers have somewhat limited bargaining power to the extent that many do not want to leave the company; but that loyalty is related to them being paid well. Nevertheless, Costco does try to have a high level of internal consistency in its pay.
The Costco compensation model is based on creating a system where employees are able to make significant contributions to the company. The recognition of these is primarily on the overall level where people are well-compensated and there is an understanding that this will result in better performance and ongoing contributions to the success of the company. The second element of recognition is that Costco hires internally, so employees who are seeking a pathway to moving forward will receive that. Recognition in the form of promotion opportunities is important, and Costco is a believer in creating this form of intrinsic motivation, rather than offering cash rewards for performance. Senior managers might receive stock options, however, as part of their performance reward. This is based primarily on the need to be externally consistent with respect to equity-based compensation. Even where base executive pay is lower than average, linking compensation to the value of the company's stock creates significant motivation, and goodness knows the stock has performed well over time.
Discretionary benefits are not a major theme at Costco, but they can still have some value. Many employees do not seek promotion, so some element of discretionary benefits is needed to provide greater reward for performance among employees who otherwise are happy to remain in their current position. Occasional rewards can be used to create motivation in the workforce. But it should also be noted that financial rewards should be kept to a minimum because of their cost, and instead most reward should be in non-financial forms. Evidence shows that things like positive feedback are correlated with better behavior (Deci, Ryan & Koestner, 1999).
A second recommendation is to set benchmarks for executive and senior management-level discretionary benefits. These benchmarks should be external in nature. The market for senior managerial talent is competitive, and right now Costco relies heavily on its own people. As the company grows, and other companies provide a similar positive environment but better compensation, Costco might find it tougher to get the right people into senior management positions. This is something that the company needs to take into account -- it needs to be externally competitive in the market for senior talent.
Costco provides retirement benefits for its employees, which is something that Wal-Mart often does not do, at least not for its part-timers. Full-time employees at Wal-Mart have retirement plan options. Even part-timers at Wal-Mart are offered a 401K option with company match. Costco's…
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