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BUS-670

CK MILLER
M4 CASE STUDY
Costco Wholesale in 2012: Mission, Business Model, and
Strategy
1.

What is Costcos business model? Is the companys business


model appealing? Why or why not?
Costcos business model is based on a best-cost strategy. They
take the low-cost provider approach and combine that with
creating value for the various stakeholders by focusing on
excellent customer service, a strict code of ethics, treating
employees like family, respecting suppliers, rewarding
shareholders, and a strong sense of environmental stewardship.
They have implemented unique cost-saving strategies in their
production, operations, and marketing which have allowed them
to attract the most affluent customers in discount retailing. The
central focus of their business model revolved around high sales
volumes and rapid inventory turnover by offering fee-paying
members attractively low prices on a limited selection of goods
which consist of a mixture of nationally branded and selected
private-label products in a wide range of merchandise categories.
This is a very appealing business model as it provides the ability
to operate profitably at much lower gross margins by securing
vendor volume purchasing agreements, efficient distribution, nofrill self-service warehouse facilities and supplemental
membership fee revenue. Another attractive feature is due to
the high sales volume and rapid inventory turnover design of this
business model, the accelerated cash conversion cycle permitted
Costco to collect the funds for inventory prior to vendor payables
becoming due. This provided for vendor financing and the ability
to take advantage of early payments discounts which further
reduced operating costs. As a testament to the success of this
business model, from 2008 through 2011, Costco was able to
increase the number of warehouses by 15.6%, revenues by
22.6%, and net income by 14.0%.

2.

What are the chief elements of Costcos strategy? How good is


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the strategy?
Costcos key strategy elements consist of:
ultra-low prices,
a limited selection of nationally branded and private-label
products,
a treasure hunt shopping environment,
low operating cost emphasis, and
geographic expansion
Due to ultra-low prices, they have been able to lure a larger
population of affluent customers. From 2010 to 2011 net sales
increased by14.0% and membership fee revenue by 10.4% -annual goal was 5% or more. However, when membership
revenue is consistently higher than net income. Therefore,
without the membership revenue, Costco would be operating in
the red. Also, when reviewing ROS from 2000 to 2011, even
though sales have increased, cost have not been contained as
efficiently. This is evidenced by the gradual ROS erosion of 2000
ROS of 1.96% to 2011 ROS of 1.64%. With such a small ROS, any
increase in variable cost could be detrimental.
On the other strategic elements such as geographic expansion,
limited product selection, and providing a treasure hunt
shopping environment, Costco was very successful.

3.

Do you think Jim Senegal has been an effective CEO? What


grades would you give him in leading the process of crafting
and executing Costcos strategy? What support can you offer
for these grades? Refer to Figure 2.1 in Chapter 2 in
developing your answers.
Jim Senegal was a very effective CEO. He was able to take
capitalize on the membership warehouse concept that he
learned from Sol Price when he worked for Price club in the late
1970. In 1983, he developed a strategic mission and values to
continually provide our members with quality goods and services
at the lowest prices possible. This resulted in the first Costco
being opened in 1983. The crafted strategy objectives centered
around ultra-low prices, limited product selection, a treasure
hunt shopping experience, low operating costs, and geographic
expansion. The Rapid inventory turnover, vendor financing, low
operating costs, and self service facilities enabled Costco to

operate at a significantly lower gross margin and to pass on


those savings to members through lower prices and higher
quality goods. By charging members a prepaid fee, which
supplemented overall profitability, it provided shareholders with
an acceptable return.
Jim had a tremendous ability to set the organization tone at the
top through his hands-on approach along with treating his
employees like business owners. This gave him tremendous
ability to reinforce the companys mission on a daily basis. He
was constantly touring warehouses giving attention to product
displays, quality of goods, and pricing. He would continuously
ask store managers to report on sales volumes and inventory.
Even though he demanded much of managers and employees,
on multiple occasions he took the opportunity to mentor
managers by asking them to do further research when he was
not satisfied with their answers or felt the experience would
serve as a learning opportunity.
Jims success in executing the company strategy is evident by
the 2011 10% annual sales growth, 52 additional stores, and
12.2% increase in net income. The negative ramifications of
Costcos strategy execution exist due to weak profitability, low
dividend yield, and moderate liquidity when compared with the
wholesale discount variety store industry. When reviewing the
positives and negatives of Jims ability to execute strategy
successfully, I would award Jim a grade of a B.

4.

What core values or business principles has Jim Sinegal


stressed at Costco?
There are basically 5 operating principles that focus around
ethical business practices and treating all stakeholders with the
utmost respect. He was known for propagating the idea of
viewing all stakeholders as part of the corporate family. Jim
wanted to ensure that the company would be known as being
on a first-name basis with everyone. This is evident by the
following principles:
1 1. Obey the law.
2 2. Take care of our members. This was done by
honoring the trust
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extend by the members by virtue of their
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membership fee.
4 3. Take care of our employees. As the most important
asset,
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employees should be highly valued by providing
them with
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rewarding challenges and opportunities for personal
and career
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growth.
8 4. Respect our suppliers. As business partners, honor
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commitments and approach relationship from a winwin
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perspective.
11 5. Reward our shareholders.

5.

What is competition like in the North American wholesale club


industry? Which of the five competitive forces is strongest and
why? Use the information in Figures 3.4, 3.5, 3.6, 3.7, and 3.8
(and the related discussions in Chapter 3) to do a complete
five-forces analysis of competition in the North American
wholesale club industry.
Rivalry Among Competing Sellers Strong Competitive Force

All competitors offer low prices and provide considerable


cost savings which more than offset membership fees
All competitors pursue revenue growth through expansion
and increased members
Switching costs are low - relatively easy to switch
memberships
Similarity in merchandise offerings among competitors
along with Costcos low degree of product line
differentiation provides for a vast amount of substitutes
available from competitors.

Threats of New Entrants - Weak Competitive Force


Wholesale club industry is fairly saturated. Additionally,
barriers to entry are high due to:
o Costco and Sam enjoy sizeable economies of scale
which are not easily duplicated.
o Capital investment is high in order to compete
with industry moguls
o Marketing and advertising costs that would be
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required to win loyal customers from existing


competition would be intensive.
Bargaining Power of Suppliers Moderate to Weak
Competitive Force

Even though many of the products are well-known


brands, the supplier doesnt possess any leverage that
would allow them to dictate terms and conditions to the
warehouse clubs.
Intensive bargaining power exists for Costco and Sams
due to amount of merchandise they purchase. Also,
both companies have ensured that no single supplier
represents a large percentage of purchased
merchandise so it is relatively easy to switch suppliers.

Bargaining Power of Buyers (Customers) Weak


Competitive Force

Club members purchase in small quantities and no


single member purchases reflect a large percentage of
the wholesale clubs annual sales.
Club members can choose not to purchase a product or
procure it from another wholesale club, but they cant
negotiate for better prices or any additional benefits
other than those provided by their membership.

Threats of Substitute Products or Services Strong


Competitive Force

6.

Product differentiation low which increases the available


substitutes.
Switching costs low. Even though the price may be
higher at another retailer, the range of products is
greater and increases the probable availability of
acceptable substitutes.
The demographic customer base of the wholesale
discount retail market is comfortable with and embraces
the treasure hunt shopping experience which
proliferates an eternal vigilance for the next substitute
product at a cheaper price.

How well is Costco performing from a financial perspective? Do


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some number-crunching using the data in case Exhibit 1 to


support your answer. Use the financial ratios presented in
Table 4.1 of Chapter 4 (pages 104-105) to help you diagnose
Costcos financial performance.
2011 Sales Growth Strong - Costco realized a 14.1% sales
growth and a 17.4% increase in operating income. This is due to
the 10.4% increase in membership fees which flowed directly to
operating income. This ability to increase sales along with
successful cost containment has allowed for a 12.2% increase in
net income. This signifies that the increase in membership
revenues went straight to the bottom line.
2011 Profitability Low - Gross Margin 12.6%, industry 36.0%;
Net Profit Margin 1.6%, industry 3.0%; Operating Margin 2.7%,
industry 5.0%; ROE of 11.6% is weak considering industry
average is 20.6%.
2011 Liquidity Moderate Current Ratio of 1.14 indicates the
corporation can pay its current liabilities in with liquid assets in
full once. The industry average is 2.4. However, a Current Ratio
that would be closer 2.0 would offer a more preferred liquid
position. Working Capital of $1.6M is favorable and represents a
stronger liquidity considering it is higher than the companys
annual net income to date and higher than the industry average
of $895K
2011 Leverage Low Debt-to-Equity Ratio 17.1%, industry
62.7%. Low leverage ratio and high times-interest-earned ratio of
21.03 is very attractive for future creditors which will pave the
way for further warehouse expansion in the future.
2011 Earnings Power and Persistance Moderate - DEPS
increased by 13.0% to $3.30. Dividend yield is at 1.1% which is
considerably lower than the industry average of 2.30%. The
market views this stock as a good investment as their P/E ratio of
24.08 is higher than the industry average of 17.4.

7.

Based on the data in case Exhibits 1, 5 and 6, is Costcos


financial performance superior to that at Sams Club and BJs
Wholesale?

When comparing Sams Club and Costco, only 2011 U.S. data
was considered as International sales and operating income data
was not included in Exhibit 5 for Sams Club. Costco
outperformed Sams Club in total revenue and sales growth.
However, Sams did a much better job of reducing costs as even
though Sams had meager sales growth, it increased its
operating income 4 times the amount of sales growth. Possibly
this large increase in operating income could be due to the fact
that Sams Club only added 4 warehouses in 2011 as opposed to
Costcos 8 warehouses. This reduced the fixed expenses that
accompany any expansionary effort.

U.S. Sales
U.S. Sales Growth
U.S.Operating Income
# of Addl Stores

Costco
$64,904
8.9%
6.5%
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Sams Club
$49,459
3.5%
12.9%
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Costco has a definite advantage and outperformed BJs with


respect to total sales, sales growth, operating income, and
expansionary efforts. The interesting thing to note about BJs is
the due to lack of cost management there was significant erosion
to operating income. Even though BJs realized sales growth of
6.8% they resulted in zero profit and actually eroded the profit of
the previously existing sales base.
Total Sales
Sales Growth
Operating Income
# of Addl Stores

8.

Costco
BJs
$88,915
$10,877
14.1%
6.8%
17.4%
-7.1%
6
4

Does the data in case Exhibit 4 indicate that Costcos


expansion outside the U.S. is financially successful? Why or
why not?

2011 expansion in Canada looks fairly successful, with the


addition of 3 warehouses, 8.0% increase in average sales per
location, and a 12.2% annual sales growth. Due to cost
containment and reduced capital expenditures, operating income
increased by 13.5%. Since the increase in operating income is
greater than sales growth, that signifies that more of the
additional sales flowed to operating income due to reduced cost.
2011 expansion in other international was very successful.
Even with the large increase in capital expenditures due to the
addition of 36 warehouses, the increase in operating income of
92.3% far surpassed the increase of 59.3% in sales growth. The
slight drop in average sales per location was as a result of the
additional 36 warehouses not being open for the full year.
9.

How well is Costco performing from a strategic perspective?


Does Costco enjoy a competitive advantage over Sams Club?
Over BJs Wholesale? If so, what is the nature of its
competitive advantage? Does Costco have a winning strategy?
Why or why not?
Per our textbook, on page 14, it mentions two basic indicators of
the whether or not the company has a winning strategy. They
are as follows:
Profitability and financial strength
Costco does not possess a competitive advantage when it comes
to profitability. As stated before, their Net Profit Margin is only
approximately half the industry average. Low liquidity and
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efficiency when compared to industry averages is another


weakness. Even though they claim to have rapid inventory
turnover, the 2011 3.2 inventory turnover still falls short of the
industry average of 5.4. However, they do exhibit an area of
financial strength with low leverage and a high time-interestearned ratio.

Competitive Strength and Market Standing


Clearly, Costco enjoys a competitive advantage over Sams Club
and BJs when it comes to market share. In 2011, Costco
possessed 51.8% of the market share. Whereas, Sams Club has
39.5% and BJs 8.7%.
Costco is the market leader and has done this by appealing to a
more affluent customer base by offering high quality goods at
low prices. However, do they possess a durable competitive
advantage? They possess a high level of bargaining power which
enables them to reduce the cost of merchandise. However, how
long will the stockholders be happy with a low dividend yield?

10.

Are Costcos prices too low? Why or why not?


As mentioned previously, profitability is a weakness for Costco. With
the industry at 3.0% in 2011 and Costco at roughly half at 1.6%, how
long are stockholders going to be happy with EPS of $3.30 and
dividends of $.89?
Obviously, the members are happy as is evident by the continued
sales growth year after year. Profitability must be improved. A
balance between providing a good return to shareholders and
providing value to the members has to be reached. To increase
profitability, Costco has two choices either selectively raise the prices
of the goods or raise membership fees.