By Stanley Holmes and Wendy Zellner
Business Week

APRIL 12, 2004
The Costco Way Higher wages mean higher profits. But try telling Wall
Street

Costco Wholesale Corp. (COST ) handily beat Wall Street expectations on
Mar. 3, posting a 25% profit gain in its most recent quarter on top of a
14% sales hike. The warehouse club even nudged up its profit forecast
for the rest of 2004. So how did the market respond? By driving the
Issaquah (Wash.) company's stock down by 4%. One problem for Wall Street
is that Costco pays its workers much better than archrival Wal-Mart
Stores Inc. (WMT ) does and analysts worry that Costco's operating
expenses could get out of hand. "At Costco, it's better to be an
employee or a customer than a shareholder," says Deutsche Bank (DB )
analyst Bill Dreher.

The market's view of Costco speaks volumes about the so-called
Wal-Martization of the U.S. economy. True, the Bentonville (Ark.)
retailer has taken a public-relations pounding recently for paying
poverty-level wages and shouldering health insurance for fewer than half
of its 1.2 million U.S. workers. Still, it remains the darling of the
Street, which, like Wal-Mart and many other companies, believes that
shareholders are best served if employers do all they can to hold down
costs, including the cost of labor.

Surprisingly, however, Costco's high-wage approach actually beats
Wal-Mart at its own game on many measures. BusinessWeek ran through the
numbers from each company to compare Costco and Sam's Club, the Wal-Mart
warehouse unit that competes directly with Costco. We found that by
compensating employees generously to motivate and retain good workers,
one-fifth of whom are unionized, Costco gets lower turnover and higher
productivity. Combined with a smart business strategy that sells a mix
of higher-margin products to more affluent customers, Costco actually
keeps its labor costs lower than Wal-Mart's as a percentage of sales,
and its 68,000 hourly workers in the U.S. sell more per square foot. Put
another way, the 102,000 Sam's employees in the U.S. generated some $35
billion in sales last year, while Costco did $34 billion with one-third
fewer employees.

Bottom line: Costco pulled in $13,647 in U.S. operating profit per
hourly employee last year, vs. $11,039 at Sam's. Over the past five
years, Costco's operating income grew at an average of 10.1% annually,
slightly besting Sam's 9.8%. Most of Wall Street doesn't see the broader
picture, though, and only focuses on the up-front savings Costco would
gain if it paid workers less. But a few analysts concede that Costco
suffers from the Street's bias toward the low-wage model. "Costco
deserves a little more credit than it has been getting lately, [since]
it's one of the most productive companies in the industry," says
Citigroup/Smith Barney retail analyst Deborah Weinswig. Wal-Mart
spokeswoman Mona Williams says that Sam's pays competitively with Costco
when all factors are considered, such as promotion opportunities.

PASSING THE BUCK. The larger question here is which model of competition
will predominate in the U.S. Costco isn't alone; some companies, even
ones like New Balance Athletic Shoe Inc. that face cheap imports from
China, have been able to compete by finding ways to lift productivity
instead of cutting pay. But most executives find it easier to go the
Wal-Mart route, even if shareholders fare just as well either way over
the long run.

Yet the cheap-labor model turns out to be costly in many ways. It can
fuel poverty and related social ills and dump costs on other companies
and taxpayers, who indirectly pick up the health-care tab for all the
workers not insured by their parsimonious employers. What's more, the
low-wage approach cuts into consumer spending and, potentially, economic
growth. "You can't have every company adopt a Wal-Mart strategy. It
isn't sustainable," says Rutgers University management professor Eileen
Appelbaum, who in 2003 edited a vast study by 38 academics that found
employers taking the high road in dozens of industries.

Given Costco's performance, the question for Wall Street shouldn't be
why Costco isn't more like Wal-Mart. Rather, why can't Wal-Mart deliver
high shareholder returns and high living standards for its workforce?
Says Costco CEO James D. Sinegal: "Paying your employees well is not
only the right thing to do but it makes for good business."

Look at how Costco pulls it off. Although Sam's $11.52 hourly average
wage for full-timers tops the $9.64 earned by a typical Wal-Mart worker,
it's still nearly 40% less than Costco's $15.97. Costco also shells out
thousands more a year for workers' health and retirement and includes
more of them in its health care, 401(k), and profit-sharing plans. "They
take a very pro-employee attitude," says Rome Aloise, chief Costco
negotiator for the Teamsters, which represents 14,000 Costco workers.

In return for all this generosity, Costco gets one of the most
productive and loyal workforces in all of retailing. Only 6% of
employees leave after the first year, compared with 21% at Sam's. That
saves tons, since Wal-Mart says it costs $2,500 per worker just to test,
interview, and train a new hire. Costco's motivated employees also sell
more: $795 of sales per square foot, vs. only $516 at Sam's and $411 at
BJ's Wholesale Club Inc. (BJ ), its other primary club rival. "Employees
are willing to do whatever it takes to get the job done," says Julie
Molina, a 17-year Costco worker in South San Francisco, Calif., who
makes $17.82 an hour, plus bonuses.

MANAGEMENT SAVVY. Costco's productive workforce more than offsets the
higher expense. Its labor and overhead tab, also called its selling,
general, and administrative costs (SG&A), total just 9.8% of revenue.
While Wal-Mart declines to break out Sam's SG&A, it's likely higher than
Costco's but lower than Wal-Mart's 17%. At Target (TGT ), it's 24%.
"Paying higher wages translates into more efficiency," says Costco Chief
Financial Officer Richard Galanti.

Of course, it's by no means as simple as that sounds, and management has
to hustle to make the high-wage strategy work. It's constantly looking
for ways to repackage goods into bulk items, which reduces labor, speeds
up Costco's just-in-time inventory and distribution system, and boosts
sales per square foot. Costco is also savvier than Sam's and BJ's about
catering to small shop owners and more affluent customers, who are more
likely to buy in bulk and purchase higher-margin goods. Neither rival
has been able to match Costco's innovative packaging or merchandising
mix, either. Costco was the first wholesale club to offer fresh meat,
pharmacies, and photo labs.

Wal-Mart defenders often focus on the undeniable benefits its low prices
bring consumers, while ignoring the damage it does to U.S. wages. Costco
shows that with enough smarts, companies can help consumers and workers
alike.