Competition Among the North American Warehouse Clubs

Issues: Upon completion of the in depth analysis of Costco and the industry in which it operates, two major issues were identified. These issues relate to the long term sustainable growth of Costco and needs to be addressed by management. One issue that that was evident throughout the analysis was the stagnating profitability. One aspect that is causing this issue is the above-average employee compensation (relative to industry standards) offered by Costco. Being accumulated into the selling and administrative expense line on the income statement, it places a downward pressure on profitability.

Much of the manual work accomplished within the store environment (cashier, stocking clerk) is not skilled and therefore does not require a premium wage. In keeping such costs to a minimum, Costco would be able to increase the productivity of its operations and increase in profitability. This will ensure that it will achieve its strategic objective. A second aspect of the profitability issue is its impact on its shareholders.

As a public company, Costco has to have the maximization of shareholder wealth as one of its objectives. However, it would appear that shareholder wealth maximization is being treated as a low priority objective.

When this was brought up by a Wall Street analyst, Jim Sinegal defended his position as being long term. However, this will not hold true if profitability continues to decline. Where as sales continued to increase in the 2008-2009 year-over-year (YoY) for Sam’s Club and BJ’s, Costco saw a decline. This translated into a 3% decline in ROE.

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While the recession of 2008-2009 would have contributed to this decline, it raises questions about Costco’s resilience to the cyclical business environment. A second issue that was identified is Costco’s reliance on the North American market (United States and Canada).

In terms of geographic profitability, 90% of Costco’s operating profits are earned in the US and Canadian markets. This is further evidenced in the number of warehouses broken down by geography (Total warehouses: 567, US warehouses: 414, Canadian warehouses: 77, rest of the world: 76). The lack of geographic diversification seems especially like an opportunity being missed, when the fact that the two most profitable stress are in Taiwan and Korea are taken into consideration. The high concentration on the North American market increases the risk to Costco due to the relatively slow economic growth that has persisted in recent years.

While Costco has made strides in expanding into the global marketplace, further diversification is necessary to reduce the risk of overreliance on the North American market. Integrated Strategy: In responding to the above stated issues, management has to be careful not to make drastic changes within a short time frame. Also, the changes should be consistent with the existing business model that Costco has as their value proposition remains a best cost warehouse retailer. In terms of dealing with the profitability issues, management should implement a two pronged approach.

First, the exuberant employee compensation system for employees working the floor should be modified. Reducing wages of existing employees will result in rapid deterioration in employee morale and lead to high employee turnover. Rather, this change should be managed by grandfathering the old system and implementing new wage scales for new hires. This process should be gradual as a drastic shift would result in high inequality among employees. The new system should start employees out at lower wages and/or take them longer to raise their wage level in comparison to the existing system.

This will lead to cost savings (Costco can further enhance its low cost position), better productivity and result in higher profitability. Second, in terms of shareholder maximization, the obvious limitation is the capped margins at 14% and 15%. While this policy is consistent with Jim Sinegal’s objective of providing the lowest cost products, it is not consistent with Costco being a publically traded company and the implied objective of shareholder maximization. Therefore these two objectives have to be balanced. The ideal situation would be to raise the margin cap slightly by even as low as 0. % or 1% and staggering it out over a few years while maintaining the relative cost advantage that Costco has over its competitors. This would result in a balanced approach and ensure sustained growth and profitability in the long run. In order to reduce Costco’s reliance on the US and Canadian markets, placing an emphasis on international expansion would not only lead to diversification, but also better profitability. While it is engaged in expanding internationally, an accelerated expansion strategy should be employed in order to tap into the high growth markets.

The high growth markets of the BRIC nations as well as the growing East Asian markets remain relatively untapped and would provide an excellent opportunity for global growth. The rising middle income demographic in these markets would provide a sustainable customer base for Costco’s long term growth. In order to penetrate these markets, Costco would have to duplicate its success in warehouses located in Taiwan and Korea. This expansion, however, must be managed delicately as penetrating new markets comes with its own risks.

Consideration needs to be given to the differences in cultural factors and the political and operating environment that exists within these markets. In conclusion, Costco has operated very well within its defined market and has established an efficient value chain system. It does, however, have a couple of issues that warrant management consideration and a slight shift in those areas would enhance profitability and sustain growth into the future APPENDIX A – Company’s External Environment (External) Key Economic and Industry Variables: * Industry size: $125 billion, 1250 warehouse locations in North America, ? 500 worldwide * Geographic segmentation: * Industry origins can be traced to the United States and its subsequent expansion into the Canadian and Mexican markets; some expansion into the international markets * Product Segmentation: * ‘discount warehouse and wholesale club’ segment of the retail industry * Product categories range from food and household supplies to electronics, furniture and appliances to office supplies clothing and books * Industry Concentration: * Concentrated industry with 3 main players and smaller competitors; top 2 make up 92%

* Industry lifecycle: Within North America (especially the US), the industry has entered maturity stage; the years rapid store openings have slowed, still some store openings * “Most every major metropolitan had one if not several warehouse club operations” * new store openings target states and cities where one does not exist or areas capable of handling two or more (potential for some cannibalization) * Decline in the capital expenditure in 2009 in the US for the first time; also fewer store openings (partly due to recession) * Rate of growth in store openings in US and Canada have peaked and are declining * Internationally, however, it is at the rapid growth stage: * Eg. Taiwan: warehouse sales tripled between 2004 and 2009; overall retail sales had only grown by 8. 3% in the same time period; also only one warehouse retailer

* discount warehouse and wholesale retail space is relatively new in other parts of the world: evidenced by relatively small market and relatively few stores globally The international market presents opportunity for rapid growth and profitability while the North American marketplace is relatively a low growth environment. Key Success Factors: 1. Maintain low prices: * also necessary for keeping the best cost model of the industry 2. Keep operating costs low: main reason to being able to offer low prices that cannot be matched by ordinary retailers is the discount warehouse’s ability to keep its operating costs lower 3. Loyalty of members: * business model is member driven; based on the exclusivity of being a member and selling in high volumes to them; membership fees account for about 70% of profits 4. Maintain quality to maintain best cost model: * in order to continuously make the argument for value proposition to customers, have to keep quality standards to an acceptable level PEST Analysis Political –By opening expanding into the global market place companies need to be aware of the political and regulatory environment

Economic –Recession: 2008 to 2009 slowdown in sales growth, sustained low Socio-Cultural –Prevalence in value conscious customers increase demand for low cost merchandise Technological –Increased online sales presence and improvements in the use of technology to operate efficiently “efficient warehouse management system enabled sufficient maintenance of logistics, inventories, and warehouse replenishment” and electronic article surveillance technology Porter’s 5 Forces: Competition from Rivals – High – Competitive industry has three key players competing for market share, all offering a similar product line and breadth. The industry is at a mature stage of its lifecycle in the North American market.

Competition from New Entrants – Low – There are many barriers to entry including high capital start up, operating costs, difficult to establish low cost distribution channels, and finally stealing market share from two major players consuming a combined 92% of the industry. Competition from Substitutes – High – Similar products can be obtained (usually in smaller quantities) from stores like Walmart, Target, or other discount grocery stores. Buyer Bargaining Power – Low to Moderate – Switching clubs is easy due to many competitors and substitutes available, lack of product differentiation, commodity products, and low switching cost (just membership fees). However limited time product offers at some warehouse clubs keep buyers revisiting often, demonstrated by Costco’s 87% membership retention rate.

Supplier Bargaining Power – Low – Warehouse clubs have a high purchasing power which demands low prices by buying “truckloads” of products from suppliers by leveraging existing relationships (Sam’s club/Walmart) or grey market purchases from suppliers going out of business or needing to turn over inventory. Strategic Group Map Costco, Sam’s Club and BJ’s Wholesale are competing warehouse clubs, using a best cost model when distinguishing price and quality, and with comparable product breadth. Sam’s Club and Costco have an advantage in their distribution due to the scale of their operation; Sam’s Club leverages Walmart’s distribution channel and technology to help lower their operating costs. BJ’s Wholesale offers higher customer service and a customer focused experience while accepting a full line of payment options. Overall, Costco is positioned best in the industry as demonstrated by their market share.

Competitor Analysis Costco Strengths: Industry leader 5% market share | Loyal members 87% retention | Strong value chain and efficient distribution system | Low operating cost| Weaknesses: High employee compensation | Low profit margin| Short operating hours 60hours/week | CEO Jim Sinegal is aging | Narrow merchandise offerings approximately only 4000| Heavily depended on the North American market for 90% of income, 70% of revenue is derived from high membership fees | Threats: Continuous decline in profit due to high employee compensation cost, low profit margin and the overdependence in the North American market | Sam’s Club Strengths:

Access to Walmart’s value chain capabilities | Greater retail space | Placement of store location adjacent to Walmart (improved efficiency of distribution)| Weaknesses: Narrow merchandise offerings approximately only 4000| Placement of store location adjacent to Walmart | Threats: Potential of losing customers due to lack of product variety| Cannibalization of potential sales to Walmart| BJ’s wholesale Strengths: Broad merchandise offerings | Both small and large quantity of products sold with different categories (good, deluxe and luxury)| Weaknesses Small player in a concentrated industry | Threats Inability to scale in order to match key competitors’ cost structure | APPENDIX B – Company’s Resource and Competitive Position (Internal) Appendix B (1) – Company Vision and Mission/Purpose

Vision| For Costco to develop into a company which offers exceptionally low prices to its members and to continue to keep growing as wholesaler. Reaching these goals by generating consistent profits and obtaining a large market share will ensure Costco’s success in the discount retail industry. | Mission| The mission of Costco is to continually provide their members with quality goods and services at the lowest possible prices. | Issues| The main issue with Costco’s mission is that the low cost strategy Costco has implemented has now affected the shareholders. One of the key reasons that Costco is able to remain competitive and financial successful in its ndustry is the fact that they are known to provide reduced priced items to its members. To achieve this, Costco has capped its margins on both its brand name and private labeled merchandise which they have been criticized for sacrificing profits in order to please customers. Costco is barely breaking even on their sales and relies heavily on membership fees to produce 70% of their profits. | Appendix B (2) – Competitive Advantage (VRIO) and Value Chain Resources/Capabilities| V| R| I| O| Low Prices| V| III| III| III| Logistics & Distribution | V| III| I| IV| Corporate Leadership & Culture | IV| II| IV| II| Quality/Product Performance | III| II| I| II| Organizational Structure | III| I| I| II|

Scale – I to V (Low to High) Costco achieves a competitive advantage in its sophisticated capability in Logistics and Distribution. By effectively minimizing costs throughout out the value chain, Costco’s is able to maintain low operating costs which in turn allows them to produce low prices. This efficient process is highly competitive in the industry and gives Costco a competent advantage above other competitors. Primary Activities Profit Margin Customer Service Product Display and Advertising In Store Operations Logistics & Distribution Merchandising Selection & Direct Buying Support Activities General Administration Human Resources Site Selection

Primary Merchandising Selection & Direct Buying- Contacting the manufacturer and negotiating price for selected merchandise Logistics and Distribution: Received goods in warehouse or cross docking depots which are then transported via trucks to stores. Merchandise usually shipped within 24 hours. In Store Operations: Merchandise is moved directly to the floor eliminating certain receiving costs, shorter store hours, no frills decor store design, self service Product Display and Advertising: Treasure hunt merchandising, direct mail Customer Service: Customer service after sales; Check outs Profit Margin: Capped margins on brand name and private labelled merchandise

Secondary Site Selection: Position stores near metropolitan areas and avoid prime real estate Human Resources: Hired staff, high wages, enforced corporate culture General Administration: Accounting finance, relationships with suppliers Appendix B (3) – Financial Analysis Key Financials | | 2006| 2007| 2008| 2009| Net Sales| $58963| $7725| $39798| $63088| $8280| $41582| $70977| $8792| $44336| $69889| $9802| $46889| Return on Equity| 12%| 13%| N/a| 13%| 7%| N/a| 14%| 13%| N/a| 10%| 14%| N/a| Working Capital Ratio| 1. 05| 1. 29| N/a| 1. 09| 1. 23| N/a| 1. 07| 1. 21| N/a| 1. 11| 1. 18| N/a| Gross ProfitMargin| . 11| . 09| N/a| . 11| . 08| N/a| . 1| . 08| N/a| . 11| . 08| N/a| Costco BJ’s Sam’s Club From 2006 to 2008 Costco’s net sales have been steadily increasing. Although, in 2009 Costco experienced a 1. 53% decline in their net sales while BJ’s and Sam’s Club net sales continued to rise. This decline is not significant in regards to Costco’s ability to remain competitive. Costco maintains a strong working capital ratio which entails that Costco is managing their cash available for day to day operations efficiently. Even though BJ’s working capital ratio appears to be mounting, Costco experiences a larger sales volume than BJ’s and still upholds a working capital ratio greater than 1.

Gross profit margin has been consistent for Costco and demonstrates the firm’s ability to cover its operating expenses and yield a profit on its extremely low prices. The only real concern for Costco is that they experienced a decrease in return on equity from 2008 to 2009. As a rule, a return in the 12% to 15% range is average; Costco’s ROE dipped from 14% to 10%. This may suggest that Costco is less resilient to economic cycles and is mismanaging its revenues. 2001 – 2004 estimated 2001 – 2004 estimated Overall, Costco’s is achieving its strategic objective of offering low prices to consumers while yielding a consistent profit. In turn, Costco establishes a competent advantage from its relative Low cost position and remains an above average industry performer. SWOT Analysis

Strengths * Able to offer low prices on top quality merchandise relative to other competitors * Offer a wide range of products from national brand names to private labels * Implemented a treasure hunt merchandising strategy to entice bargain hunting shoppers * Have a low operational and marketing costs strategy * Strong market position * Providing membership rewards| Weaknesses * The selection within each product category is restricted * Only stock items that can be priced at bargain levels, therefore possibly eliminating popular brand name products * Aims to please customers at the expense of not maximizing wealth for shareholders * Shorter hours of operation * Too much reliance on membership fees in order to raise significant operating profits * Highly compensate employees which can hurt the business in the long-run| Opportunities * Private label growth, as the private label/ signature products already being provided have a standard of quality better than highly regarded brands * Expansion of business into more international markets * Growth of E-commerce business| Threats * Increasing competition from other wholesalers like Sam’s Club and BJ’s * Competitors having longer hours of operations * Not diverse enough in product selection * Primarily focused in North America, not enough expansion in continents like Asia and Europe|