Costco craig jelinek net worth

tho75109_case04_C17-C40.indd C-17 12/14/18 05:16 PM

Costco Wholesale in 2018: Mission, Business Model, and Strategy

Arthur A. Thompson Jr., The University of Alabama

Six years after turning the leadership of Costco Wholesale over to then-president, Craig Jelinek, Jim Sinegal, Costco’s co-founder and chief exec- utive officer (CEO) from 1983 until year-end 2011, had ample reason to be pleased with the company’s ongoing revenue growth and competitive standing as one of the world’s biggest and best consumer goods merchandisers. Sinegal had been the driving force behind Costco’s 35-year evolution from a startup entre- preneurial venture into the third largest retailer in the United States, the seventh largest retailer in the world, and the undisputed leader of the discount warehouse and wholesale club segment of the North American retailing industry. Since January 2012, when Craig Jelinek took the reins as Costco Wholesale’s president and CEO, the company had prospered, growing from annual revenues of $89 billion and 598 membership warehouses at year-end fiscal 2011 to annual revenues of $126.2 billion and 741 membership warehouses at year-end fiscal 2017. Costco’s growth continued in the first nine months of fiscal 2018; 9-month rev- enues were $95.0 billion, up 12.0 percent over the first 9 months of fiscal 2017, and the company had opened four additional warehouses. As of June 2018, Costco ranked as the second largest retailer in both the United States and the world (behind Walmart).

COMPANY BACKGROUND The membership warehouse concept was pioneered by discount merchandising sage Sol Price, who opened the first Price Club in a converted airplane hangar on Morena Boulevard in San Diego in 1976. Price Club lost $750,000 in its first year of opera- tion, but by 1979 it had two stores, 900 employees,

200,000 members, and a $1 million profit. Years ear- lier, Sol Price had experimented with discount retail- ing at a San Diego store called Fed-Mart. Jim Sinegal got his start in retailing at the age of 18, loading mat- tresses for $1.25 an hour at Fed-Mart while attending San Diego Community College. When Sol Price sold Fed-Mart, Sinegal left with Price to help him start the San Diego Price Club store; within a few years, Sol Price’s Price Club emerged as the unchallenged leader in member warehouse retailing, with stores operating primarily on the West Coast.

Although Price originally conceived Price Club as a place where small local businesses could obtain needed merchandise at economical prices, he soon concluded that his fledgling operation could achieve far greater sales volumes and gain buying clout with suppliers by also granting membership to individuals—a conclusion that launched the deep-discount warehouse club industry on a steep growth curve.

When Sinegal was 26, Sol Price made him the manager of the original San Diego store, which had become unprofitable. Price saw that Sinegal had a special knack for discount retailing and for spotting what a store was doing wrong (usually either not being in the right merchandise categories or not sell- ing items at the right price points)—the very things that Sol Price was good at and that were at the root of Price Club’s growing success in the marketplace. Sinegal soon got the San Diego store back into the black. Over the next several years, Sinegal continued to build his prowess and talents for discount merchan- dising. He mirrored Sol Price’s attention to detail and absorbed all the nuances and subtleties of his mentor’s

CASE 4

Copyright ©2019 by Arthur A. Thompson. All rights reserved.

Final PDF to printer

tho75109_case04_C17-C40.indd C-18 12/14/18 05:16 PM

C-18 PART 2 Cases in Crafting and Executing Strategy

style of operating—constantly improving store opera- tions, keeping operating costs and overhead low, stocking items that moved quickly, and charging ultra- low prices that kept customers coming back to shop. Realizing that he had mastered the tricks of running a successful membership warehouse business from Sol Price, Sinegal decided to leave Price Club and form his own warehouse club operation.

Sinegal and Seattle entrepreneur Jeff Brotman founded Costco, and the first Costco store began operations in Seattle in 1983—the same year that Walmart launched its warehouse membership for- mat, Sam’s Club. By the end of 1984, there were nine Costco stores in five states serving over 200,000 members. In December 1985, Costco became a public company, selling shares to the public and raising addi- tional capital for expansion. Costco became the first ever U.S. company to reach $1 billion in sales in less than six years. In October 1993, Costco merged with Price Club. Jim Sinegal became CEO of the merged company, presiding over 206 PriceCostco locations, with total annual sales of $16 billion. Jeff Brotman, who had functioned as Costco’s chairman since the company’s founding, became vice chairman of PriceCostco in 1993 and was elevated to chairman of the company’s board of directors in December 1994, a position he held until his unexpected death in 2017.

In January 1997, after the spin-off of most of its non- warehouse assets to Price Enterprises Inc., PriceCostco changed its name to Costco Companies Inc. When the company reincorporated from Delaware to Washington in August 1999, the name was changed to Costco Wholesale Corporation. The company’s headquarters was in Issaquah, Washington, not far from Seattle.

Jim Sinegal’s Leadership Style Sinegal was far from the stereotypical CEO. He dressed casually and unpretentiously, often going to the office or touring Costco stores wearing an open-collared cot- ton shirt that came from a Costco bargain rack and sporting a standard employee name tag that said, sim- ply, “Jim.” His informal dress and unimposing appear- ance made it easy for Costco shoppers to mistake him for a store clerk. He answered his own phone, once tell- ing ABC News reporters, “If a customer’s calling and they have a gripe, don’t you think they kind of enjoy the fact that I picked up the phone and talked to them?”1

Sinegal spent considerable time touring Costco stores, using the company plane to fly from location to location and sometimes visiting 8 to 10 stores daily

(the record for a single day was 12). Treated like a celebrity when he appeared at a store (the news “Jim’s in the store” spread quickly), Sinegal made a point of greeting store employees. He observed, “The employ- ees know that I want to say hello to them, because I like them. We have said from the very beginning: ‘We’re going to be a company that’s on a first-name basis with everyone.’”2 Employees genuinely seemed to like Sinegal. He talked quietly, in a commonsensi- cal manner that suggested what he was saying was no big deal.3 He came across as kind yet stern, but he was prone to display irritation when he disagreed sharply with what people were saying to him.

In touring a Costco store with the local store manager, Sinegal was very much the person-in- charge. He functioned as producer, director, and knowledgeable critic. He cut to the chase quickly, exhibiting intense attention to detail and pricing, wandering through store aisles firing a barrage of questions at store managers about sales volumes and stock levels of particular items, critiquing merchan- dising displays or the position of certain products in the stores, commenting on any aspect of store opera- tions that caught his eye, and asking managers to do further research and get back to him with more information whenever he found their answers to his questions less than satisfying. Sinegal had tremen- dous merchandising savvy, demanded much of store managers and employees, and definitely set the tone for how the company operated its discounted retail- ing business. Knowledgeable observers regarded Jim Sinegal’s merchandising expertise as being on a par with Walmart’s legendary founder, Sam Walton.

In September 2011, at the age of 75, Jim Sinegal informed Costco’s Board of Directors of his intention to step down as CEO of the company effective January 2012. The Board elected Craig Jelinek, President and Chief Operating Officer since February 2010, to suc- ceed Sinegal and hold the titles of both President and CEO. Jelinek was a highly experienced retail executive with 37 years in the industry, 28 of them at Costco, where he started as one of the Company’s first ware- house managers in 1984. He had served in every major role related to Costco’s business operations and merchandising activities during his tenure. When he stepped down as CEO, Sinegal retained his position on the company’s Board of Directors and, at the age of 79, was re-elected to another three-year term on Costco’s board in December 2015; he retired from Costco’s Board at the end of his term in January 2018.

Final PDF to printer

tho75109_case04_C17-C40.indd C-19 12/14/18 05:16 PM

CAse 4 Costco Wholesale in 2018: Mission, Business Model, and Strategy C-19

members per day. Annual sales per store averaged about $170 million ($3.3 million per week) in 2017, over 70 percent higher than the $99.2 million per year and $1.9 million per week averages for Sam’s Club, Costco’s chief competitor. In 2014, 165 of Costco’s warehouses generated sales exceeding $200 million annually, up from 56 in 2010; and 60 warehouses had sales exceeding $250 million, including two that had more than $400 million in sales.4 In 2018, Costco was the only national retailer in the history of the United States that could boast of average annual revenue in excess of $170 million per location.

Exhibit 1 contains a financial and operating summary for Costco for fiscal years 2000, 2005, and from 2014 through 2017.

COsTCO WHOLesALe IN 2018 In June 2018, Costco was operating 750 membership warehouses, including 520 in the United States and Puerto Rico, 98 in Canada, 38 in Mexico, 28 in the United Kingdom, 26 in Japan, 14 in South Korea, 13 in Taiwan, 9 in Australia, 2 in Spain, 1 in France, and 1 in Iceland. Costco also sold merchandise to mem- bers at websites in the United States, Canada, the United Kingdom, Mexico, South Korea, and Taiwan. Over 90 million cardholders were entitled to shop at Costco as of January 2018; in fiscal year 2017, mem- bership fees generated over $2.85 billion in revenues for the company. Headed into 2018, on average, traf- fic at Costco’s warehouse locations averaged 3 million

EXHIBIT 1 selected Financial and Operating Data for Costco Wholesale Corp., Fiscal Years 2000, 2005, and 2014–2017 ($ in millions, except for per share data)

Fiscal years ending on Sunday closest to August 31

Selected Income Statement Data 2017 2016 2015 2014 2005 2000

Net sales $126,172 $116,073 $113,666 $110,212 $51,862 $31,621

Membership fees 2,853 2,646 2,533 2,428 1,073 544

Total revenue 129,025 118,719 116,199 112,640 52,935 32,164

Operating expenses

Merchandise costs 111,882 102,901 101,065 98,458 46,347 28,322

Selling, general and administrative

12,950 12,068 11,445 10,899 5,044 2,755

Preopening expenses 82 78 65 63 53 42

Provision for impaired assets and store closing costs

——— ——— ——— ——— 16 7

Total operating expenses 124,914 115,047 112,575 109,420 51,460 31,126

Operating income 4,111 3,672 3,624 3,220 1,474 1,037

Other income (expense)

Interest expense (134) (133) (124) (113) (34) (39)

Interest income and other, net 62 80 104 90 109 54

Income before income taxes 4,039 3,619 3,604 3,197 1,549 1,052

Provision for income taxes 1,325 1,243 1,195 1,109 486 421

Net income $ 2,714 $ 2,350 $ 2,377 $ 2,058 $ 1,063 $ 631

Diluted net income per share $ 6.08 $5.33 $5.37 $4.65 $2.18 $ 1.35

Dividends per share (not including special dividend of $7.00 in 2017 and $5.00 in 2015)

$ 1.90 $1.70 $1.51 $1.33 0.43 0.00

Millions of shares used in per share calculations

440.9 441.3 442.7 442.5 492.0 475.7

(Continued)

Final PDF to printer

tho75109_case04_C17-C40.indd C-20 12/14/18 05:16 PM

C-20 PART 2 Cases in Crafting and Executing Strategy

2017 2016 2015 2014 2005 2000

Balance Sheet Data

Cash and cash equivalents $ 4,546 $ 3,379 $ 4,801 $ 5,738 $ 2,063 $ 525

Merchandise inventories 9,834 8,969 8,908 8,456 4,015 2,490

Current assets 17,317 15,218 16,779 17,588 8,238 3,470

Current liabilities 17,485 15,575 16,539 14,412 6,761 3,404

Net property and equipment 18,161 17,043 15,401 14,830 7,790 4,834

Total assets 36,347 33,163 33,017 33,024 16,514 8,634

Long-term debt 6.573 4,061 4,852 5,093 711 790

Stockholders’ equity 10,778 12,079 10,617 12,515 8,881 4,240

Cash Flow Data

Net cash provided by operating activities

$ 6,726 $ 3,292 $ 4,285 $3,984 $ 1,773 $ 1,070

Warehouse Operations

Warehouses in operation at beginning of yeara

715 686 663 634 417 292

New warehouses opened (including relocations)

28 33 26 30 21 25

Existing warehouses closed (including relocations)

(2) (4) (3) (1) (5) (4)

Warehouses at end of year 741 715 686 663 433 313

Net sales per warehouse open at year-end (in millions)

$ 170 $ 162 $ 166 $ 166 $ 120 $ 101

Average annual growth at warehouses open more than a year (excluding the impact of changing gasoline prices and foreign exchange rates)

4% 4% 7% 6% 7% 11%

Members at year-end

Businesses, including add-on members (000s)

10,800 10,800 10,600 10,400 5,000 4,200

Gold Star members (000s) 38,600 36,800 34,000 31,600 16,200 10,500

Total paid members 49,400 47,600 44,600 42,000 21,200 14,700

Household cardholders that both business and Gold Star members were automatically entitled to receive

42,600 42,600 40,200 34,400 n.a. n.a.

Total cardholders 90,300 86,700 81,300 76,400 ——— ———

a At the beginning of Costco’s 2011 fiscal year, the operations of 32 warehouses in Mexico that were part of a 50 percent-owned joint ven- ture were consolidated and reported as part of Costco’s total operations.

Note: Some totals may not add due to rounding and to not including some line items of minor significance in the company’s statement of income.

Sources: Company 10-K reports for fiscal years 2000, 2005, 2015, 2016, and 2017.

Final PDF to printer

tho75109_case04_C17-C40.indd C-21 12/14/18 05:16 PM

CAse 4 Costco Wholesale in 2018: Mission, Business Model, and Strategy C-21

Big sales volumes and rapid inventory turnover— when combined with the low operating costs achieved by volume purchasing, efficient distribution, and reduced handling of merchandise in no-frills, self- service warehouse facilities—enabled Costco to oper- ate profitably at significantly lower gross margins than traditional wholesalers, mass merchandisers, supermarkets, and supercenters. Membership fees were a critical element of Costco’s business model because they provided sufficient supplemental rev- enues to boost the company’s overall profitability to acceptable levels. Indeed, Costco’s revenues from membership fees typically exceeded 100 percent of the company’s net income, meaning that the rest of Costco’s worldwide business operated on a slightly below breakeven basis (see Exhibit 1)—which trans- lated into Costco’s prices being exceptionally com- petitive when compared to the prices that Costco members paid when shopping elsewhere.

Another important business model element was that Costco’s high sales volume and rapid inventory turnover generally allowed it to sell and receive cash for inventory before it had to pay many of its mer- chandise vendors, even when vendor payments were made in time to take advantage of early payment discounts. Thus, Costco was able to finance a big percentage of its merchandise inventory through the payment terms provided by vendors rather than by having to maintain sizable working capital (defined as current assets minus current liabilities) to enable timely payment of suppliers.

Costco’s Strategy The key elements of Costco’s strategy were ultra- low prices, a limited selection of nationally branded and top-quality Kirkland Signature products cov- ering diverse merchandise categories, a “treasure hunt” shopping environment that stemmed from a constantly-changing inventory of about 900 “while- they-last specials,” strong emphasis on low operating costs, and ongoing expansion of its geographic net- work of store locations.

Pricing Costco’s philosophy was to keep custom- ers coming in to shop by wowing them with low prices and thereby generating big sales volumes. Examples of Costco’s 2015 sales volumes that con- tributed to low prices in particular product cat- egories included 156,000 carats of diamonds, meat sales of $6.4 billion, seafood sales of $1.3 billion,

COsTCO’s MIssION, BUsINess MODeL, AND sTRATeGY Costco’s stated mission in the membership warehouse business was: “To continually provide our members with quality goods and services at the lowest possible prices.”5 However, in a “Letter to Shareholders” in the company’s 2011 Annual Report, Costco’s three top executives—Jeff Brotman, Jim Sinegal, and Craig Jelinek—provided a more expansive view of Costco’s mission, stating:

The company will continue to pursue its mission of bringing the highest quality goods and services to mar- ket at the lowest possible prices while providing excel- lent customer service and adhering to a strict code of ethics that includes taking care of our employees and members, respecting our suppliers, rewarding our share- holders, and seeking to be responsible corporate citizens and environmental stewards in our operations around the world.”6

In the company’s 2017 Annual Report, Craig Jelinek elaborated on how environmental sustainabil- ity fit into Costco’s mission:

Sustainability to us is remaining a profitable business while doing the right thing. We are committed to less- ening our environmental impact, decreasing our carbon footprint, sourcing our products responsibly, and work- ing with our suppliers, manufacturers, and farmers to preserve natural resources. This will remain at the fore- front of our business practices. 7

The centerpiece of Costco’s business model was a powerful value proposition that featured a combi- nation of (1) ultra-low prices on a limited selection of nationally branded and Costco’s private-label Kirkland Signature products in a wide range of mer- chandise categories, (2) very good to excellent prod- uct quality, and (3) intriguing product selection that included both everyday items and ongoing special purchases from a big variety of merchandise suppli- ers that turned shopping at Costco into a money- saving treasure hunt. Ever since the company’s founding, Costco management had strived diligently to ensure that shopping at Costco delivered enough value to keep existing members returning frequently to a nearby warehouse and spur membership growth every year, thereby generating high sales volumes and rapid inventory turnover at each warehouse and cre- ating opportunities to open new warehouses.

Final PDF to printer

tho75109_case04_C17-C40.indd C-22 12/14/18 05:16 PM

C-22 PART 2 Cases in Crafting and Executing Strategy

compete somewhere else.” Some years ago, we were sell- ing a hot brand of jeans for $29.99. They were $50 in a department store. We got a great deal on them and could have sold them for a higher price but we went down to $29.99. Why? We knew it would create a riot.8

At another time, he said:

We’re very good merchants, and we offer value. The tra- ditional retailer will say: “I’m selling this for $10. I won- der whether we can get $10.50 or $11.” We say: “We’re selling this for $9. How do we get it down to $8?” We understand that our members don’t come and shop with us because of the window displays or the Santa Claus or the piano player. They come and shop with us because we offer great values.9

Indeed, Costco’s markups and prices were so fractionally above the level needed to cover company- wide operating costs and interest expenses that Wall Street analysts had criticized Costco management for going all out to please customers at the expense of increasing profits for shareholders. One retailing analyst said, “They could probably get more money for a lot of the items they sell.”10 During his tenure as CEO, Sinegal had never been impressed with Wall Street calls for Costco to abandon its ultra-low pric- ing strategy, commenting: “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.”11 He went on to explain why Costco’s approach to pricing would remain unaltered during his tenure:

When I started, Sears, Roebuck was the Costco of the country, but they allowed someone else to come in under them. We don’t want to be one of the casualties. We don’t want to turn around and say, “We got so fancy we’ve raised our prices, and all of a sudden a new com- petitor comes in and beats our prices.”12

Product Selection Whereas typical supermar- kets stocked about 40,000 items and a Walmart Supercenter or a SuperTarget might have 125,000 to 150,000 items for shoppers to choose from, Costco’s merchandising strategy was to provide members with a selection of approximately 3,800 active items that could be priced at bargain levels and thus provide members with significant cost savings. Of these, about 75 percent were quality brand-name products and 25 percent carried the company’s private-label Kirkland Signature brand. The Kirkland Signature label appeared on everything from men’s dress shirts to laundry detergent, pet food to toilet paper, canned

television sales of $1.8 billion, fresh produce sales of $5.8 billion (sourced from 44 countries), 83 million rotisserie chickens, 7.9 million tires, 41 million pre- scriptions, 6 million pairs of glasses, and 128 million hot dog/soda pop combinations. Costco was the world’s largest seller of fine wines ($965 million out of total 2015 wine sales of $1.7 billion).

For many years, a key element of Costco’s pric- ing strategy had been to cap its markup on brand-name merchandise at 14 percent (compared to 25 percent and higher markups for other discounters and most supermarkets and 50 percent and higher markups for department stores). Markups on Costco’s private- label Kirkland Signature items were a maximum of 15 percent, but the sometimes fractionally higher mark- ups still resulted in Kirkland Signature items being priced about 20 percent below comparable name-brand items. Except for Walmart, Costco’s prices for fresh foods and grocery items ranged 20 to 30 percent below of the leading supermarket chains. Aside from being lower-priced, Costco’s Kirkland Signature products— which included vitamins, juice, bottled water, coffee, spices, olive oil, canned salmon and tuna, nuts, laundry detergent, baby products, dog food, luggage, cookware, trash bags, batteries, wines and spirits, paper towels and toilet paper, and clothing—were designed to be of equal or better quality than national brands.

As a result of its low markups, Costco’s prices were just fractionally above breakeven levels, produc- ing net sales revenues (not counting membership fees) that exceeded all operating expenses (mer- chandise costs + selling, general and administrative expenses + preopening expenses and store relocation expenses) by only $1.0 billion to $1. 2 billion in fiscal years 2017, 2016, and 2015 and by just $400 million to $800 million dollars in fiscal years 2014, 2005 and 2005. As can be verified from Exhibit 1, Costco’s revenues from membership fees accounted for 69 to 75 percent of the company’s operating profits in fis- cal years 2014 to 2017 and exceeded the company’s net income after taxes in every fiscal year shown in Exhibit 1 except for fiscal year 2000—chiefly because of the company’s ultra-low pricing strategy and prac- tice of capping the margins on branded goods at 14 percent and private-label goods at 15 percent.

Jim Sinegal explained the company’s approach to pricing:

We always look to see how much of a gulf we can cre- ate between ourselves and the competition. So that the competitors eventually say, “These guys are crazy. We’ll

Final PDF to printer

tho75109_case04_C17-C40.indd C-23 12/14/18 05:16 PM

CAse 4 Costco Wholesale in 2018: Mission, Business Model, and Strategy C-23

limited to fast-selling models, sizes, and colors. Many consumable products like detergents, canned goods, office supplies, and soft drinks were sold only in big- container, case, carton, or multiple-pack quantities. In a few instances, the selection within a product category was restricted to a single offering. For example, Costco stocked only a 325-count bottle of Advil—a size many shoppers might find too large for their needs. Sinegal explained the reasoning behind limited selections:

If you had 10 customers come in to buy Advil, how many are not going to buy any because you just have one size? Maybe one or two. We refer to that as the intel- ligent loss of sales. We are prepared to give up that one customer. But if we had four or five sizes of Advil, as most grocery stores do, it would make our business more difficult to manage. Our business can only succeed if we are efficient. You can’t go on selling at these margins if you are not.13

In the last several years, organics had become a fast-growing category in both the fresh produce section and the grocery items section, and Costco buyers were devoting increased attention to growing the selection of organic items. In the fresh meats cat- egory, Costco was pursuing increased vertical inte- gration, constructing a meat plant in Illinois and a poultry plant in Nebraska. The approximate percent- age of net sales accounted for by each major category of items stocked by Costco is shown in Exhibit 2.

Costco had opened ancillary departments within or next to most Costco warehouses to give reasons

foods to cookware, olive oil to beer, automotive prod- ucts to health and beauty aids. According to Craig Jelinek, “The working rule followed by Costco buyers is that all Kirkland Signature products must be equal to or better than the national brands, and must offer a savings to our members.” Management believed that there were opportunities to increase the number of Kirkland Signature selections and gradually build sales penetration of Kirkland-branded items to at least 30 percent of total sales—in 2017 Kirkland-brand sales exceeded 27 percent of total sales. Costco exec- utives in charge of sourcing Kirkland Signature prod- ucts constantly looked for ways to make all Kirkland Signature items better than their brand name coun- terparts and even more attractively priced. Costco members were very much aware that one of the great perks of shopping at Costco was the opportunity to buy top quality Kirkland Signature products at prices substantially lower than name brand products.

Costco’s product range covered a broad spectrum—rotisserie chicken, all types of fresh meats, seafood, fresh and canned fruits and vegetables, paper products, cereals, coffee, dairy products, cheeses, fro- zen foods, flat-screen televisions, iPods, digital cam- eras, fresh flowers, fine wines, caskets, baby strollers, toys and games, musical instruments, ceiling fans, vacuum cleaners, books, apparel, cleaning supplies, DVDs, light bulbs, batteries, cookware, electric tooth- brushes, vitamins, and washers and dryers—but the selection in each product category was deliberately

EXHIBIT 2 Costco’s sales by Major Product Category, 2005–2017

2017 2016 2010 2005

Food (fresh produce, meats and fish, bakery and deli products, and dry and institutionally packaged foods)

35% 36% 33% 30%

Sundries (candy, snack foods, tobacco, alcoholic and nonalcoholic beverages, and cleaning and institutional supplies)

20% 21% 23% 25%

Hardlines (major appliances, electronics, health and beauty aids, hardware, office supplies, garden and patio, sporting goods, furniture, cameras, and automotive supplies)

16% 16% 18% 20%

Softlines (including apparel, domestics, jewelry, housewares, books, movie DVDs, video games and music, home furnishings, and small appliances)

12% 12% 10% 12%

Ancillary and Other (gasoline, pharmacy, food court, optical, one-hour photo, hearing aids, and travel)

17% 16% 16% 13%

Source: Company 10-K reports, 2005, 2011, 2016, and 2017.

Final PDF to printer

tho75109_case04_C17-C40.indd C-24 12/14/18 05:16 PM

C-24 PART 2 Cases in Crafting and Executing Strategy

mattresses, and Dom Perignon champagne. Many of the featured specials came and went quickly, some- times in several days or a week—like Italian-made Hathaway shirts priced at $29.99 and $800 leather sectional sofas. The strategy was to entice shoppers to spend more than they might by offering irresistible deals on big-ticket items or name-brand specials and, further, to keep the mix of featured and treasure-hunt items constantly changing so that bargain-hunting shoppers would go to Costco more frequently rather than only for periodic “stock up” trips.

Costco members quickly learned that they needed to go ahead and buy treasure-hunt specials that interested them because the items would very likely not be available on their next shopping trip. In many cases, Costco did not obtain its upscale treasure hunt items directly from high-end manu- facturers like Calvin Klein or Waterford (who were unlikely to want their merchandise marketed at deep discounts at places like Costco); rather, Costco buy- ers searched for opportunities to source such items legally on the gray market from other wholesalers or distressed retailers looking to get rid of excess or slow-selling inventory.

Management believed that these practices kept its marketing expenses low relative to those at typical retailers, discounters, and supermarkets.

Low-Cost Emphasis Keeping operating costs at a bare minimum was a major element of Costco’s strategy and a key to its low pricing. As Jim Sinegal explained:

Costco is able to offer lower prices and better values by eliminating virtually all the frills and costs historically associated with conventional wholesalers and retailers, including salespeople, fancy buildings, delivery, billing, and accounts receivable. We run a tight operation with extremely low overhead which enables us to pass on dra- matic savings to our members.14

While Costco management made a point of locat- ing warehouses on high-traffic routes in or near upscale suburbs that were easily accessible by small businesses and residents with above-average incomes, it avoided prime real estate sites in order to contain land costs.

Because shoppers were attracted principally by Costco’s low prices and merchandise selection, most warehouses were of a metal pre-engineered design, with concrete floors and minimal interior décor. Floor plans were designed for economy and efficiency in use of selling space, the handling

to shop at Costco more frequently and make Costco more of a one-stop shopping destination. Some loca- tions had more ancillary offerings than others:

2015 2010 2007

Warehouses having stores with

Food Court 680 534 482

One-Hour Photo Centers 656 530 480

Optical Dispensing Centers 662 523 472

Pharmacies 606 480 429

Gas Stations 472 343 279

Hearing Aid Centers 581 357 237

Note: The company did not report the number of ancillary offerings for its warehouses at year-end 2016 and 2017, but the company did increase the number of gas stations to 508 in 2016 and to 536 in 2017. Costco did not sell gasoline at its warehouses in France and South Korea.

Source: Company 10-K reports, 2007, 2011, 2015, and 2017.

Costco’s pharmacies were highly regarded by members because of the low prices. The company’s practice of selling gasoline at discounted prices at those store locations where there was sufficient space to install gas pumps had boosted the frequency with which nearby members shopped at Costco and made in-store purchases (only members were eligible to buy gasoline at Costco’s stations). Almost all new Costco locations in the United States and Canada were opening with gas stations; globally, gas stations were being added at locations where local regulations and space permitted.

Treasure-Hunt Merchandising While Costco’s product line consisted of approximately 3,800 active items, some 20 to 25 percent of its product offerings were constantly changing. Costco’s merchandise buy- ers were continuously making one-time purchases of items that would appeal to the company’s clientele and likely to sell out quickly. A sizable number of these featured specials were high-end or luxury-brand prod- ucts that carried big price tags; examples included $1,000 to $4,500 big-screen Ultra HD LCD and LED TVs, $800 espresso machines, expensive jewelery and diamond rings (priced from $10,000 to $200,000+), Omega watches, Waterford Crystal, exotic cheeses, Coach bags, cashmere sports coats, $1,500 digi- tal pianos, $800 treadmills, $2,500 memory foam

Final PDF to printer

tho75109_case04_C17-C40.indd C-25 12/14/18 05:16 PM

CAse 4 Costco Wholesale in 2018: Mission, Business Model, and Strategy C-25

in fiscal 2011, 6 percent in both fiscal 2013 and 2014, 7 percent in fiscal 2015, and 4 percent in 2016 and 2017 (see Exhibit 1).

Costco had been aggressive in opening new warehouses and entering new geographic areas. As of December 2000, the Company operated a chain of 349 warehouses in 32 states (251 locations), 9 Canadian provinces (59 locations), the United Kingdom (11 locations, through an 80 percent- owned subsidiary), South Korea (four locations), Taiwan (three locations, through a 55 percent-owned subsidiary) and Japan (two locations), as well as 19 warehouses in Mexico through a 50 percent joint venture partner. Ten years later, in December 2010, Costco was operating 585 warehouses in 42 states (425 locations), 9 Canadian provinces (80 loca- tions), Mexico (32 locations), the United Kingdom (22 locations), Japan (9 locations), South Korea (7 locations), Taiwan (6 locations), and Australia (1 location). Since then, Costco had opened an addi- tional 165 warehouses and entered 2 more states and 3 additional countries. In 2017, Costco opened 28 new warehouses, including its first ones in Iceland and France. Costco expected to open 20 to 25 new warehouses and relocate up to six warehouses in fis- cal year 2018 beginning September 4, 2017.

Exhibit 4 shows a breakdown of Costco’s geo- graphic operations for fiscal years 2005, 2010, 2015, 2016, and 2017.

Marketing and Advertising Costco’s low prices and its reputation for making shopping at Costco something of a treasure-hunt

of merchandise, and the control of inventory. Merchandise was often stored on racks above the sales floor and/or displayed on pallets containing large quantities of each item, thereby reducing labor required for handling and stocking. In-store signage was done mostly on laser printers; there were no shopping bags at the checkout counter—merchandise was put directly into the shopping cart or sometimes loaded into empty boxes. Costco warehouses ranged in size from 73,000 to 205,000 square feet; the aver- age size was about 145,000 square feet. Newer units were usually in the 150,000- to 205,000-square-foot range, but the world’s largest Costco warehouse was a 235,000 square-foot store in Salt Lake City that opened in 2015. Images of Costco’s warehouses are shown in Exhibit 3.

Warehouses generally operated on a 7-day, 70-hour week, typically being open between 10:00 a.m. and 8:30 p.m. weekdays, with earlier closing hours on the weekend; the gasoline operations out- side many stores usually had extended hours. The shorter hours of operation as compared to those of traditional retailers, discount retailers, and super- markets resulted in lower labor costs relative to the volume of sales. By strictly controlling the entrances and exits of its warehouses and using a membership format, Costco had inventory losses (shrinkage) well below those of typical retail operations.

Growth Strategy Costco’s growth strategy was to increase sales at existing stores by 5 percent or more annually and to open additional warehouses, both domestically and internationally. Average annual growth at stores open at least a year was 10 percent

EXHIBIT 3 Images of Costco’s Warehouses

©Casiohabib/Shutterstock ©a katz/Shutterstock

Final PDF to printer

tho75109_case04_C17-C40.indd C-26 12/14/18 05:16 PM

C-26 PART 2 Cases in Crafting and Executing Strategy

EXHIBIT 4 selected Geographic Operating Data, Costco Wholesale Corporation, Fiscal Years 2005–2017 ($ in millions)

United States Operations

Canadian Operations

Other International Operations Total

Year Ended September 3, 2017

Total revenue (including membership fees) $93,889 $18,775 $16,361 $129,025

Operating income 2,644 841 626 4,111

Capital expenditures 1,714 277 511 2,502

Number of warehouses (as of December 31, 2017)

518 98 130 746

Year Ended August 30, 2016

Total revenue (including membership fees) $86,579 $17,028 $15,112 $118,719

Operating income 2,326 778 568 3,672

Capital expenditures 1,823 299 527 2,649

Number of warehouses 501 91 123 715

Year Ended August 29, 2015

Total revenue (including membership fees) $84,451 $17,341 $14,507 $116,199

Operating income 2,308 771 545 3,624

Capital expenditures 1,574 148 671 2,393

Number of warehouses 487 90 120 697

Year Ended August 29, 2010

Total revenue (including membership fees) $59,624 $12,501 $ 6,271 $ 77,946

Operating income 1,310 547 220 2,077

Capital expenditures 804 162 89 1,055

Number of warehouses 416 79 45 540

Year Ended August 28, 2005

Total revenue (including membership fees) $43,064 $ 6,732 $ 3,155 $ 52,952

Operating income 1,168 242 65 1,474

Capital expenditures 734 140 122 995

Number of warehouses 338 65 30 433

Note: The dollar numbers shown for the “Other International” categories represent only Costco’s ownership share, since all foreign opera- tions were joint ventures (although Costco was the majority owner of these ventures). Countries with warehouses in the Other International category as of year-end 2017 included Mexico (37), United Kingdom (28), Japan (26), South Korea (13), Taiwan (13), Australia (9), Puerto Rico (2), Spain (2), Iceland (1), and France (1); Costco’s two warehouses in Puerto Rico were included in the United States Operations cat- egory. The warehouses operated by Costco Mexico in which Costco was a 50 percent joint venture partner were not included in the data for “Other International” until Fiscal Year 2011.

Source: Company 10-K reports, 2017, 2016, 2015, 2010, and 2007.

made it unnecessary to engage in extensive advertis- ing or sales campaigns. Marketing and promotional activities were generally limited to monthly coupon mailers to members, weekly e-mails to members from Costco.com, occasional direct mail to prospective new members, and regular direct marketing pro- grams (such as The Costco Connection, a magazine

published for members), in-store product sampling, and special campaigns for new warehouse openings.

For new warehouse openings, marketing teams personally contacted businesses in the area that were potential wholesale members; these contacts were supplemented with direct mailings during the period immediately prior to opening. Potential Gold Star

Final PDF to printer

tho75109_case04_C17-C40.indd C-27 12/14/18 05:16 PM

CAse 4 Costco Wholesale in 2018: Mission, Business Model, and Strategy C-27

delivery times. New offerings were added at Costco Travel, and the company introduced hotel-only book- ing reservations. Costco Travel’s rental car rates were consistently some of the lowest in the marketplace and in 2017 car rentals became available to members in Canada and the United Kingdom. Additionally, the annual 2 percent reward for Executive members was extended to apply to Costco Travel purchases in the United States and Canada. Lastly, the company launched Costco Grocery, a two-day delivery on dry grocery items, and a same-day delivery offering both fresh and dry grocery items through partnering with Instacart.

Supply Chain and Distribution Costco bought the majority of its merchandise directly from manufacturers, routing it either directly to its warehouse stores or to one of the company’s cross-docking depots that served as distribution points for nearby stores and for shipping orders to members making online purchases. In early 2018, Costco had 24 cross-docking depots with a combined space of approximately 11 million square feet in the United States, Canada, and various other interna- tional locations. Depots received container-based shipments from manufacturers, transferred the goods to pallets, and then shipped full-pallet quantities of several types to goods to individual warehouses via rail or semi-trailer trucks, generally in less than 24 hours. This maximized freight volume and handling efficiencies. Depots were also used to ship bulky merchandise to members that had been ordered online; members typically picked up online orders that would fit in their vehicles at nearby warehouses.

When merchandise arrived at a warehouse, fork- lifts moved the full pallets straight to the sales floor and onto racks and shelves (without the need for multiple employees to touch the individual packages/ cartons on the pallets)—the first time most items were physically touched at a warehouse was when shoppers reached onto the shelf/rack to pick it out of a carton and put it into their shopping cart. Very little incoming merchandise was stored in locations off the sales floor in order to minimize receiving and handling costs.

Costco had direct buying relationships with many producers of national brand-name mer- chandise and with manufacturers that supplied its Kirkland Signature products. Costco’s merchandise buyers were always alert for opportunities to add

(individual) members were contacted by direct mail or by promotions at local employee associations and businesses with large numbers of employees. After a membership base was established in an area, most new memberships came from word of mouth (exist- ing members telling friends and acquaintances about their shopping experiences at Costco), follow-up messages distributed through regular payroll or other organizational communications to employee groups, and ongoing direct solicitations to prospective busi- ness and Gold Star members.

Website Sales Costco operated websites in the United States, Canada, Mexico, the United Kingdom, Taiwan, and South Korea—both to enable members to shop for many in-store products online and to provide mem- bers with a means of obtaining a much wider vari- ety of value-priced products and services that were not practical to stock at the company’s warehouses. Craig Jelinek was committed to a website strategy that provided exceptional service and value to Costco members who wanted to shop online. In recent years, online merchandise offerings had expanded signifi- cantly, and the company was continuously explor- ing opportunities to deliver added value to members via a broader array of online offerings. Examples of value-priced items that members could buy online included sofas, beds, mattresses, entertainment cen- ters and TV lift cabinets, outdoor furniture, office furniture, kitchen appliances, billiard tables, and hot tubs. Members could also use the company’s websites for such services as digital photo process- ing, prescription fulfillment, travel, the Costco auto program (for purchasing selected new vehicles with discount prices through participating dealerships), and other membership services. In 2015, Costco sold 465,000 vehicles through its 3,000 dealer part- ners; the big attraction to members of buying a new or used vehicle through Costco’s auto program was being able to skip the hassle of bargaining with the dealer over price and, instead, paying an attractively low price pre-arranged by Costco. At Costco’s online photo center, customers could upload images and pick up the prints at their local warehouse in little over an hour. Website sales accounted for 4 percent of Costco’s total net sales in fiscal 2017 and 2016, versus 3 percent in 2015 and 2014.

In 2017, Costco made improvements in web- site functionality, search capability, checkout, and

Final PDF to printer

tho75109_case04_C17-C40.indd C-28 12/14/18 05:16 PM

C-28 PART 2 Cases in Crafting and Executing Strategy

Business, Business add-on, and Gold Star mem- bers in the United States and Canada could upgrade to Executive membership for an additional $60 (an annual membership fee of $120); upgrade fees to Executive memberships elsewhere varied by country. The primary appeal of upgrading to Executive mem- bership was eligibility for a 2 percent annual reward (rebate) on qualified pre-tax purchases. Reward certificates were issued annually and could be used toward purchases of most merchandise at the front- end registers of Costco warehouses—rebate awards could not be used to purchase alcohol and tobacco products, gasoline, postage stamps, and food court items. The 2 percent rebate for Executive members was capped at $1,000 for any 12-month period in the United States and Canada (equivalent to annual qualified pre-tax purchases of $50,000); the maxi- mum rebate varied in other countries. Executive members also were eligible for savings and benefits on various business and consumer services offered by Costco, including merchant credit card process- ing, small-business loans, auto and home insurance, long-distance telephone service, check printing, and real estate and mortgage services; these services were mostly offered by third-party providers and varied by state—Executive members did not receive 2 per- cent rebate credit on purchases of these ancillary services. In fiscal 2017, Executive members repre- sented 38 percent of Costco’s cardholders (includ- ing add-ons, but not holders of household cards) and accounted for approximately two-thirds of total company sales. Costco’s member renewal rate was 90 percent in the United States and Canada, and 87 percent on a worldwide basis in 2017. Recent trends in membership are shown at the bottom of Exhibit 1.

In general, with variations by country, Costco members could pay for their purchases with certain debit and credit cards, co-branded Costco credit cards, cash, or checks; in the United States and Puerto Rico, members could use a co-branded Citi/ Costco Visa Anywhere credit card for purchases at Costco and elsewhere, Costco Cash cards, and all Visa cards. Since the June 2016 launch of Citi/ Costco Visa® Anywhere Card, 1.8 million new mem- ber accounts (approximately 2.4 million new credit cards) were opened. The enhanced cash-back Visa Anywhere rewards included earning 4 percent on gas; 3 percent on restaurant, hotel, and eligible travel; 2 percent at Costco and Costco.com; and 1 percent on all other purchases, exceeding the company’s pre- vious co-branded credit card offering with American

products of top quality manufacturers and vendors on a one-time or ongoing basis. No one manufacturer supplied a significant percentage of the merchandise that Costco stocked. Costco had not experienced dif- ficulty in obtaining sufficient quantities of merchan- dise, and management believed that if one or more of its current sources of supply became unavailable, the company could switch its purchases to alternative manufacturers without experiencing a substantial dis- ruption of its business.

Costco’s Membership Base and Member Demographics Costco attracted the most affluent customers in discount retailing—the average annual income of Costco members was approximately $100,000 (in 2015 Costco management believed the 8.6 million subscribers to the company’s monthly Costco Connection magazine had an average annual income of $156,000).15 Many members were affluent urban- ites, living in nice neighborhoods not far from Costco warehouses. One loyal Executive member, a criminal defense lawyer, said, “I think I spend over $20,000 to $25,000 a year buying all my products here from food to clothing—except my suits. I have to buy them at the Armani stores.”16 Another Costco loyalist said, “This is the best place in the world. It’s like going to church on Sunday. You can’t get anything better than this. This is a religious experience.”17