Costco Wholesale Corporation mission, business model, and strategy analysis

Costco's business model is to undertake a cost leadership strategy. The company operates with a warehouse store concept. The warehouse store concept focuses on offering large volumes of goods at low prices. A typical Costco warehouse has a relatively low number of SKUs available, and any given product is usually only available in a single SKU. Consumers are attracted to the low prices associated with volume buying. Each store has a set number of permanent items, with other items rotated through on a temporary or seasonal basis. This keeps the selection of goods relatively fresh for consumers.

Costco is able to achieve cost leadership through a number of different strategies. The first of these strategies is volume buying. Costco gets discounts over what other retailers get because of its ability to buy large quantities of any good. Thus, the company's size allows it efficiencies of scale in purchasing, distribution and sales that in turn allow it to offer low prices to consumers. Frills such as store design are eliminated as needless in the Costco business model. In addition, Costco does not have carrying costs for debt and has very low carrying costs for its inventory as part of its cost leadership strategy.

The business model is appealing for a couple of reasons. Consumers find the Costco business model to be appealing because of the low prices that Costco offers. The cost leadership strategy, no matter how applied, is typically very popular with American consumers. The business model is also appealing for investors because any company that can successfully apply this model is likely to enjoy a strong market share. The business model has built in feedback loops wherein the low prices facilitate growth in volume, which in turn improves the company's buying power, allowing it to lower prices further. Smaller competitors have difficulty matching prices of a firm as large as Costco because they lack the buying power and operating efficiencies. Costco was able to establish dominant market position in warehouse retail with its first mover advantage, which has facilitated its ability to stay ahead of its competition.

The biggest difficulty with the Costco business model is with respect to the difficulty of executing it. Cost leadership demands excellence in all aspects of the business, especially operating efficiency. A single-minded pursuit of cost-cutting is typically required in order to properly execute this model. In addition, there is generally room for only one or two highly successful retailers with this strategy, as market share is a key determinant in efficiency and buying power. As such, this business model would not be attractive to a new firm in the industry today because there are three major competitors in the U.S.; but for established firms the model remains highly attractive.

One of the elements of the cost leadership strategy that is particularly appealing is that the strategy requires the company to be a best-in-industry performer. Working on a top cost leader is challenging, but successful implementation of the strategy allows a firm to be a volume leader with high market share. In short, the cost leadership strategy is a "go big or go home" strategy, and that has tremendous appeal to both consumers and to potential managers considering working in the industry.

2. There are several chief elements of Costco's strategy. These include efficiencies of scale, merchandising, working capital management and human resources. Efficiencies of scale allow Costco to purchase goods at low prices, and then pass those savings onto customers. Costco also enjoys significant savings from its economies of scale in distribution and logistics as well. The store locations are typically in lower-rent suburban areas, which allows the company to minimize the cost per square foot of its stores, increasing profit per square foot.

Costco's merchandising strategy is another key element. In addition to the standard range of products, Costco also rotates through a number of limited time products. Some of these are loss leaders, such as major label goods that are not normally found at discount prices. These products represent substantial savings, and bring customers into the store. In addition, the limited stock of goods allows for faster inventory turnover. The variety of goods that Costco sells allows for the company to have a high average ticket because consumers can find savings on a broad range of goods -- they may come in for cheap food but they leave with electronics, furnishings and other items as well.

Working capital management is a significant source of savings for Costco. The company sells goods quickly, which allows it to pay its suppliers with the cash generated from the sale of the good, and sometimes even capture the early payment discount. This allows Costco to operate with almost no accounts receivable. Thus, Costco is able to cycle its earnings back into the business immediately, tightening the working capital turnover cycle and improving working capital efficiency. The high rate of inventory turn also allows Costco to operate with a minimal amount of inventory, lowering the costs associated with warehousing and logistics.

In order to execute its strategies, Costco needs to have a high quality workforce that makes the right decisions, supports the customers and makes few mistakes. As such, Costco has chosen human resources as the one area not to cut costs. This engenders strong loyalty to the company, giving Costco a very low turnover rate for a retailer. This lowers the costs associated with training and employee learning curves, something that the company considers to be important given the need for perfection in executing the firm's management systems.

The strategy has proven to be excellent for Costco. Each element of the strategy contributes to the ability of Costco to maintain a cost leadership stance. The company has the lowest costs associated with inventory and working capital management of any retailer, and its low turnover and high employee loyalty allow it to perform well on customer service and to execute its systems with a high level of effectiveness. The evidence of the success of Costco's strategies has been in its ability to deliver low prices to customers, which in turn has fueled strong growth in revenues, profits and market share. In addition, it is worth noting that in its history, Costco has never changed the core elements of its strategy. This, combined with the company's success, indicates that the strategy has been successful and the company believes that there is no reason to make adjustments to the strategy.

3. I believe that Sinegal is an effective CEO. There are two main reasons for making this claim. The first is the company's success in terms of revenues, profits and market share; the second is the esteem in which Sinegal is held within the company. Sinegal is the clear leader of Costco. He leads by example, following the same strategies to which he expects the rest of the organization to adhere. This has earned him a strong following within the company, and Sinegal is received well at every Costco store as a result. If Sinegal was not an effective leader, his reputation among Costco workers and managers would be poor.

Ultimately, however, Sinegal owes his duty to the shareholders of Costco. His leadership is measured by his ability to deliver financial results. In that, Sinegal has also proven to be a highly effective leader. In the 2010 fiscal year, Costco recorded sales of $77.946 billion and profits of $1.303 billion. These figures are both company records, and both show evidence of steady growth over the past five years (MSN Moneycentral, 2010). Earnings per share are also high, and the company's returns, which although below industry averages are consistent with those of a high-volume, low-margin retailer. Costco's balance sheet is equally healthy, again indicating the success of Sinegal's strategies.

I would give Sinegal an A in both crafting and executing Costco's strategy. The strategy that Sinegal laid out for Costco was risky and courageous at the time. There were few successful firms attempting this strategy, but Sinegal had enough vision to realize that it could work on a large scale. The strategy combines disparate elements -- logistics and purchasing, merchandising, human resources, information technology, working capital management and leadership -- and each serves a specific purpose within the overall strategy at Costco. This indicates that the strategy was well-conceived from the outset, especially given that there have not been any major strategic changes over the course of the company's growth.

Executing this strategy represented another challenge. The margin for error is very low at Costco (the company has a gross margin of just 12.8% and a net margin of 1.7%) so executing is critical to the company's success (MSN Moneycentral, 2010). The biggest challenge with respect to executing Costco's strategy is probably scaling the strategy up from a small regional operation to a national (now international) powerhouse. Scaling up a strategy that relies on flawless execution is difficult because of human resources constraints, but Costco has been able to clearly and effectively communicate its vision and its processes to thousands of employees and managers, allowing it to grow rapidly without sacrificing operational quality. This is testament to Sinegal's leadership that he has created operations and culture that allow for this to occur.

In further support of Sinegal's A grade it is worth pointing out that Costco is the best in industry, despite strong performances from both BJs and Sam's Club. That Costco has been able to essentially beat Wal-Mart (Sam's Club) in a field where the regular Wal-Mart is the undisputed leader is evidence of the strength of Sinegal's leadership. The best in the business is deserving of an A grade, and Costco remains the largest and best-performing warehouse club in the U.S.

4. Costco's financial performance is excellent. There are elements of the performance that appear to not compare well with the industry, but when the figures are taken in context of Costco's high-volume, low-margin business model it becomes clear that the company's performance is either in line with expectations or exceeds them. The company has enjoyed year-over-year revenue growth averaging 8.04% over the past five years, compared with the industry average of 7.53%. Costco did not see a reduction in business during the recession years of 2008-2010, but increased sales steadily over this period. Net income was up 20% last year, and has increased an average of 4.15% over the past five years, lower than the industry average of 6.38% (MSN Moneycentral, 2010).

The company has lower margins and returns than most of its competitors, which is a function of its business model. Gross margins have averaged 12.5% over the past five-year, compared with 24.3% for the industry. Net margins have averaged 1.7% compared with 3.4% in the industry. These figures are consistent with the Costco business model, and the company has the second-highest revenue of general retailers behind only Wal-Mart.

Costco's return on assets over the past five years is 5.9%, compared with 7.9% for the industry. Its average return on equity for the past five years is 12.5%, compared with 18.8% for the industry. Costco's return on investment for the past five years is 10.3%, compared with 12.7% for the industry. Each of these figures would indicate underperformance were it not for the fact that each is expected from the cost leader. The cost leadership strategy depends on the firm having dominant market share and volume, and Costco's status as the nation's number two retailer indicates that the firm has been successful in that element of the strategy as well.

Costco has a healthy balance sheet. The company's current ratio is 1.2, better than the industry average of 1.1. Costco's quick ratio is 0.6, again superior to the industry average (0.4). In addition, Costco has a relatively low degree of leverage compared with the industry. Costco's debt to equity ratio is just 0.20, compared with an industry average of 0.79. This not only leaves the company with low interest expense, but it also allows Costco to weather difficult economic climates better. The cost leadership strategy does not leave must room for error, as margins are very slim. As debt increases the company's risk by introducing obligations that must be paid out of EBITDA, keeping a low debt level is essential to reducing Costco's risk and the company has succeeded on debt control, relative to its industry peers. As a result, Costco covers its interest expense 90 times, compared to 25 times for the rest of the industry, again a sign of a healthy balance sheet.

Overall, Costco's financial performance has been strong. The areas where the company can be expected to lag the industry averages as a consequence of its business model are the areas where the lag occurs. In most other areas, such as the quality of the balance and in revenue growth, Costco performs favorably compared with the other firms in the industry. Thus, overall Costco's financial performance can be considered strong, especially given the relative lack of struggles in the recent economic downturn.

5. From a strategic perspective, Costco is performing relatively well. There are two key elements to this strategic success. The first is that the company has been able to deliver cost leadership. The second is that Costco has been able to withstand all competitive and economic pressures to continue its growth trajectory.

The basic strategy on which Costco competes is that of cost leadership. In order to measure the success of the cost leadership strategy, it must be considered whether Costco truly has a cost leadership perception in the industry. Perception is more important than actual cost leadership -- having the lowest prices only attracts customers when they believe that you have the lowest prices. For Costco, the company does have a high perception of cost leadership. Consumers are attracted to Costco for the opportunity to save money and on most goods they do. Costco operates on slim margins, which indicates that the company is working to keep prices down and the firm's ability to stake out dominant market share in warehouse stores, and the position at the number two retailer in the U.S., is indicative of the firm's ability to deliver a high perception of cost leadership.

In addition, Costco has been successful with this strategy as evidenced by its continued strong financial performance during the economic downturn. In a growing market, success is easy. The true test of a company's strategy comes during difficult times in the market. Costco has been a strategic success because the company attracts a clientele that is, on average, relatively wealthy. These consumers are almost always employed, and many are professionals. As a result, Costco's customer base in more impervious to economic downturn than the customer base at many other discount retailers. The result of this is that the company did not see much revenue decline during the downturn and only a minor profit decline as well. In addition, Costco rebounded strongly in 2010 from the downturn. The target market is an essential part of Costco's strategy, and serves to differentiate it from a number of the company's competitors. This target market also serves to insulate Costco somewhat from business cycles, and in this the company's strategy can be considered to be a success.

Costco does enjoy a competitive advantage over Sam's Club. While it may be difficult to argue that Costco has a competitive advantage in buying power, the company does have a better image among consumers than does Sam's Club. Costco's brand value is higher, and it attracts wealthier consumers. While Sam's Club performs well, Costco's long-run performance is superior. In part, this comes from the singular focus that Costco has on its warehouse retail, whereas Sam's Club is ancillary to the flagship Wal-Mart stores. BJ's Wholesale is regionally strong, but does not have the buying power, pricing power or national distribution of Costco. Thus, against BJ's, Costco has a strong name and superior economies of scale.

All told, Costco has a winning strategy. That Costco has been able to maintain its success and fend off such stiff competition is indicative of not only the strength of its strategy but also its ability to execute on that strategy.

6. Costco's prices are not too low. The company competes on a cost leadership platform, which inherently necessitates that prices are lower than those of the competition. Costco therefore needs to consistently drive prices down to undercut the competition. From a competitive perspective, then, Costco's prices are not too low.

From a financial perspective, the key for Costco with respect to its prices is that the company remains profitable. Prices can only be considered too low if the company is not profitable. Costco has maintained a steady 1.7% net margin over the past five years. While this is lower than the industry average, that the company has maintained this mark consistently is evidence that Costco does not have prices that are too low. In addition, other financial metrics support the view that Costco's prices are not too low. In particular, the firm has been able to maintain EPS growth over the long-term, which indicates that the prices are not too low.

It could be argued that Costco's prices are below the point of optimal profit. There is a point at which every company can balance output and prices to achieve the greatest profit. The industry average net margin for retailers is 3.4%, double Costco's 1.7%. This indicates that for many firms, the optimal price point for profit is higher than that at which Costco sets its prices. However, the price point must be considered in the context of the firm's overall strategy.

A key element of Costco's strategy is to grow a dominant market share within its segment. To do this, the company must offer lower prices than those of its competitors. This is especially true because Costco has fewer items than either of its main competitors. Its primary points of differentiation are the strength of its brand and its low prices. The brand strength depends on the perception of low prices. Therefore, if Costco did not utilize its advantages to undercut its competitors, the company would not be sufficiently differentiated to maintain market domination. As such, it can hardly be argued that Costco is selling at prices that are too low. Indeed, the rock bottom prices and razor thin margins at which Costco operates are precisely part of the business plan. Concessions on prices would put the company's reputation as a low cost provider at risk, and would open the door for either Sam's Club or BJ's to win market share from Costco. Thus, the low prices are both offensive and defensive in nature.

In order for Costco to justify raising prices, it would need to adjust its time frame. Costco's strategy has always been oriented towards the long-term. An increase in prices would provide a short-term profit boost, but over the long run the company could lose its competitive advantage or worse yet market share. The market share -- and the volume that comes with it -- is a feedback loop that allows the company to gain greater efficiencies of scale, so it is essential that Costco defend this market share. The best means for Costco to do that is to keep long-run prices lower than those of the competition. The lower prices also facilitate other elements of the strategy. Inventory and working capital management, for example, benefit from the low prices because the company sells its goods before it needs to make payments to the supplier for those goods. This is possible because of the low price, and it allows Costco to carry very little inventory and accounts receivable, while still maintaining the ability to collect early payment discounts from suppliers.

7. I do not believe that Costco pays its employees too much. Costco's human resources strategy is one of the most significant sources of competitive advantage. The first perspective with which to analyze the issue is that of opportunity cost. Costco relies on perfect execution of its strategies. This implies that employees should be well-trained, adhere tightly to the corporate culture and understand how the system supports the overall corporate strategy. A high level of turnover would make this difficult. Training costs would be higher, the company would be subject to more errors, and employees would have steeper learning curves. Overall organizational efficiency would be much lower if the company experienced high turnover. What Costco has done is analyzed the cost of this reduced efficiency against the cost of paying its employees better and realized that paying employees more is cheaper in the long run than paying poorly and having high turnover rates.

The second perspective from which to analyze the issue is with respect to direct costs. The cost leadership strategy would imply that employee costs are minimized. By that argument, Costco should reduce staffing costs. However, the company wishes to attract the industry's best employees and seeks to do that with higher wages. Because it believes that its employees are a source of competitive advantage, it does make sense for Costco to pay better.

The other firms in the industry utilize lower end labor and ultimately, this should reflect in higher turnover, higher training costs, higher costs relating the employee inefficiency and lower customer service. All of these could be considered acceptable if the firms are not engaged in a highly competitive oligopoly. A firm with monopoly power -- as all three firms once had on a regional basis when the industry was nascent -- can afford to have lower customer service quality and higher net staffing costs simply because customers would have an option to switch in the event of poor service or occasional higher prices. However, in a highly competitive national oligopoly where all three players have very low prices, there are few means by which the firms can differentiate themselves. Customer service is one of those ways. For Costco, having a staff comprised of dedicated long-term employees allows it to provide superior service in addition to lower net staffing costs. This tactic supports Costco's target market strategy -- high-earning professionals place significant emphasis on service even when shopping for bargains. By being able to attract this demographic, Costco has been able to weather the recent economic storm and engender strong brand loyalty among its clientele. The customer service and corporate culture rub off on the customers, and this provides Costco with a source of sustainable competitive advantage over its closest competitors.