In 2015, author and consultant Stan Slap published the following interview with Costco’s Jim Sinegal and Craig Jelinek on how the company’s approach to employee compensation started.
Slap writes in Under The Hood (all bold emphasis added):
But what was the genesis of the decision to approach performance reinforcement this way? Was it the right thing to do, or simply the right thing to do for the business? I asked Costco co-founder Jim Sinegal and CEO/President Craig Jelinek how the approach originated. And what it means to them professionally and personally.
JIM: It was a business decision when we first started. We knew we were going to get a lot of skepticism, because we’re a crazy business—forklifts running around, stuff stacked up to the ceiling, cement floors. We didn’t want our customers to think, They’re probably making money off the backs of their employees.
Today people are seventy cents of every dollar that we spend to run this business . . . and Craig is spending a lot. (Laughing)
CRAIG: Thanks, that’s hysterical. (Laughing)
JIM: Any company had better pick some aspect of its business to be good at. Getting productivity is so important to us. If you buy the promise that Costco is the low-cost provider of goods, and we’re paying the highest wages and making a profit, we must be getting better productivity.
CRAIG: You can measure this directly in our business.
JIM: An analyst at one time wrote a big, catchy headline, saying that it’s better to be a Costco employee or customer than it is to be a shareholder. But if you look at our business, like Craig says, you can measure the impact of how we run it. We went public in 1985. In the twenty-nine years since, we have grown our sales at a compounded rate of about 13.8 percent and profits at a 13.3 percent compounded rate. Our stock value, market value, has grown at a 16.9 percent compounded rate. As we’ve told the shareholders, it isn’t getting any better.
JIM: In 2003, our stock took a huge hit. I was shaving that morning when the news broke, so thank God I’m still alive. It wasn’t about our performance; we were using a company that, in error, didn’t fax all of our detailed reports to everyone, so it looked like a selective release of information.Our employees were very upset and wanted to know if we were okay, if they were okay. Our response was immediate: We put our arms around them.
CRAIG: In 2008, we were holding a meeting of our seventeen-person executive committee right after the meltdown of the economy, when things were really horrible. We just happened to be redoing our culture’s employment agreements at the time. Every single person in that room said, We have to give the employees an increase.
JIM: True. There wasn’t anyone who said, Listen, they’re going to have jobs, they’re already the highest-paid employees in retail, and everybody else is going to be adjusting wages downward. Not anyone. That’s how deeply imbedded the culture is as a priority in our company.
CRAIG: I watch this all of the time, in every country we do business in. My attitude is, we don’t want to just be better than every other retailer in Mexico, as an example. We want to be Costco in Mexico. That means we pay thirty percent to forty percent more than any other retailer in the country. And I know some say, Hey, you don’t have to do it. But we want our entire employee culture to understand that we’re not going to try to lower wages every time we get the chance.
CRAIG: I’m big on respecting people. What it gets down to is that you have to build trust with your employee culture by trusting it. If you build the trust, then you build the people, and good things are going to happen.
It’s been very successful for us.
JIM: To answer your question, Stan, we feel that we have a responsibility to make sure that our employee culture feels secure. That it can sleep at night.
Fulfilling this responsibility is how I sleep at night.
To be clear, Costco’s strategy around its employee compensation interlocks with every other element of its business strategy. The retailer guarantees every day low prices — and in fact has a rule that they never mark products up by more than 14% (it is allowed to mark up products in their Kirkland Signature house brand by 1% more: 15%). These are accompanied by company ‘legends’; in a talk Jim Sinegal gave to a class taught by MIT Sloan business school professor Zeynep Ton:
To protect low prices, Costco has in place what organizational psychologists call “commitment devices” that deliberately limit what it can do in the future. There is a rule for not marking up any branded item by more than 14% and any Kirkland item by more than 15%. Customers’ willingness to pay is irrelevant. Sinegal tells the story of selling Calvin Klein jeans for $29.99 that others were pricing at $50 or more. When Costco buyers were able to get a shipment at a much lower price, the company cut the price to $22.99. “I didn’t have to go to the buyer to lower the price,” Sinegal told my students. “They did it automatically because that’s what we do … Do you know how tempting that is, if you got 500,000 pairs of jeans, and you know you can make seven bucks a pair on them? Well, once you do, that’s like taking heroin. You can’t stop. It becomes addictive and then you’ve changed your business plan totally.”
Prices aren’t just about markup, though, and Costco also has stories built-into its culture to keep product variety low. Ton continues (emphasis added):
Costco also doesn’t add more products even if doing so might help grow sales because of the connections between complexity, work, and competitiveness. Its leaders even have a term for it: intelligent loss of sales. Sinegal told my students how Costco almost killed off its private label Kirkland shirts when it added slim-fit shirts. The increased variety made it harder to predict demand and manage inventory. It reduced labor productivity. If standard shirts are acceptable to most members, losing the customer who doesn’t buy the standard fit is an intelligent loss of sales.
These everyday low prices attract plenty of customers, who have to pay a $65 annual membership fee (in 2024) to shop at Costco. In fact the bulk of Costco’s operating profits come from these membership fees, which is nearly pure margin. In 2023, the fees from its 129m members netted $4.6bn, which was slightly above half of Costco’s operating profits.
A 2024 Economist article lays out the rest of the business model:
Costco is the world’s third-biggest retailer, behind Walmart and Amazon. Though its sales are less than half of Walmart’s, its return on capital, at nearly 20%, is more than twice as high. Charlie Munger, a famed investor who served on Costco’s board from 1997 until his death last year, called it a “perfect damn company”. [Former Costco CFO] Mr [Richard] Galanti, who describes Costco’s business model as “arrogantly simple”, says the company is guided by a simple idea—hook shoppers by offering high-quality products at the lowest prices. It does this by keeping markups low while charging a fixed membership fee and stocking fewer distinct products, all while treating its employees generously.
(…) Joe Feldman, an analyst at Telsey Advisory Group, a research firm, argues that the membership model creates a virtuous circle. The more members the company has, the greater its buying power, leading to better deals with suppliers, most of which are then passed on to its members. The fee also encourages customers to focus their spending at Costco, rather than shopping around. That seems to work; membership-renewal rates are upwards of 90%.
Next, consider the way the company manages its product lineup. Costco stores stock a limited selection of about 3,800 distinct items. Sam’s Club, Walmart’s Costco-like competitor, carries about 7,000. A Walmart superstore has around 120,000. Buying more from fewer suppliers gives the company even greater bargaining heft, lowering prices further. By limiting its range, Costco can better focus on maintaining quality. Less variety in stores helps it use space more efficiently: its sales per square foot are three times that of Walmart. And with fewer products, Costco turns over its wares almost twice as fast as usual for retailers, meaning less capital gets tied up in inventory. It has also expanded its own brand, Kirkland Signature, which now accounts for over a quarter of its sales, well above average for a retailer. Its margins on its own-brand products are about six percentage points higher than for brands such as Hershey or Kellogg’s.
Costco also uses its considerable size to negotiate with suppliers, getting them to produce Costco-only products at larger sizes. This has the triple benefit of a) increasing order check size, which results in higher absolute dollar free cash flow for Costco, but also b) benefits customers, which pay less per unit volume. Finally, bulk sizes c) cuts pilferage, since bulkier items are harder to steal.
Costco’s labour strategy fits neatly into this tapestry of decisions: because it pays higher wages than its competitors, it is able to recruit from a higher quality talent pool. (These employees are, in turn, less likely to steal — which is always a major consideration for retailers). Costco provides far better customer service compared to other retailers, and suffers less than 8% employee turnover globally, compared to an industry average of around 60%. Its leaders care about its employees. In return, the company is rewarded with excellent employees, and the company makes it a point to promote from within.
Ton writes that Costco goes one step further. It signals to its employee base that employee development is paramount, since it unit manager availability bottlenecks company expansion. Ton writes (all emphasis added):
In 2020, when analysts pushed Richard Galanti, the CFO of Costco, on why Costco doesn’t open more units when there are so many opportunities (by 2024, Costco only had 871 stores — which it calls “warehouses” — worldwide, including in Japan, South Korea, Mexico, and Australia), Galanti responded that Costco’s hands-on model requires it to grow more slowly. Its leaders felt good about the pace and felt no urge to mess with it.
Costco’s hands-on model requires seeing the connections between strong warehouse managers, competitiveness, and financial performance. Unit managers — those who run a single factory, store, hospital, call center, or hotel — are arguably a multi-unit organization’s most important employees. (…)
Strong warehouse managers are critical for Costco’s success. In fact, Sinegal told my students that if he were to visit Costco in 20 years, he would judge the success of Costco by the quality of its warehouse managers. The managers are almost all promoted from within. They feel ownership of their performance and take pride in developing people. Developing those strong managers requires time and learning by doing. It doesn’t happen because of a two-week training program. So, since its early days, the growth rate at Costco has been determined by the availability of strong managers. Anytime its leaders looked at a new market, the first question they asked was, “Who do we have to manage these places? What’s our talent pipeline?”
The Economist article closes with the following note:
The late Mr Munger was confident that Costco had “a marvellous future”. Its customers could be enjoying $1.50 hot dogs for many years to come.