Case Study on Business Models: Wal-Mart vs. Costco

costco

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CASE STUDY

Can you tell me the key differences between Wal-Mart’s (not just Sam’s Club) and Costco’s business models?  Could Wal-Mart raise it’s minimum wage to Costco’s higher level without effecting profits. Why or why not.

This case gives you a way to learn about different retail business models.  How would you go about answering this question?

HINT: What would be the big difference between a Wal-Mart and a Costco store as soon as you entered?

If a union leader from Wal-Mart wanted to have its members have the same wage rates as Costco, how would you advise?

I am not asking for a valuation, but an analysis of the differences between retail models. Is one better than the other?

Harvard Business School Magazine December 2006

The High Cost of Low Wages

by Wayne F. Cascio

Executive Summary from Harvard Business School 

Wal-Mart’s legendary obsession with cost containment shows up in countless ways, including aggressive control of employee benefits and wages. Managing labor costs isn’t a crazy idea, of course. But stingy pay and benefits don’t necessarily translate into lower costs in the long run.

Consider Costco and Wal-Mart’s Sam’s Club, which compete fiercely on low-price merchandise. Among warehouse retailers, Costco—with 338 stores and 67,600 full-time employees in the United States—is number one, accounting for about 50% of the market. Sam’s Club—with 551 stores and 110,200 employees in the United States—is number two, with about 40% of the market.

Though the businesses are direct competitors and quite similar overall, a remarkable disparity shows up in their wage and benefits structures. The average wage at Costco is $17 an hour. Wal-Mart does not break out the pay of its Sam’s Club workers, but a full-time worker at Wal-Mart makes $10.11 an hour on average, and a variety of sources suggest that Sam’s Club’s pay scale is similar to Wal-Mart’s. A 2005 New York Times article by Steven Greenhouse reported that at $17 an hour, Costco’s average pay is 72% higher than Sam’s Club’s ($9.86 an hour). Interviews that a colleague and I conducted with a dozen Sam’s Club employees in San Francisco and Denver put the average hourly wage at about $10. And a 2004 Business Week article by Stanley Holmes and Wendy Zellner estimated Sam’s Club’s average hourly wage at $11.52.

On the benefits side, 82% of Costco employees have health-insurance coverage, compared with less than half at Wal-Mart. And Costco workers pay just 8% of their health premiums, whereas Wal-Mart workers pay 33% of theirs. Ninety-one percent of Costco’s employees are covered by retirement plans, with the company contributing an annual average of $1,330 per employee, while 64 percent of employees at Sam’s Club are covered, with the company contributing an annual average of $747 per employee.

Costco’s practices are clearly more expensive, but they have an offsetting cost-containment effect: Turnover is unusually low, at 17% overall and just 6% after one year’s employment. In contrast, turnover at Wal-Mart is 44% a year, close to the industry average. In skilled and semi-skilled jobs, the fully loaded cost of replacing a worker who leaves (excluding lost productivity) is typically 1.5 to 2.5 times the worker’s annual salary. To be conservative, let’s assume that the total cost of replacing an hourly employee at Costco or Sam’s Club is only 60% of his or her annual salary. If a Costco employee quits, the cost of replacing him or her is therefore $21,216. If a Sam’s Club employee leaves, the cost is $12,617. At first glance, it may seem that the low-wage approach at Sam’s Club would result in lower turnover costs. But if its turnover rate is the same as Wal-Mart’s, Sam’s Club loses more than twice as many people as Costco does: 44% versus 17%. By this calculation, the total annual cost to Costco of employee churn is $244 million, whereas the total annual cost to Sam’s Club is $612 million. That’s $5,274 per Sam’s Club employee, versus $3,628 per Costco employee.

In return for its generous wages and benefits, Costco gets one of the most loyal and productive workforces in all of retailing, and, probably not coincidentally, the lowest shrinkage (employee theft) figures in the industry. While Sam’s Club and Costco generated $37 billion and $43 billion, respectively, in U.S. sales last year, Costco did it with 38% fewer employees—admittedly, in part by selling to higher-income shoppers and offering more high-end goods. As a result, Costco generated $21,805 in U.S. operating profit per hourly employee, compared with $11,615 at Sam’s Club. Costco’s stable, productive workforce more than offsets its higher costs.

These figures challenge the common assumption that labor rates equal labor costs. Costco’s approach shows that when it comes to wages and benefits, a cost-leadership strategy need not be a race to the bottom.

Have a GREAT WEEKEND and HAPPY LABOR DAY to those in the U.S.

Best response gets a choice of prizes.

THE FOURTH REICH

 Why the U.S. IS Using Syria as a Pre-Text to War

http://www.youtube.com/user/StormCloudsGathering?feature=watch

Always ask, “Qui Bono?” Who benefits from a Mid-East War?

The U.S. needs to attack Syria to stop Russian pipelines from feeding Europe and hastening the fall of the Petrodollar:  http://www.tfmetalsreport.com/podcast/5015/holiday-tradition-fresh-jackass

17 responses to “Case Study on Business Models: Wal-Mart vs. Costco

  1. Charlie Munger, 2/6/13: Sol Price (founder of Price Club) used to say, success in business came from deciding which business you could intelligently do without. He had a list of business he didn’t want. Those things he didn’t want — he didn’t want business from people who wrote bad checks. He didn’t want business of people who shoplifted. He didn’t want business of people who clogged-up his parking lot without buying very much. He carefully invented a system where he kept those people out, and succeeded by deciding what he would be better off without and avoiding it. This is a very good way to think, and it’s not all that common. It’s, perfectly, obvious, isn’t it? And it has been of enormous help to the people sitting at this head table. But most people just aren’t trained to do that —if it’s more business, they tend to want it.

    • Thanks Punchcard. You know your Munger lessons well.

      Costco, I need to find recent stats, has the highest sales per square foot of any retailer in history. The inventory turns are immense.

  2. Price Club, of course, evolved into Costco.

  3. Thanks Punchcardblog: Interesting.

    Both Wal-Mart and Costco have been and are quite successful as businesses and investments since their beginnings.

    But what can we learn about their differences? Both sell cheap, but why the difference in labor costs? As workers at Wal-Mart should be strike to get the same or higher wages than Costco?

    I can’t offer you the choice of three prizes:

  4. If you are comparing Wal-Mart to Costco strictly, Costco has a large base of revenue, it’s membership fees, that don’t have associated costs, which allow them to keep prices low and probably funnel some of that to its employees.

    I realize on some level that’s captured in SAMs, but if Wal Mart wanted to charge a membership fee, it may be able to funnel that to employees.

    • Ok, to put on the analyst hat: doesn’t WMT have more revenue than Costco? Yes, Costco charges a membership fee while WMT doesn’t. Why? Why doesn’t WMT charge such a fee? Could it if it wanted to? Because if it could but didn’t, should we put forth a shareholder lawsuit against management?

      How are wages set? Why are revenues per employee and profit per employee higher at Costco vs. WMT? Is Costco’s management more “moral” than WMT?

      Have you been to the two stores? Anything strike you as VERY different between the stores?

  5. I was a bit vague. Coscto intentionally limits the number of products for sale (SKUs). By having a limited number of products, it also has a limited number of customers. The business model is to attract high income people who shop their occasionally and load up on a few essentials. WMT’s business model is to carry a high number of SKUs and attract low income people who shop their regularly for everyday needs. COST’s model is much less labor intensive. As a result, they need less employees and can afford higher wages. The quote from Munger gets at the fact that Costco does not try to appeal to everybody.

  6. The distinction between Wal-Mart and Costco likes in membership.

    Costco is able to offer low prices and take in low margins because they charge a membership and incentive customers to purchase more to get “theirs money’s worth”. Irregardless of what the customer does, get a membership and buy lots vs get a membership and buy little, Costco makes money either way.

    Wal-mart on the other hand doesn’t charge a membership fee and therefore they must suppress their costs because there is no incentive for the customer to purchase at Wal-Mart other than its marketing of “everyday low price” and “price matching policies”. However to continue to stay as the market leader, they must continually suppress costs to a point where their competitors are unable to suppress their costs to the same extent. Unfortunately, as a side effect of surprising the wages of workers, Wal-Mart has an asset (“labor”) that don’t perform as well.

    See, (“labor”) is a unique asset in retailing. The cost of labor is a function of how much you are willing to “invest” in it. Invest too much and it has tremendous diminishing marginal returns. Likewise, if you invest too little, they simply don’t produce. Therefore there is actually a “sweet spot”, if you will, for labor and Costco seems to have perfected the art of mastering that asset.

    Wal-mart is taking their capital and investing it in cost reduction while Costco is taking their capital and able to invest it in ecommerce or expansion.

    • Dear TC:

      What do you mean by “suppress” costs. Does WMT have a lower cost of goods sold than its competitors? Can it get Coke or Pepsi or J&J to sell its products at a lower price to WMT than competitors? What is WMT a market leader in? Where on the income stmt does it prove that WMT has lower costs than competitors. Numbers?

      I am too confused by your last two paragraphs to understand………..

      But thanks for the post.

  7. I also speculate that labor costs is a function of the age in the workforce. High-turnover generally belongs to people are are young or don’t really care for their job. (Walmart) As a result paying more for someone working at 80% of their capacity is still 20% wasted.

    Likewise, Costco is able to display the persona of being steady and therefore people are more willing to operate at a higher level. Assuming Costco employees perform at 85%, then their waste is lower.

    However judging by the pay of the two companies, Walmart pay is only $10.11/$17 = ~60% A Wal-mart employee is only 60% as productive as a Costco employee…… If you add in health benefits and other extracurricular, you would find the Wal-Mart number drops even more…

  8. A high percentage of Costco’s net income comes from membership dues. The dues are paid at the beginning of the year and earned into income ratably during the year. Renewal is high. Thus membership unearned income amounts to an interest-free loan, which, while recorded as a liability, is in fact a valuable asset.

    What is more, we feel we being treated fairly. Indeed, we are; if they can buy something for a bargain price they pass the bargain on to members. But since we have paid most of their profit up front, the price seems an even better deal, because it isn’t in the markup. And the employees are rarely surly; I know a number by name. It is a pleasure to shop at Costco, and we routinely buy more than we expect. It is a truly remarkable business.

    I’m surprised more businesses haven’t tried to emulate Costco.

  9. Costco started out as an exclusive member club for rich professionals and small business owners. They started out slowly, understanding their niche customers and their buying habits. Walmart on the other hand bought stuff in bulk and sold it out for lower prices than the next guy. Walmart catered to every age and income demographic. Costco on the other hand entertained people with fat wallets who would purchase in bulk and even pay membership fees for greater savings on selected products.

    Because Costco’s member is invested in the company even before he shops there they’re more likely to be loyal. And the greater amount they spend the lower their percentage cost for the membership. For example, a person who spends $5,500 pays 1% for their membership ($55). On the other hand a family that spends $11,000 pays only 0.5% for their membership. The more you buy the lower your effective membership cost.

    Costco has a treasure hunt atmosphere. You see everyone loading up on stuff in their huge shopping carts. You don’t mind jumping in since the stuff is way cheaper than it is at other places.

    Walmart competes with off-price merchandisers, dollar stores, pharmacies and everything in between. Costco’s arch-nemesis? – Sam’s Club. Average Walmart SKU – 140,000 vs Costco’s average SKU of 4,000.

    Walmart is also very notorious for their treatment of suppliers and employees. I’ve talked to a lot of Walmart employees and almost all of them had a negative view of the company. Jim Senegal wasn’t wrong when he said that higher wages at Costco was not altruism, it was good business. The positive marketing and sales they’ve received due must have paid for their higher employee costs many times over although it is hard to quantify.

    Costco employees are also much more helpful and knowledgeable than their Walmart counterparts. I don’t doubt the role wages play in this.

    Costco have free money in the form of membership income which they can use to build new warehouses and distribution centers. I recall that Costco sells all their inventory more than twice before it needs to pay the vendors. Who needs working capital?

  10. I looked at the non-cogs expenses a while ago and costco approached 10% while WalMart came closer to 30%. Obviously, costco does bulk items unlike walmart, but those kind of slim margins speak highly for the value their customers receive, and it probably makes them at least a little unlikely to be easy to compete against.

  11. The Plague Doctor

    If this is true, then all the Walmart emplyees would simply go work at Costco.

    ZING!

  12. The Plague Doctor – you are assuming that Costco would choose to hire the same caliber of employee that Walmart does. Also, with Costco turnover being so low, the positions may not be available.

    ZING?

    • I aM NOT SURE WHAT YOU ARE ASKING? Lower turnover for Costco may lower their overall employee costs. Also, the type of employee might be slightly different than at Wal-Mart–more competition for the job.

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