Costcos Business Model - Research Paper Example

?Case Study What is Costco’s business model? Is the company’s business model appealing? Why or why not? Costco's business model involves using their membership warehouse business to “generate high sales volumes and rapid inventory turnover by offering members very low prices on a limited selection of nationally branded and select private-label products in a wide range of merchandise categories”. Costco gains revenue not only from individual membership, but also households, and companies. This membership revenue pool is fixed for the year and in 2008 generated $1.5 billion. The main part of the business is literally to please the customer by having the best price. Everything else is based on that concept. Customer's have the ultimate say in what will be bought and sold. Costco doesnt want to have inventory that the customer has no desire for and thus inventory that will be slow moving. Thus Costco watches for specific characteristics of inventory which they will purchase and efficiently deliver to the customer at a price below its competitors. Another part of Costco's business model is the fact that Costco owns 80% of its retail operation stores. This investment in real estate allows Costco to avoid paying lease costs thus cutting down on operating costs. This cost reduction can further allow Costco to concentrate on having a low price, high volume merchandise business model. Also the membership fees can be allocated to purchasing buildings within a year or two since to access the savings the customers provide revenue outright. This can save Costco on long term debt if managed properly. Yes its a good model because due to their memberships customers are more likely to buy directly from them and with a certain level of guaranteed revenue, prices can be low with the assumption that volume will be high. Volume is never guaranteed but Costco can operate on this assumption because it is more than likely that the customer will do daily shopping for groceries in the case of the individual, and household while more than likely that businesses will purchase supplies through Costco in order to purchase office supplies. The only issue with the model is that when customers purchase in bulk, it is likely that the need for the product will be low for a considerable amount of time. If an individual purchases 5-10 boxes of energy efficient light bulbs, that customer is unlikely to come back for more light bulbs for a long time and the same can be said of companies and households. On the other hand it could be likely that the customer purchasing in bulk could be selling each bulb. 2. What are the chief elements of Costco’s strategy? How good is the strategy? “Low prices, a limited product line and limited selection, and a “treasure hunt” shopping environment”, are a few of the chief elements of Costco's strategy. They accomplish this by having rapid inventory turnover, less handling, efficient distribution, operating efficiency and “offering members very low prices on a limited selection of nationally branded and select private-label products in a wide range of merchandise categories.” Costco also only kept the best bargains on the shelves with little advertising and deciding on a growth strategy focusing on opening more warehouses and developing a loyal customer base. This is good strategy all around for a variety of reasons. Here is a breakdown of some of the major efficiencies Costco obtained: Due to the fact that they are able to receive cash before the payable is due, Costco didn't have to worry about carrying extra capital throughout the year in order to meet vendor payments. Therefore Costco was able to take advantage of discounts while obtaining direct financing from the vendor's. By doing this Costco was able to pass on part of the savings to customers and obviously retain some of the savings as profit. The way that Costco was able to provide such low prices to its member was that it only sought a 14 percent margin on national brands as opposed to the 20-50% that most other discount retailers and wholesalers sought from their customers. The margins on Costco's private-label was also very low at about 15% but still being 15-20% below the national brand and with the same or better quality. This means customers will either be indifferent as to the brand or if they are loyal to a specific brand will still want to purchase from Costco, with such low prices. Specializing in rapid inventory turnover was another part of the strategy that worked very well with Costco's strategy. Costco only purchased inventory that would be fast moving. The characteristics of the inventory that were specifically sought after were: fast-selling models, sizes, colors, and many consumable products were sold in a carton, case, or multiple pack quantities. Operating efficiency was achieved by keeping track of the major selling categories, as well as keeping ancillary businesses near Costco in order to keep customers coming back. The main types of businesses that were used to continue to attract customers were one hour photo stores and food courts and hot dog stands. Efficient distribution and handling also went a long way in protecting the merchandise from possible damages. The items were usually stored on pallets, there were no shopping bags, and the items were loaded directly into a box. Treasure-hunt merchandising was another part of Costco's strategy where Costco's merchandise buyers would look at for fast selling products that would appeal to the customer. The buyers shop for discount deals with distressed retailers or wholesaler's that want to get rid of excess, slow-selling inventory. Costco utilizes direct advertising over media advertising. Essentially Costco makes initial contact for the beginning of a warehouse then allows the customer to do the advertising by word of mouth. The customer usually does this because of the experience with the company. The strategy of Costco is a good strategy not because of their rock bottom prices but because of their precision in achieving this pricing for now and the future. The model is extremely flexible and effective. 3. Do you think Jim Sinegal is an effective CEO? What grades would you give him in leading the process of crafting and executing Costco’s strategy? What support can you offer for these grades? Refer to Figure 2.1 in Chapter 2 in developing your answers. Yes, Jim Sinegal is an effective CEO. Here are a few reasons why Sinegal was effective: Sinegal learned directly from the creator of the chain and had an eye for discount merchandising. Knowing what specific product customers wanted to buy and at what price point. Along with “constantly improving store operations, keeping operating costs and overhead low, stocking items that moved quickly, and charging ultra-low prices that kept customers coming back to shop”. Sinegal's practice of going to each store and talking with employee's not only motivates employee's but improves company morale. The employee's know that the CEO cares about them and the customers just as much as he cares about the net income and his benefits. Not only that but his critiquing and ability to see the stores at the level of employee while being an executive gave Sinegal insight into what needed to be changed. This is something he would not be able to notice unless he actually saw the layout of the store. Id offer a grade of A for Costco's operations crafting and execution of its strategy. Here are the reasons why: The main reason for Costco's success is because Sinegal took the time to execute his strategy around the desires of the customer. With the customer receiving exactly what he or she wanted, everyone was able to profit from the transaction. Financially the company is continuously increasing its membership fees because of the cost savings associated with Costco. Another reason Sinegal is effective is that he pushes the company to continuous savings, not getting complacent and allowing someone else to enter into the business at a lower price. Sinegal encouraged pushing out the competition which would in turn create more business for Costco. Using past knowledge about Sears fall from grace when changing their strategy, Sinegal has helped the company avoid the trap of thinking our prices are too law as Wall Street analysts have said or becoming too greedy because of recent success. Instead Sinegal looks to guide the company into a low cost, efficient 50 years. This is even more impressive when shareholders are demanding a higher dividend. Sinegal has so far been able to keep the shareholders from changing the company strategy. 4. How well is Costco performing from a financial perspective? Do 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 Costco’s financial performance. Costco is performing well due to the following explanation: Costco's membership fee revenue has increased steadily every year 14.5% in 2008 when fees increased from $1,313 to $1,506 million and 10.5% when in 2007 fees increased from $1,188 to $1,313 million. These increases are yearly and the company is showing no hints of slowing down in fee revenue. Net Sales have increased in similar fashion. Net Sales increased from $63,088 million in 2007 to $70,977 million in 2008 marking a 12.5% increase. From 2006 to 2007 net sales increased from $58,963 million to $63,088 million which is a 7% increase. This shows that revenue is still increasing even though Costco has been in existence as a public company since 1985. Operating income continues to increase as well as does net income. Operating income seems to be slowing down from the massive prior increases and in one year actually decreased. In 2007 operating income was $1,609 million and in 2006 was $1,626 million which is a 1% decrease. In 2006 operating income was $1,626 million up from $1,474 million in 2005 which was a 10.3% increase. Selling, general and administrative expenses are becoming less of a cause for concern. In Figure 2.1 the increase from selling, general and administrative costs increased from $6,273 million in 2007 to $6,954 million in 2008 which is equal to an 10.9% increase in one year. That cost increase is less than the increase from $5044 million in 2005 to $5,732 million in 2006 which was a 13.6% increase. Interest expense has been increasing every year which can be expected due to the fact that the business is increasing every year. The increase from year to year has not been consistent from 2005 to 2008 in fact in 2000 the interest expense was higher at $39 million than in 2005 at $34 million. The issue is that in 2007 interest expense increased drastically to $64 million from $13 million. That is almost a 500% increase in expense. It then increased again in 2008 to $103 million from $64 million which represents a 67% increase. This might be due to the beginning of the recession in 2008 and a desire to use cash in a deflationary period on merchandise but is a glaring need for improvement going forward. Based on all of the information above the income statement shows a company that is only expanding in revenue and naturally in costs but at rates that are not out of the ordinary. In the Balance Sheet a few things stand out: The current asset balances more than sufficiently cover the current liabilities of the company every year. Also the total assets in relationship to total debt is about a 20-to-1 ratio. Those two relationships show not only that the company is in perfect shape currently but also in the future because borrowing will always be available but it wont necessarily be needed with the current liquidity position. It seems mostly inventory is the reason for borrowing and almost everything else is owned. 5. Based on the data in case Exhibits 1 and 4, is Costco’s financial performance superior to that at Sam’s Club and BJ’s Wholesale? Yes Costco's performance is superior to Sam's Club and BJ's Wholesale. Here are the reasons why: Looking at sales Sam's Club has been growing at a rate of 4.3% from 2005 to 2006 6.7% from 2006 to 2007. Sam's Club is constantly growing but seems to be increasing sales at a slower rate than Costco. The sales of BJ's Wholesale has been growing at 6.7% from 2005 to 2006 and 6.2% from 2006 to 2007. BJ's wholesale on the other hand has steady increases in Sales, but still less than Costco. Looking at operating income Sam's Club has a growth rate of 4.9% from 2005 to 2006 and 9.3% from 2006 to 2007. Sam's Club has a pretty high increase from 2006 to 2007 but Costco's rate is higher at 10.3%. BJ's wholesale has an operating income decrease of 33% from 2005 to 2006 and a 35.4% increase from 2006 to 2007. Even though BJ's Wholesale had an increasing operating income, it still had not reached 2005 levels in 2007. BJ's Wholesale and Sam's Club experienced issues where Costco had none. These numbers are pretty indicative of the financial superiority of Costco. Not only did Costco sell more merchandise because of its low price model but Costco also realized more a similar profit as Sam's Club in 2006 that Sam's Club experienced in 2007. Granted Sam's Club sold less merchandise and had lower total revenue than Costco. Overall Costco is the better company because it has more assets, a loyal customer base, and a continuously rising revenue base. Read More