COSTCO TAKES THE GOLD WITH MORE THAN PRICE

ISSAQUAH, Wash. -- In its 2002 annual report, Costco Wholesale here vowed to become the low-cost provider of merchandise and services in 37 states and in its markets abroad.That has been Costco's mantra from the beginning, said Richard Galanti, executive vice president and chief financial officer.Like other everyday-low-price competitors profiled in this issue of SN, Costco achieves its low prices

ISSAQUAH, Wash. -- In its 2002 annual report, Costco Wholesale here vowed to become the low-cost provider of merchandise and services in 37 states and in its markets abroad.

That has been Costco's mantra from the beginning, said Richard Galanti, executive vice president and chief financial officer.

Like other everyday-low-price competitors profiled in this issue of SN, Costco achieves its low prices through smart volume buys, material-handling logistics, limited assortment, packaging and product sizes.

"Costs associated with traditional retailers are taken out, reduced, or greatly eliminated," Galanti told SN. Examples of some cost-cutting measures are as follows:

Costco is predicated on large volume buys, including large package sizes.

The selection, which spans an array of consumable, general merchandise and service categories, is limited to about 4,200 stockkeeping units per warehouse. "By doing this, we drive more sales into the items we sell, and turn items significantly faster than other forms of retail," said Galanti. Costco turns its inventory 11 to 12 times a year.

Time and labor costs are reduced through efficient materials handling. Shrink-wrapped pallets of products are shipped directly to each warehouse club unit or to a cross dock where product is shipped out within nine hours. Once at the warehouse, pallets are moved directly to the selling floor. Costco procures directly from suppliers, and no inventory is warehoused.

Costco does not advertise, vs. other retailers that allocate 5% to 10% of their budget to advertising. It also tries to avoid the slotting-promotional allowance game in getting dead net vendor prices.

It accepts few debit and credit cards limiting merchant fees. Low transaction fees are negotiated on the cards it does accept, like American Express. About half of its $38 billion in sales last year was tendered through cash and checks, said Galanti.

About 20% of Costco's 290 U.S. warehouses (as of the end of 2002) are unionized. While analysts said unionization saves Costco additional costs that are passed onto the consumer via lower prices, Galanti noted that Costco's wage and benefits package is on par with union shops.

Jonathan Ziegler, principal, PUPS Investment Management, Santa Barbara, Calif., said Costco achieves cost efficiencies in a number of ways. One important method is cultivating unique partnerships with its vendors. In doing so, the company also takes chances by bringing in product from small vendors in an effort to have an exclusive product offering that contributes to the treasure hunt experience in the stores.

Ziegler described elements of such partnerships. "This includes everything from working with suppliers on how product is packaged, reducing case shrinkage and bruising of produce and fruit, to creating new uses for products that all work to drop Costco's cost. Costco also has worked with vendors to find other outlets, such as other uses for dark meat, so the vendor can charge Costco less for the white meat."

What differentiates Costco from the others is how the shopping experience is geared toward capturing the impulse buy of its 20 million members who pay anywhere from $45 to $100, depending on the level of membership, for the privilege of shopping the store. Individual Gold Star members represent about 60% of the membership and generate 40% of sales. Business members make up 40% of the membership and represent 60% of sales due to larger rings at the register.

Costco has spent the last 15 years developing its fresh-food offering into a signature department. This is in terms of quality, Galanti noted. "[Fresh food] brings people in on a more frequent basis, and when they are there, they can't help but pick up a pair of jeans, a dozen golf balls, or a TV. It feeds on itself," he said.

In recent years, Costco has concentrated on global sourcing of its produce. Instead of being in stock with the best-looking grapes 14 weeks out of the year, Costco can now stock those grapes 40 weeks out of the year, said Galanti.

Chuck Cerankosky, analyst, McDonald Investments, Cleveland, said, "They have a strong value image that makes them a destination for a certain amount of regular shopping." However, Cerankosky said, the Costco experience takes customers beyond regular shopping. "There is the huge fun element of the bargain quest. The general merchandise provides the trade-up opportunity that a lot of other formats just don't have.

"Costco merchandises by telling customers, 'We've got some great deals for you.' There is better pricing on consumables, and Costco tempts customers with all the big-ticket discretionary items," he said.

Costco has developed a good private-label program, but much of its merchandise is brand name and a lot of it can be classified as luxury goods.

"Our biggest thing is price quality," said Galanti. "When everybody thinks of discount, they think of lower price points. We trade customers up, not down, although we mark up very little. Our average markup on goods is a little over 10%."

All this means that Costco draws in a higher-income demographic, which is another distinguishing characteristic from other low-price discounters. Just focusing on the small business owner tends to draw a more affluent customer, said analysts.

Galanti said that over the last 25 years, Costco has cultivated upscale merchandise. "This ultimately cultivates upscale customers." The average household income of Costco's customers is in the mid-to-high $50,000 range. This compares to an average median household income of $42,200 for the United States, according to Census Bureau statistics for 2001. Over 90% of Costco's members own their own home, compared to 67.9% of home owners in all U.S. households.

In terms of future growth, Costco is here to stay and can only get stronger, said analysts. "Costco will continue to do more of what it is doing. They are winning new loyalty. Renewal rates on membership are extremely high. They have a great opportunity globally. Management is constantly experimenting with new formats and products. They'll have opportunity to tap into new markets," said Ziegler.