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Sunday, July 20, 1997 - Page updated at 12:00 AM

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Costco: The Empire Built On Bargains -- Top Brands And Low Prices Have Made Costco The Nation's Seventh-Biggest Retailer. But Where Does It Get All That Great Stuff? That's What Makers Of Some Costco Merchandise Want To Know

Seattle Times Business Reporter

As shoppers pushed by with oversized grocery carts laden with giant bags of dog food and jumbo boxes of laundry detergent, Jack Martin and his assistant Joan Meadows emerged from the Costco Warehouse in South Seattle with so many gifts for their company picnic that they needed a six-wheel metal flatbed cart to carry everything out.

The $1,000 they spent on a Toshiba color television, Fantom Thunder vacuum cleaner, Coleman lantern, Gargoyles sunglasses and other prizes was only the start of their buying spree. They were to return in a few days to spend $800 more on food and drinks for Totem Ocean Trailer Express's annual employee get-together.

"We can come with a truck and load it up," said Martin, Totem's vice president for human resources.

People who shop at Costco are accustomed to buying big. They're also accustomed to finding brand-name goods at low prices, a key to the Issaquah-based chain's success and a source of complaints from some manufacturers who object to their goods being sold in Costco's stripped-down warehouses.

In just 14 years, Costco has become the 49th-largest company in the United States, the country's seventh-largest retailer and the state's second-largest sales leader, behind Boeing.

"I told Phil Condit (Boeing CEO) I was so aggravated with him," Costco Chairman Jeffrey Brotman said, recalling an encounter with the Boeing chairman at a meeting of business leaders in February. "We were going to catch him next year, and he went and bought McDonnell Douglas!"

Should Costco eclipse the aerospace behemoth, it will do so by selling industrial-sized packages of toilet paper, huge boxes of Cheerios, giant bottles of olive oil, tires and Calvin Klein jeans. Costco's $19.6 billion in sales last year trailed Boeing's $22.7 billion and outpaced Microsoft's $8.7 billion ($11.4 billion this year) and Nordstrom's $4.5 billion, according to the Fortune 500 survey of the largest companies in the United States.

With 26 million card-carrying members in North America who pay a basic $30 to $35 annual fee to shop at Costco, the company that began in a former ship's chandlery in the industrial flats of South Seattle sells to about one in every 11 people in the United States and Canada.

Customers walk away with deals on everything from lawn mowers to potted plants, and Costco walks away with big profits as well: While it makes only about 1.3 cents of profit on every dollar's worth of merchandise sold, that added up to $249 million last year.

Conspiracy accusations

With nearly 55,000 employees, Costco has 252 warehouses stretching from here to Miami and from coast to coast in Canada, and 20 more locations in Mexico, Taiwan, South Korea, England and Scotland. It has 1 million international cardholders.

Behind the chain's phenomenal growth is a tale tinged with international intrigue, courtroom drama and bare-knuckled competition among the nation's top retailers.

To admirers, Costco is a whip-smart merchant whose mission to push costs and prices down ranks among the milestones of 20th century retailing - along with the start-up of the department store and the development of the suburban shopping mall.

Detractors, however, say Costco and other warehouse clubs like it use an elaborate network of middlemen to get hold of department-store-type merchandise that manufacturers and the full-price retailers don't want sold in downscale warehouses.

Some manufacturers have accused Costco of conspiring with foreign middlemen to divert expensive bicycles, jeans and other goods meant to open up new overseas markets in places such as Russia and Poland, into Costco warehouses, a claim the company labels as ludicrous.

"Why is it that sometimes these goods go offshore at half the price that they are sold in the United States? We're not entitled to get those goods? The American consumer is not entitled to that stuff? I think so. I think so," says Jim Sinegal, Costco president and chief executive officer.

What defines Costco is value, said Sinegal - offering the highest-quality goods at the lowest-possible prices. And it will use mass buying, operational efficiencies and hard-nosed bargaining to get those prices, company officials said.

Nordstrom it's not

To understand Costco, it helps to know what it is not. It is not Nordstrom. There is no piano player in the lobby or phalanx of helpful salespeople. There are no dressing rooms, nice carpets or attractive furnishings. Many people have never heard of Costco because it doesn't advertise.

The warehouses can be as large as 135,000 square feet - almost 2 1/2 football fields - and with parking can cover up to 15 acres. Inside, there are the computers, stereos and power tools, trampolines, books, baked goods, fresh meat and produce, much of it sold in sizes that restaurants, gift shops and very large, hungry or thrifty families might want. The floors are concrete - easier to clean - and everywhere are pallets of television sets, dishwashing detergent, disposable diapers and canned goods, which have been hoisted directly onto steel racks by forklifts: Less handling means lower labor costs.

Catering to business owners and families, Costco averages $80 million a year in sales per warehouse, almost double that of competitor Sam's Club, a division of Wal-Mart with about 440 locations, including two in the Seattle area.

Despite its huge sales volume, Costco's no-frills image has hurt its chance to buy from some well-known manufacturers who refuse to sell to the retailer.

"Bongo has spent tens of millions of dollars over the past five years advertising and promoting Bongo goods in order to create and maintain a high-quality and prestigious image. . . ." Michael Caruso & Co., the California-based manufacturer of Bongo clothing for women, said in a suit pending against Costco in Los Angeles Superior Court. "The warehouse style of discount stores maintained by Price-Costco (Costco's name until earlier this year) is inimical to the kind of stores Bongo sells Bongo goods to. . . ."

The attorneys for Wisconsin-based Trek Bicycles were even blunter: "Costco is a retailer out to make a quick buck without any investment in providing quality or safety to the consumer," they said in a 1994 suit.

As a measure of what is at stake, Trek's attorney, David Brezina of Chicago, said the 1,500 mountain bikes Costco got hold of that year, meant for sale in India, represented only "three or four thousandths of 1 percent" of Costco's annual sales, but, he said, the damage to Trek's reputation from having the bikes sold without Trek being able to control the quality of assembly and service was incalculable. Costco sold the bikes for about $680, some $220 less than authorized dealers were asking.

Costco's attorney in the case, Warren Rheaume of Seattle, countered that the bikes were professionally assembled according to the same instructions Trek's authorized dealers use. Costco got the bikes through a legitimate vendor, not the company Trek asserted diverted the shipment from India. Costco declined to identify its vendor, saying it was concerned of potential retaliation against the vendor by Trek.

The legal issues are so immense that the question of when a company holding a copyright ceases to be able to control the sale of its product is now before the United States Supreme Court. The suit involves a different set of companies, but Costco has joined a friend-of-the-court brief in support of a clause in U.S. copyright law that Costco says upholds a retailer's right to freely purchase and resell goods once a copyright owner has sold the goods for the first time.

In the 1994 Trek case, U.S. District Court Judge Walter McGovern denied Trek's request for a temporary restraining order against Costco, saying he had "some serious doubt" as to whether Trek would succeed at trial on the merits of its claim.

Still, Brezina said the whole diversion picture "stinks."

"They are taking a (free) ride on Trek's advertising and they are doing it in an underhanded way," he said. "They are sneaking around. Who are they kidding?"

Costco has been sued for everything from alleged interference with contracts between manufacturers and their dealers to selling counterfeit goods. Costco's corporate counsel, Patrick Callans, said Calvin Klein twice sued Costco last year for allegedly selling poorly made Calvin Klein jeans and counterfeit Calvin Klein T-shirts.

Costco representatives went around to the country's top department stores and found the same jeans made in Mexico that Calvin Klein had said were not intended for sale in the U.S. and the same T-shirts that Calvin Klein asserted were counterfeit when sold in Costco warehouses. Legal action against Costco halted, said Callans.

"We don't have any interest in selling counterfeit goods. Our interests are aligned with the manufacturers'. We don't want to sell counterfeit goods because it's illegal. It also fits in with Jim's (Sinegal's) philosophy that you provide the best quality merchandise at the best possible price. Counterfeit goods don't fit into that philosophy," Callans said.

Among the cases still pending is the lawsuit filed earlier this year by Michael Caruso, the designer of Bongo women's wear. Caruso's attorney, Mark Brutzkus of Encino, Calif., alleged Costco diverted Bongo jeans intended for sale in Russia, Poland and Argentina to its U.S. warehouses, using "layers of middlemen between itself and Bongo, in an attempt to insulate itself from the wrongful means which it utilized, instigated and directed to unlawfully obtain the Bongo goods." Costco's wrongful sale of Bongo goods will cause Bongo "great and irreparable harm," he said.

Costco attorney Norman Levine of Los Angeles said there was "a complete absence of evidence" in Bongo's case that Costco participated in any conspiracy.

Brotman puts it emphatically.

"We will never do anything illegal. Period. End of story."

Costco executives said some manufacturers actually want their goods to be sold through Costco, though they won't say so publicly. A department store might even sell Costco some excess goods: it gets paid for the goods, plus picks up a commission from Costco for selling, said Brotman.

Some Costco goods might have different model numbers than merchandise sold in department stores. A company executive said manufacturers sometimes produce special models for Costco with more features, or assign different model numbers to distinguish the goods from those sold to competitors. Costco officials say the company's merchandise is the same as or better than goods sold in department stores.

Brotman recalled meeting the president of a company that manufactures rubber shoes. The president was angry that Costco had obtained his product.

"He said I was disturbing his distribution," Brotman said. But Brotman pointed out to the president that Costco accounted for half the manufacturer's sales. "Nobody was really selling his product. They were just diverting it to us," said Brotman. After Brotman pointed that out, the manufacturer began selling directly to Costco, he said.

Big volume, low price

For all the global maneuvering the lawsuits suggest, most of what Costco does can be seen unfolding in the lobby of its Issaquah headquarters, where manufacturers and their representatives gather each day.

On a recent morning, Jeffrey Meek and several colleagues were busily assembling a collection of outdoor furniture they were hoping Costco would agree to carry.

Meek had flown in from Rhode Island, where he is president of Rustic Natural Cedar Furniture. A sale could mean keeping his manufacturing plant running year around.

"We'd never done that kind of big-customer sale," Meek said of the hour-and-10-minute presentation to Costco buyer Deanne Witt. No question was too small. Witt wanted to know if Meek's company could package its swing set in one box instead of two. She wanted to know how quality differed between his product and a competitor's. She asked if the company could make its bench more curved for leg comfort.

It may be months before Witt completes her review and Rustic knows whether it has a deal with Costco. But the payoff could be immense.

When Costco places an order, its numbers can be staggering. For popular items like trousers or shirts, it doesn't bat an eye ordering 500,000 pieces at a time.

Judy Mullins and Mary Gustaff, co-owners of Auburn-based Brass Key, a designer and manufacturer of collectible dolls, recently received an order from Costco for 197,000 of their 16-inch porcelain dolls. Costco will sell the dolls for $17.99. Brass Key is making a similar doll for a national catalog company that will sell them for around $60 each.

The difference? The catalog company ordered only 10,000 pieces.

Unlike some stores that carry 80,000, 90,000 or 100,000 different items in all sizes, colors and brands, Costco keeps its inventory to 3,600 to 4,000 different items.

"Because we can only buy one or two items in a particular category, it is pretty simple," said Cynthia Glaser, a Costco assistant vice president. "We figure out what the top-of-the-line product is. Then we work from the bottom up in cost and see how close we can come to what the mass merchants can sell a much lower-end product for."

Take basketballs. Costco carries only one style of basketball, Spalding's NBA synthetic leather model. It sells it for $13.99, about half of what the ball sells for at some other stores.

Costco decided on the Spalding ball after cutting it open, measuring the thickness of its outside skin, measuring the depth of its pebbles and testing the strength of the butyl bladder inside, said Doug Schutt, Costco senior vice president and a former buyer for Wilson Sporting Goods.

Costco will switch brands, depending on the price it can get at any particular time. "People might come in one time and see we have Chicken of the Sea tuna," said Sinegal. "They might come in the next time and it is Starkist tuna. It's always an acceptable brand, but we are picking the best value that is available in the marketplace."

If Costco cannot find a brand-name product it can sell at a low enough price, it will seek out manufacturers to make its own private-label goods, under the name Kirkland Signature, for the Eastside city where Costco used to be headquartered.

Merger with Price Club

When Brotman and Sinegal co-founded Costco in 1983, they had in mind the so-called hypermarkets Brotman had seen in Europe - stores that sold huge volumes of food and other merchandise - and the pioneering Price Club warehouses founded by Sol Price in 1976 in San Diego. Sinegal had been an executive with Price.

"I was very sure on one thing, that the retail environment in the Northwest was completely noncompetitive," said Brotman. "I was absolutely certain that anybody who came into this market and offered high-quality products at low, good values would succeed."

But competition heightened as the warehouse concept caught on. In 1983, Wal-Mart opened its first Sam's Club warehouse in Midwest City, Okla. By the early 1990s, Price and Costco each were about half the size of Sam's. "In terms of size and buying power, there was a motivation to improve our purchasing power to better compete," said Richard Galanti, Costco's chief financial officer.

The two companies merged in 1993, but it took a couple of years to smooth operations. Costco, which dropped Price from its name earlier this year, saw its stock drop to $12.25 in early 1995. It now is trading in the $33 range.

In some ways Costco is a far cry from the dimly lit warehouse where it began on Fourth Avenue South in Seattle, with its lone hot-dog stand out front.

Costco has added food courts, pharmacies, optical departments and photo processing. It has a mail-order business. It offers health-care plans and home insurance. It has a car-buying program for its members. Its international division is looking to expand to Singapore, Malaysia, Japan and perhaps China. It has a pilot family sports center, SportsNation, in Tualatin, Ore., outside of Portland. It has opened its own gas stations and experimented with offering discount real-estate brokerage services to its members in Arizona.

Membership requirements are broad. To qualify for a business membership, applicants must own their own business or manage a nonprofit or government agency. Individual memberships are available to current or retired employees of schools, financial institutions, government agencies, approved corporations, and transportation and health care providers; and to members of licensed professions, credit unions and various associations.

The company focuses on serving small businesses, employer groups and their employees, said Ginnie Roeglin, Costco vice president of marketing. Membership fees help offset operating expenses and keep prices down. The membership qualifications and fees give customers a sense of ownership in Costco, she said.

As Costco grows, some things are unlikely to change, such as its obsession with lower costs. Don't expect Costco to adopt a tonier format any time soon. While its warehouse facades are a little nicer, to fit into local retail corridors, "We keep the insides of them pretty plain," Sinegal said.

Sinegal doesn't expect Costco to replace Nordstrom for the service it provides or local department stores and supermarkets for the variety of products they offer. Costco still faces tough competition not only from Sam's Club but also from other big chains, he said.

Does Sinegal ever have nightmares about Costco warehouses empty? Like other big-box chains when they faced bankruptcy from oversaturation?

"No. We think we are well-positioned," he said. "We don't think we've got that type of problem. . . . I think if we lose sight of what it is we are trying to do, that could happen. There is no annuity in this business. You don't have any guarantees. You're only as good as your latest act."

Copyright (c) 1997 Seattle Times Company, All Rights Reserved.

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