COSTCO'S MISSION, BUSINESS MODEL, AND STRATEGY Costco's stated mission in the membership warehouse business was: "To continually provide our members with quality goods and services at the lowest possible page on prices."4 However, in a \"Letter to Shareholders\" in the company's 2011 Armual Report, Costco's three top executivesJeff Brotman, Jim Sinegal, and Craig Jelinek provided a more expansive view of Costco's mission, stating: The company will continue to pursue its mission of bringing the highest quality goods and services to market at the lowest possible prices while providing excellent customer service and adhering to a strict code of ethics that includes taking care of our employees and members, respecting our suppliers, rewarding our shareholders, and seeking to be responsible corporate citizens and environmental stewards in our operations around the world.\" 5 ln the company's 2011' Annual Report, Craig Jelinek elaborated on how environmental sustainability t into Costco's mission: Sustainability to us is remaining a protable business while doing the right thing. We are committed to lessening our environmental impact. decreasing our carbon footprint. sourcing our products responsibly, and working with our suppliers. manufacturers and farmers to preserve natural resources. This will remain at the forefront of our business practices.'i The centerpiece of Costco's business model was a powerful value proposition that featured a combination of ( l) ultra-low prices on a limited selection of nationally branded and Costco's privatelabel Kirkland Signature products in a wide range of merchandise categories, (2) very good to excellent product quality, and (3} intriguing product selection that included both everyday items and ongoing special purchases from a big variety of merchandise suppliers that turned shopping at Costco into a money-saving treasure hunt. Ever since the company's founding, Costco management had strived diligently to ensure that shopping at Costco delivered enough value to keep existing members returning frequently to a nearby warehouse and to spur membership growth every year, thereby generating high sales volumes and rapid inventory turnover at each warehouse and creating opportunities to open new warehouses both domestically and internationally. Big sales volumes and rapid inventory tumoverwhen combined with the low operating costs achieved by volume purchasing, efcient distribution, and reduced handling of merchandise in nofrills, selfservice warehouse facilitiesenabled Costco to operate protably at signicantly lower gross margins than traditional wholesalers, mass merchandisers, supermarkets, and supercenters. Membership fees were a critical element of Costco's business model because they provided sufcient supplemental revenues to boost the company's overall protability to acceptable levels' Indeed, Costco's revenues from membership fees typically exceeded [BO percent ofthe company's net income, meaning that the rest of Costco's worldwide business operated on a slightly below breakeven basis (see Exhibit 1 )which translated into Costco's prices being exceptionally competitive when compared to the prices that Costco members paid when shopping elsewhere. Another important business model element was that Costco's high sales volume and rapid inventory turnover generally allowed it to sell and receive cash for inventory before it had to pay many of its merchandise vendors, even when vendor payments were made in time to take advantage of early payment discounts. Thus, Costco was able to nance a big percentage of its merchandise inventory through the payment terms provided by vendors rather than by having to maintain sizable working capital (dened as current assets minus current liabilities} to enable timely payment of suppliers. Costco's Membership Base and Member Demographlcs Costco attracted the most a luent customers in discount retailingthe average annual income of Costco members was approximately $100,000 (in 2015 Costco management believed the 8.6 million subscribers to the company's monthly Casino Connection magazine had an average annual income of $156,000).'5 Many members were afuent urbanites, living in nice neighborhoods not far from Costco warehouses One loyal Executive member, a crimina] defense lawyer, said, "I think I spend over $20,000 to $25,000 a year buying all my products here from food to clothingexcept my suits. I have to buy them at the Armani stores."" Another Costco loyalist said, \"This is the best place in the world. It's like going to church on Sunday. You can't get anything better than this. This is a religious experience." '7 Costco had two primary types of' memberships: Business and Gold Star (individuaJ). Business memberships were limited to businesses, but included individuals with a business license, retail sales license, or other evidence of business existence Abusiness membership a]so included a free household card (a signicant number of business members shopped at Costco for their persona] needs). Business members also had the ability to purchase \"add-on\" membership cards for up to six partners or associates in the business. Costco's current annual fee for Business and Gold Star memberships was $60 in the United States and Canada and varied by country in its Other Internationa] operations. lndividuals in the United States and Canada who did not qualify for business membership could purchase a Gold Star membership, which included a household card for another family member (additional add-on cards could not be purchased by Gold Star members). All types of members (including household card members} could shop at any Costco warehouse. Business, Business add-on, and Gold Star members in the United States and Canada could upgrade to Executive membership for an additional $60 (an annual membership fee of $ 120); upgrade fees to Executive memberships elsewhere varied by country. The primary appeal of upgrading to Executive membership was eligibility for a two percent annua] reward (rebate) on qualied pretax purchases. Reward certicates were issued annually and could be used toward purchases of most merchandise at the front-end registers of Costco warehousesrebate awards could not be used to purchase alcohol and tobacco products, gasoline, postage stamps, and food court items. The two percent rebate for Executive members was capped at $1,000 for any 12month period in the United States and Canada (equivalent to annual qualied pretax purchases of $50,000); the maximum rebate varied in other countries. Executive members also were eligible for savings and benets on various business and consumer services o'ered by Costco, including merchant credit card processing, small-business loans, auto and home insurance, long-distance telephone service, check printing, and real estate and mortgage services; these services were mostly offered by thirdparty providers and varied by stateExecutive members did not receive two percent rebate credit on purchases of these ancillary services. In sca] 2019, Executive members represented 39 percent of Costco's cardholders (including add-ons, but not holders of household cards) and accounted for approximately two-thirds of total company sales. Costco's member renewal rate was 91 percent in the United States and Canada, and 88 percent on a worldwide basis at the end of scal 2019. Recent trends in membership are shown at the bottom of [Q1 Exhibit 1. ln general, with variations by country, Costco members could pay for their purchases with certain debit and credit cards, cobranded Costco credit cards, cash, or \"9' 030 checks; in the United States and Puerto Rico, members could use a cobranded CitifCostco Visa Anywhere credit card for purchases at Costco and elsewhere, Costco Cash cards, and all Visa cards. Since the June 2016 launch of CitiJCostco Visa Anywhere Card, 1.8 million new member accounts (approximately 2.4 million new credit cards} were opened. The enhanced cash-back Visa Anywhere rewards included earning four percent on gas; three percent on restaurant, hotel, and eligible travel; two percent at Costco and Camemm; and one percent on all other purchases, exceeding the company's previous cobranded credit card oedng with American Express. Executive Members using the new Visa Anywhere card continued to earn a two percent rebate on qualied purchases. Costco accepted merchandise returns when members were dissatised with their purchases. Losses associated with dishonored checks were minimal because any member whose check had been dishonored was prevented from paying by check or cashing a check at the point of sale until restitution was made. The membership format facilitated strictly controlling the entrances and exits of warehouses, resulting in limited inventory losses of less than two-tenths of one percent of net saleswell below those of typical discount retail operations. Warehouse Management Costco warehouse managers were delegated considerable authority over store operations. In effect, warehouse managers functioned as entrepreneurs running their own retail operation. They were responsible for coming up with new ideas about what items would sell in their stores, e'ectively merchandising the ever-changing lineup of treasure-hunt products, and orchestrating instore product locations and displays to maximize sales and quick turnover. ln experimenting with what items to stock and what instore merchandising techniques to employ, warehouse managers had to know the clientele who patronized their locationsfor instance, big-ticket diamonds sold well at some warehouses but not at others. Costco's best managers kept their nger on the pulse of the members who shopped their warehouse location to stay in sync with what would sell well, and they had a air for creating a certain element of excitement, hum, and buzz in their warehouses. Such managers spurred aboveaverage sales volumessales at Costco's topvolume warehouses ran about $5 million to $T million a week, with sales exceeding $l million on many days. Successful managers also thrived on the rat race of running a hightrafc store and solving the inevitable crises of the moment. Compensation and Workforce Practlces As of September 2019, Costco had 149,000 fulltime employees and [05,000 part-time employees. Approximately [6, 000 hourly employees at locations in California, Maryland, New Jersey, and New York, as well as at one warehouse in Virginia, were represented by the International Brotherhood of Teamsters. All remaining employees were non-union. in March 2019, Costco raised its minimum wage for hourly employees to $15 per hour and also bumped up pay scales for a variety of otherjobs, including supervisory positions. Hourly pay scales for warehouse jobs ranged from $l5 to $19 in the second half of 2019. The highest paid fulltime warehouse employees could earn close to $25.00 per hour after four years. Frontend supervisors averaged about $26 per hour. Compensation averaged $1I5$13 per hour for pharmacy technicians and $6 2.56 per hour for licensed pharmacists, and about $146,000 annually for pharmacy managers. '3 Salaried Costco employees earned anywhere from $30,000 to close to $200,000 annually, depending onjob type.19 For example, salaries for merchandise managers, membership managers, and meat department managers reportedly were in the $55,000 to $85,000 range; salaries for supervisors ranged from $45,000 to $75,000; salaries for database, computer systems, and software applications developersfanalystsfproject managers were in the $85,000 to $125,000 range. Average salaries for pharmacy managers were in the $146,000 range. Average total compensation (including bonuses) for assistant general managers of warehouses ranged from $703,000 to $91000 and reportedly averaged about $558,000.m Average total pay for general managers of warehouses ranged from $90,000 to $l80,000 and reportedly averaged about $13 5,000.21 Employees enjoyed the full spectrum of benets. Salaried employees were eligible for benets on the rst of the second month after the date of hire. Full-time hourly employees were eligible for benets on the rst day of the second month after completing 250 eligible paid hours; parttime hourly employees became benet-eligible on the rst day of the second month after completing 450 eligible paid hours. The benet package included the following: Page (3-31 E . Health care plans for full-time and part-time employees that included coverage for mental illness, substance abuse, and professional counseling for assorted persona] and family issues. . A choice of' a core dental plan or a premium dental plan. . A pharmacy plan that entailed (1) copayments of $3 for generic drugs and $10 to $50 for brandname prescriptions lled at a Costco warehouse or online pharmacy and [2) co-payments of $15 to $50 for generic or brandname prescriptions lled at all other pharmacies. . A vision program that paid up to $60 for a refraction eye exam (the amount charged at Costco's Optical Centers} and had $125 annual allowances for the purchase of glasses and contact lenses at Costco Optical Centers. Employees located more than 25 miles from a Costco Optical Center could visit any provider of choice for annual eye exams and could purchase eyeglasses from any innetwork source and submit claim forms for reimbursement. . A hearing aid benet of up to $1350 every four years (available only to employees and their eligible dependents enrolled in a Costco medical plan, and the hearing aids had to be supplied at a Costco Hearing Aid Center). . A 401(k) plan open to all employees who had completed 90 days of employment. Costco matched hourly employee contributions by 50 cents on the dollar for the rst $1,000 annually (the maximum company match was $500 per year). The company's u.nion employees on the West Coast qualied for matching contributions of 50 cents on the dollar up to a maximum company match of$250 a year. In addition to the matching contribution, Costco also normally made a discretionary contribution to the accounts of eligible employees based on the number of years of service with the company {or in the case of union employees based on the straightti me hours worked ). For other than union employees, this discretionary contribution was a percentage of the employee's compensation that ranged from a low of three percent {for employees with one to one years of service) to a high of nine percent (for employees with 25 or more years of service). Company contributions to all the various employee 410(k) plans were $489 million in 2016, $543 million in 2017, SETS million in 2013, and $6\" million in 2019. . A dependent care reimbursement plan in which Costco employees whose families qualied could pay for day care for children under 13 or adult day care with pretax dollars and realize savings of anywhere from $150 to $2,000 per year. . Longterm and shortterm disability coverage. . Generous life insurance and accidental death and dismemberment coverage, with benets based on years of service and whether the employee worked full-time or parttime. Employees could elect to purchase supplemental coverage for themselves, their spouses, or their children. . An employee stock purchase plan allowing all employees to buy Costco stock via payroll deduction so as to avoid commissions and fees. Although Costco's longstanding practice of paying good wages and good benets was contrary to conventional wisdom in discount retailing, co-founder and former CEO Jim Sinegal, who originated the practice, rmly believed that having a wellcompensated workforce was very important to executing Costco's strategy successfully. He said, \"Imagine that you have 120,000 loyal ambassadors out there who are constantly saying good things about Costco. It has to be a signicant advantage for you. . . . Paying good wages arid keeping your people working with you is very good business.\"22 When a reporter asked him about why Costco treated its workers so well compared to other retailers [particularly Walmart, which paid lower wages and had a skimpier benets package}, Sinegal replied: \"Why shouldn't employees have the right to good wages and good careers. . . . lt absolutely makes good business sense. Most people agree that we're the lowestcost producer. Yet we pay the highest wages. So it must mean we get better productivity. lts axiomatic in our businessyou get what you pay for." 23 l Good wages and benets were said to be why employee turnover at Costco typically averaged about 5 percent or less after the rst year of employment. Some Costco employees had been with the company since its founding in 1983. Many others had started working part-time at Costco while in high school or college and opted to make a career at the company, One Costco employee told an ABC 20/20 reporter, \"It's a good place to work; they take good care of us."24 A Costco vice president and head baker said working for Costco was a family affair: \"My whole family works for Costco, my husband does, my daughter does, my new soninlaw does."'25 Another employee, a receiving clerk who made about $40,000 a year, said, \"I want to retire here. I love it here.'25 An employee with over two years of service could not be red without the approval of a senior company ofcer. Selecting People for Open Positions Costco's top management wanted employees to feel that they could have a long career at Costco. It was company policy to ll the vast majority of its higher-level openings by promotions from within; at one recent point, the percentage ran close to 98 percent, which meant that the majority of Costco's management team members (including warehouse, merchandise, administrative, membership, front end, and receiving managers) had come up through the ranks. Many of the company's vice presidents had started in entry-level jobs. According to Jim Sinega], \"We have guys who started pushing shopping carts out on the parking lot for us who are now vice presidents of our company\"? Costco made a point of recruiting at local universities; Sinegal explained why: \"These people are smarter than the average person, hardworking, and they haven't made a career choice?\" On another occasion, he said, "If someone came to us and said he just got a master's in business at Harvard, we would say ne, would you like to start pushing carts?\" Those employees who demonstrated smarts and strong people management skills moved up through the ranks. But without an aptitude for the details of discount retailing, even upandcoming employees stood no chance of being promoted to a position of warehouse manager. Top Costco executives who oversaw warehouse operations insisted that candidates for warehouse managers be topight merchandisers with a gift for the details of making items y off the shelves. Based on his experience as CEO, Sinega] said, \"People who have a feel for itjust start to get it. Others, you look at them and it's like staring at a blank canvas. I'm not trying to be unduly harsh, but that's the way it works."3'l Most newly appointed warehouse managers at Costco came from the ranks of assistant warehouse managers who had a track record of being shrewd merchandisers and tuned into what new or di'erent products might sell well given the clientele that patronized their particular warehouse. Just having the requisite skills in people management, crisis management, and coste'ective warehouse operations was not enough. Executive (hmpensation Executives at Costco did not earn the outlandish salaries that had become customary over the past decade at most large corporations. In Jim Sinegal's last two years as Costco's CEO, he received a salary of $350,000 and a bonus of$190,400 in scal 2010 and a salary of $3 $0,000 and a bonus of5198,400 in scal 2011. Craig Jelinek's salary as President and CEO in scal 2019 was $930,000 (which was increased to $1 million for calendar year 2019), and he received a bonus of $190,400 and a stock award worth $6.? million; Richard Galanti's salary as Executive VicePresident and Chief Financial Ofcer in scal 2019 was $784,146, and he received a bonus of $105,160 and a stock award worth nearly $3.2 million. Other Costco executive ofcers received salaries in the $662,000 to $232,000 range, bonuses of about $26,000, and stock awards worth nearly $3.2 million in scal 2019. Asked why executive compensation at Costco was only a fraction of the amounts typically paid to toplevel executives at other corporations with revenues and operating scale comparable to Costco's, Sinegal replied: "I gured that if 1 was making something like 12 times more than the typical person working on the oor, that that was a fair sa]ary."3' To another reporter, he said: \"Listen, I'm one of the founders of this business. I've been very well rewarded. I don't require a salary that's 100 times more than the people who work on the sales floor."32 During his tenure as CEO, Sinegal's employment contract was only a page long and provided that he could be terminated for cause. Page 032 Page 033 l However, while executive salaries and bonuses were modest in comparison with those at other companies Costco's size, Costco did close the gap via an equity compensation program that featured awarding restricted stock units (RSUs) to executives based on dened performance criteria. The philosophy at Costco was that equity compensation should be the largest component of compensation for all executive ofcers and be tied directly to achievement of protax income targets. Costco's Business Phllosophy, Values. and Code of Ethics Jim Sinegal, who was the son of a steelworker, had ingrained ve simple and down-toearth business principles into Costco's corporate culture and the manner in which the company operated. The following are excerpts of these principles and operating approaches: 33 l. Obeytlre lawThe law is irrefutable! Absent a moral imperative to challenge a law, we must conduct our business in total compliance with the laws of every community where we do business. We pledge to: Comply with all laws and other legal requirements. Respect all public ofcials and their positions. Comply with safety and security standards for all products sold. Exceed ecological standards required in every community where we do business. Comply with all applicable wage and hour laws. Comply with all applicable antitrust laws. Conduct business in and with foreign countries in a manner that is legal and proper under United States and foreign laws. Not offer, give, ask for, or receive any form of bribe or kickback to or from any person or pay to expedite government action or otherwise act in violation of the Foreign Corrupt Practices Act or the laws of other countries. Promote fair, accurate, timely, and understandable disclosure in reports led with the Securities and Exchange Commission and in other public communications by the Company. 2. Take care of our membersCostco membership is open to business owners, as well as individuals. Our members are our reason for beingthe key to our success. If we don't keep our members happy, little else that we do will make a difference. There are plenty of shopping alternatives for our members, and if they fail to show up, we cannot survive. Our members have extended a trust to Costco by virtue of paying a fee to shop with us. We will succeed only if we do not violate the trust they have extended to us, and that trust extends to every area of our business. We pledge to: Provide topquality products at the best prices in the market. Provide highquality, safe, and wholesome food products by requiring that both vendors and employees be in compliance with the highest food safety standards in the industry. Provide our members with a [DO percent satisfaction guaranteed warranty on every product and service we sell, including their membership fee. Assure our members that every product we sell is authentic in make and in representation of performance. Make our shopping environment a pleasant experience by making our members feel welcome as our guests. Provide products to our members that will be ecologically sensitive. Provide our members with the best customer service in the retail industry. Give back to our communities through employee volunteerism and employee and corporate contributions to United Way and Children's Hospitals. 3. Take care of our employeesOur employees are our most important asset. We believe we have the very best employees in the warehouse club industry, and we are Page C-34 committed to providing them with rewarding challenges and ample opportunities for personal and career growth. We pledge to provide our employees with: Competitive wages. Great benets. A safe and healthy work environment. Challenging and fun work. Career opportunities. - An atmosphere free from harassment or discrimination. An OpenDoor Policy that allows access to ascending levels of management to resolve issues. Opportunities to give back to their communities through volunteerism and fundraising. 4. Respect our suppliersOur suppliers are our partners in business and for us to prosper as a company, they must prosper with us. To that end, we strive to: Treat all suppliers and their representatives as we would expect to be treated if visiting their places of business. Honor all commitments. Protect all suppliers' property assigned to Costco as though it were our own. - Not accept gratuities of any kind from a supplier. If in doubt as to what course of action to take on a business matter that is open to varying ethical interpretations, TAKE. THE HIGH ROAD AND DO WHAT IS RIGHT. If we do these four things throughout our organization, then we will achieve our ultimate goal, which is to: 5. Reward our shareholdersAs a company with stock that is traded publicly on the NASDAQ stock exchange, our shareholders are our business partners. We can only be successful so long as we are providing them with a good return on the money they invest in our company. . . . We pledge to operate our company in such a way that our present and future stockholders, as well as our employees, will be rewarded for our efforts. Environmental Sustainability and Responsible Sourcing of Meat and Dairy Products ln recent years, Costco management had undertaken a series of initiatives to invest in various environ mental and energy saving systems, the use of packaging that could be recycled or composted, reduction of both packaging materials and food waste, greater sourcing of sustainable seafood products from wild sheries and farmed aquaculture, working with recognized exnerts and sllnnliers tn increase the nementaoe afcairef'ree eons it sold. and mmnliance with best nraotioes in rlain.r f'armin a. animal care. and animal E well-being. The stated objective was to ensure that the company's carbon footprint grew at a slower rate than the company's sales growth and that Costco was a responsible steward of the animals, land, and other environmental resources utilized in the products it sold. Costco's metal warehouse design, which included use of recycled steel, was consistent with the requirements of the Silver Level LEED Standardthe certication standards of the organization Leadership in Energy and Environmental Design (LEED) were nationally accepted as a benchmark green building design and construction. Costco's recently- developed non-metal designs for warehouses had resulted in the ability to meet Gold Level LEED Standards. All new facilities were being designed and constructed to be more energy efcient; this included using LED lighting and energy-efcient mechanical systems for heating, cooling, and refrigeration in both new and existing facilities. In 2016, Costco began retrotting existing facilities with LED lighting; as of yearend scal 2013, 1,166 retrots had been completed, resulting in a total estimated energy savings of 206 million kilowatthours per year.\" All lighting in new construction utilized LED technology. At the end of scal 2018, Costco had rooftop solar photovoltaic systems in operation at 109 of its warehouses; some warehouses used solar power to light their parking lots. In 201?, Costco began piloting the use of fuel cells as an alternate source of electricity at a handful of locations and was continuing to evaluate their use in future facilities. So far, Costco had found the fuel cells at test sites had resulted in lower combined power and natural gas expenses. The company was also exploring use of new HVAC and refrigerant systems that were more energy eicient and increasing its use of refrigerants that further reduced global warming potential and greenhouse gas emissions. Another energy-saving initiative had been to install Internet-based energy management systems at all Costco warehouses in North America and at some international \"9' 035 locations, giving Costco the ability to regulate energy usage on an hourly basis. These, along with installation of LED lighting and warehouse skylights, had reduced the lighting loads on Costco's sales oors by over 5|} percent since 2001. Costco had undertaken a series of initiatives at company facilities worldwide to reduce water usage, reduce or remove potential chemical harm to humans and to the environment, use recycled asphalt for paving most warehouse parking lots, and use best practices to irrigate landscapes and manage groundwater runoff. Empty store cartons were given to members to carry their purchases home. Costco had been an active member of the Environmental Protection Agency's Energy Star and Climate Protection Partnerships since 2002 and was a major retailer of Energy Star qualied compact florescent lamp (CFL) bulbs and LED light bulbs. Costco was committed to sourcing all of the seafood it sold from responsible and environmentally sustainable sources that were certied by the Marine Stewardship Council; in no instances did Costco sell seafood species that were classied as environmentally endangered and it monitored the aquaculture practices of its suppliers that farmed seafood. The company had long been committed to enhancing the welfare and proper handling of all animals used in food products sold at Costco. According to the company's ofcial statement on animal welfare, \"This is not only the right thing to do, it is an important moral and ethical obligation we owe to our members, suppliers, and most of all to the animals we depend on for products that are sold at Costco?\" As part of the company's commitment, Costco had established an animal welfare audit program that utilized recognized audit standards and programs conducted by trained, certied auditors and that reviewed animal welfare both on the farm and at slaughter