“Because It’s the Right Thing to Do.”

A veteran CFO discusses the finer points of bottle design and why paying higher wages makes sense. An interview with Richard Galanti, EVP and CFO of Costco Wholesale Corp.

In 1984, Richard Galanti was a young investment banker at Donaldson, Lufkin & Jenrette when a Seattle-area start-up retailer invited him to become its vice president of finance. He is now starting his 27th year as finance chief of Costco Wholesale Corp., which has become the nation’s third-largest retailer, with fiscal 2009 revenues of $71.4 billion. Costco is a warehouse club; some 55 million people pay an annual fee to shop at its 566 locations in the United States and abroad. They buy goods, frequently in bulk, ranging from apparel and appliances to food, electronics, jewelry, and more.

But Galanti, who turns 54 in March, isn’t the only old-timer at Costco. Co-founders Jim Sinegal and Jeff Brotman, for example, are still at the helm as CEO and chairman, respectively. Indeed, turnover is generally low among Costco’s 147,000 employees. That’s because the company’s compensation and benefits are far more generous than those of its main rivals, Sam’s Club and BJ’s Wholesale Club. Costco’s shoppers are loyal, too: the member renewal rate in 2009 was 87%. (That loyalty pays dividends: in 2009, membership fees contributed just 2% of total revenue but 86% of operating income.)

Thanks to Costco’s concern for the welfare of its employees — and, increasingly, for the health of the environment — many people regard the company as the good guys of retail. Is Costco too good to be true? We recently talked with CFO Galanti to find out.

In December Costco reported growth in same-store sales for the first quarter of its fiscal year. How did the business hold up during the recession?

There were two questions for us at the beginning of the downturn. One, were customers still willing to pay a fee to shop? Two, would they still come to Costco, which is a little farther away from the local supermarket, discount store, or drugstore? In fact, the one thing that increased dramatically over the last 12 or 14 months was the frequency of shoppers. Were people spending less? Yes. Were they more discriminating in terms of what they were buying? Yes. Were categories like jewelry, home furnishings, and bigger-ticket discretionary items the weakest? Absolutely. But whatever the level of sales decline, it was less than it was for traditional retailers. As apparel stores at the mall were down 10%, 20%, and 30%, we were down 5%. As jewelry chains were down 20%, 30%, or 40%, we were down 10% and 15%.

Given that success, do you plan to expand from your current 40-state base?

Yes, but I doubt if we will ever be in all 50 states, at least not in the next five years. First of all, there are three players in our industry. While there are many cities around the country where there are two or three players and we profitably coexist, it’s always good to be first, because once the second guy comes in, customers may say, “I’ve already joined one of those clubs and I don’t need another one.” There are some states that are smaller, where if somebody else is already there, there’s not a whole lot of opportunity left. We’re not rushing to go to Arkansas, where Wal-Mart is headquartered.

That being said, we think there are still a lot of possibilities to increase penetration in many of the markets that we’re in, and we will probably be in two or three more states over the next few years.

Costco has been referred to as “the anti-Wal-Mart” because it pays its employees more and offers more-generous benefits. But Wall Street has grumbled about this.

Years ago, when we stubbed our toe and announced that we were going to miss earnings for a quarter, an analyst put out a report on Costco with the subtitle, “It’s better to be an employee or a customer than a shareholder.” [Laughs]

Wal-Mart is a great company and gets picked on more than it deserves. Certainly it has a lower wage structure and lower benefits, but that’s improved some. We have a different [business] model. It’s based on high volume, catering to businesses and more-affluent customers. We’ve figured out an efficient way that we can pay our people more and still drive down expenses as a percent of sales.

What is Costco’s hourly wage?

Our average hourly wage in the United States is a little over $19 an hour. Our lowest starting wage in the U.S. is $11. If you’re a full-timer, you hit the top of the scale by the end of your fifth year.

Why do you pay your workers so much?

Because it’s the right thing to do. I think our philosophy started at FedMart and Price Co., where many of our original people came from, under Sol Price, who just passed away. It was about providing a living wage. If you provide a living wage and affordable, quality health care, you’ll get the best employees, which in the long term makes business sense as well.

Speaking of what does or doesn’t make business sense, last year Costco issued its first formal sustainability report. It also won the “Sustainable Grocer of 2009″ award. Do you make money from sustainability initiatives?

Sustainability is profitable in many cases. Take the half-liter water bottle, whether it’s Kirkland Signature [the house brand] or the national brands that we sell. Over the last year, and we’re not the only ones, we worked with manufacturers to take about 12 grams of resin out of each bottle. That eliminated about 17 million pounds of resin a year from the system. Not only does that eliminate cost, it also reduces freight [because the bottles are lighter].

A couple of years ago we changed from the traditional gallon jug of milk, which is a squat plastic bottle, to a taller one that doesn’t have as much empty space at the top. By doing that we eliminated tens of thousands of pallets moved a year, and more than 500 truckloads of freight a year. All that was done in the name of sustainability, but it also creates savings that we can pass on to the customer.

Not many people have been CFO of the same company for 26 years. How has your job changed since you started out?

The functions I’m responsible for today are essentially the same ones I was responsible for on the very first day. I started with 24 people reporting to me — 12 in accounting, 11 in what was then called data processing, and one analyst. I took over HR in 1993, when Costco merged with Price Co. Today there are about 1,400 employees covering those functions, as well as investor relations and a much more formal internal-audit function.

And your retail career goes back further than that.

I grew up in a family retail business — four small grocery stores operated by four brothers, one of whom was my dad. All of the cousins had instant Saturday, holiday, and summer jobs starting at about age 12. So I brought more than just a financial background to the table when I was hired at Costco.

Aside from scale, how did the family business compare with Costco?

The family business was a traditional retailer. You used loss leaders to bring people in, and then you saw how much you could mark up other goods to get to a certain margin level. That markup was significantly higher than the markup Costco uses today. We don’t sell below cost, unless we’ve made a mistake on an item or are trying to get rid of it.

The mantra around here has always been, How can we improve the quality while lowering the price? If we can do that, we’ll sell more, which will allow us to go back and get a better discount, which will lower the price again.

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