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A New Year Brings New Challenges: A strategic look at Costco in 2012

Costco

Heading into 2012, Costco is well positioned not only to weather the storm of further economic downturns but also to consolidate its lead over other discount wholesalers like Wal-Mart and BJ’s Wholesale Club. Its intentionally low margin and exceptionally high inventory turnover, along with growing overseas sales and relatively low debt, are some of the main factors that point to Costco’s potential for continuing success.

The new year will also bring new challenges that the company must manage with careful strategy: increasing costs of products and labor; co-founder and CEO Jim Sinegal’s imminent retirement; and growing pressure to decide how and how quickly to expand both domestically and internationally. With its strengths and upcoming challenges in mind, we discuss a few of the key strategic decisions Costco must make, and explore how these choices might affect both its original business model and the changing retail industry in a volatile global economy.

Competitive Pricing Strategy – Can it still work for Costco?

To gain an understanding of one of Costco’s primary strategic advantages, pricing, a brief look back into its evolution into a major warehouse retailer is required. In 1954 current CEO Jim Sinegal began working for Fed-Mart, a discount department store originally open to only government employees who paid membership fees of $2 per family. Fed-Mart’s founder, Sol Price, is credited with inventing the warehouse strategy of discount pricing, high volume stores, and stocking a limited number of products to sell in bulk quantities [Cascio]. With this strategic framework Price created a blue ocean of retailing, one in which Costco still swims today. As detailed by Kim and Mauborgne, a blue ocean strategy relies on creating value for customers that captures new demand, makes competition irrelevant and creates a previously uncontested market space [Kim]. Price capitalized on all of these elements, and with Sinegal as his vice-president of merchandising, grew the first warehouse chain to 45 stores that generated approximately $300 million in annual revenue [Cascio]. Fed-Mart eventually went out of business, but Price started a new warehouse company, Price Club, which charged a $25 annual membership, and Sinegal went his own way to found Costco. Price club essentially maintained Fed-Mart’s retail philosophy, and eventually merged with Sinegal’s Costco in 1993, becoming PriceCostco and then solely Costco Wholesale Corporation in 1997.

Costco’s pricing strategy, in particular, is unlike that of any other merchandise retailer. It has established a cap on its profit margin of 14 percent for all goods except its in-house Kirkland brand items which earn 15 percent [Cascio]. By comparison, supermarkets typically maintain 25 percent profit margins and department stores mark up as much as 50 percent, making Costco a true customer value creator [Greenhouse]. The high volume and limited product selection philosophy Price and Sinegal pioneered allows the warehouse giant to be so religious about keeping the margins low. Costco carries approximately 4,000 stock keeping units (SKU’s), which is just 4 percent of the number of items typically carried by Wal-Mart. A limited selection paired with low prices results in both lower relative cost to serve each customer and high sales volume, which in turn gives Costco incredible bargaining power with suppliers and an incredibly high inventory turnover rate. At 12.7 times, it easily beats the industry average of 8.4, and means that Costco has often sold its merchandise before it has even been paid for [Hoover].

Complimenting Costco’s high volume approach is the ability to store the majority of items within its pre-existing large retail space, limiting the need for large depot centers and decreasing transportation expenses. This inventory storage approach is in stark contrast to its rival competitor, Wal-Mart owned Sam’s Club, which relies heavily on its distribution centers and private fleet of trucks for store delivery. Costco has also been quite creative with the invention of its own coupon booklet, offering further discounts on various consumer products.

Fundamentally, Costco utilizes its pricing strategy as a significant competitive advantage internally and externally. Its willingness to forego increased short term profit in favor of long term market share and customer loyalty has served it well to date and has succeeded in limiting threats from industry competitors and substitutes. As CEO Sinegal once stated, “We want to build a company that will still be here 50 and 60 years from now” [Greenhouse]. But future headwinds may test the limits of its lower profit margins: increased costs merchandise, labor and healthcare, along with stagnating demand in key markets like the US and UK are all likely to test Costco’s strategic resolve in 2012. But all retailers are experiencing similar issues, and boosting margin rates in a time of economic hardship seems like a surefire way to lose hard earned customer loyalty. Instead, Costco should continue to focus not only on finding new ways to control costs, but also on seeking smart growth that is earned in line with the company’s historically successful strategic model, whether that be found at home or abroad.

Continuing on the path of Smart Growth …. Avoiding the International “Growth Trap”

While Costco is situated fairly well to benefit from more domestic consumers flocking to buy from discount retailers, it has already done well internationally and is hearing an increasingly siren song to expand into growth markets. Between 2005 and 2010, the revenue brought in by Costco’s Canadian stores doubled, increasing from 13 to 15 percent of the company’s total revenue. Though Canada’s population, at 35 million, is just over 12 percent of America’s, Costco’s Canadian stores provide the company with 20 percent of the revenues of domestic ones [Bleeker]. This may be due to the fact that Costco has the most store locations per capita in Canada than its other markets.

More recently, Costco has been aggressive in its Australian growth as the average sales per Australian store has outpaced that of an average domestic store [International]. As domestic growth barely breaks the double digits, the triple digit growth seen in some of its overseas markets will certainly entice Costco to continue expansion in foreign markets. Though this all paints a pretty picture, global growth will present Costco’s original business model with serious challenges that should be considered when analyzing new markets and assessing the rate at which the company should expand. For example, India and China, each with growing middle classes and increasingly accommodating regulatory structures, are both huge consumer markets that on the surface appear to be heaven sent for Costco. A closer look, however, reveals possible inconsistencies between consumers in these markets and the original Costco business model: many Asian consumers prefer to buy small amounts on a more frequent basis than to buy in bulk, which is a key pricing and marketing
strategy for Costco. With lack of home storage space, smaller cars and greater reliance on public transport, most potential customers in these countries are currently ill adapted to derive much value from the Costco offering. In addition, overseas consumers often prefer global brands to private ones such as Costco’s Kirkland Signature (which brings higher profit margins and accounts for 15 percent of items and 20 percent of sales) [Costco Wholesale, 28]. This is not to say that Costco cannot enter India and China; indeed, with such frenetic change being experienced in each, consumers may well get used to and even demand Costco’s western way within short space of time, but in that time Costco must stick to its strategic guns and continue to do what it does best—provide bulk goods at low prices. Being a first mover into these markets may position Costco well for shifts in the cultural fabric that eventually produce loyal, dues-paying members willing to drive miles to stock up on Kirkland products.

Growth Decisions at Home

At the same time as having to make strategic adjustments to operate in overseas markets, Costco must be careful to not give up what makes it so special in its home market. With regards to future growth plans, it is crucial that Costco ask itself the cost of any effort designed to promote growth, to avoid getting stuck in a growth trap. According to Michael Porter, a successful strategy is one in which a company make a series of trade-offs about which activities it will not pursue [Porter]. These trade-offs are what make a company unique, and what lead to the particular set of abilities that company possesses, which in turn enable it to create value for its target customers, and reap the profits to be earned from this loyal base. Costco is a company that has had a very clear strategy but like all companies is susceptible to the blinding dazzle of the growth that is so important to Wall Street. Unfortunately, managers adopting this imperative begin to see trade-offs as constraints to growth, and seek to branch out the company’s undertakings to capture additional revenues from non-strategically-defined activities that do not fit with its core. While this may work in the short term, the company will lose that core which brings value to its customers, and be caught in an endless cycle of chasing profits through non-core activities that actually dilute the brand and cause more damage—a growth trap.

Such may be the case with one of Costco’s recent ideas, to expand domestically into anchor store spaces in suburban malls. After years of battering for the commercial real estate market, it may seem like a great bargain for Costco to both pick up space on the cheap and have it be nearer to customers than its typical big-box, out-of-the-way warehouses, but it is crucial to ask what this does to Costco’s strategy. The beauty of large stores that take some driving to get to is that they encourage customers to buy in large quantities, in order to avoid making too many trips. Almost everything about the stores reinforces this idea, like the oversized carts, in-store food and on-site gas pumps, and Costco is poised to benefit through reduced costs to serve each of these high-spending but infrequent shoppers.Many of these benefits would be lost with smaller store formats or greater density of locations, so Costco should more carefully enhance its truly strategic offerings rather than simply accepting an ill-fitting concept just because it may be cheap. One way it may achieve a strategic deepening is by moving up the value chain somewhat. Costco has begun to differentiate itself among wholesalers as an upmarket alternative, where those who can afford higher-priced memberships and $200-a-time shopping trips choose to go. Additionally, the company has carefully honed the art of bargaining with suppliers for top-shelf goods at bargain prices during periods, for example, of product overruns. Continuing to offer bulk buying of increasingly valuable goods will help, as will a focus on other profitable lines of the business, like member services such as insurance offerings and the higher-margin Kirkland branded goods, which should be developed into still-reasonably priced but ever-more premium brand. Further development of its successful internet business, which grew 12 percent in fiscal year 2011, may also be a good fit for Costco’s capabilities, as it requires a low employee to customer ratio, minimal product diversity and a no-frills warehousing model.

There are many options open to Costco as Craig Jelinek takes over the reins from co-founder Jim Sinegal. While incremental improvements and swift responses to changing market conditions are a must, maintaining an unwavering focus on Costco’s core strengths will be crucial to long term, beneficial growth. Overseas opportunities, changing home market dynamics, and cost challenges should be approached with the same patient, long term resolve Costco has exhibited since its beginnings. Creating a solid strategy of targeted growth and building customer loyalty through low pricing helped Costco become the biggest of the big warehouse retailers; its new CEO must not pursue quick growth at the expense of these strategic foundations if we are to see Sinegal’s goal of a Costco still strong after 50 or 60 years.

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