Photograph by Spencer Lowell for Fortune
Inside Costco: The Magic in the Warehouse
Culture is its edge—but even a phenomenal company faces threats.
You would never guess by looking at it that the eerily quiet, nondescript beige-and-redbrick office complex in the bucolic Seattle suburb of Issaquah, at the foot of a small mountain range called the Issaquah Alps, would be the nerve center of one of America's corporate behemoths. The security guard doesn't just wave you through; she takes time to chat with you. The reception desk has a plate of cookies, and the receptionists encourage you to take one. There is no bustle, only a sense of calm, which is especially striking, since this is the sort of week that would typically engender corporate jitters.
It's the week when Costco Wholesale, the world's third-largest retailer, with $116 billion in sales in fiscal 2016, is hosting a triple-header: its monthly budget meetings, with managers flying in from all over the world; its board of directors' meeting; and, at week's end, its annual stockholders' meeting. As the tribes gathered, Costco faced some headwinds. In a sector known for thin profit margins, there was always the threat of intensifying competition, especially from e-commerce retailers like Amazon. There was the challenge of attracting millennials. There were weakening sales at Costco's overseas stores due in part to currency fluctuations. There was the pending transition from a Costco-branded American Express credit card to a Visa card, which would turn out to be a logistical nightmare.
But none of these issues seemed to faze Costco's leaders. They know that their big-box stores make the company appear to be a tortoise in a hare's digital world. Still, they're confident they will win the race. Costco always has. But there was one thing they have been mulling for a long time. And it has nothing to do with economics, at least not directly. It has to do with identity.
Costco acts more like a cheerful cult than a hard-driving business. Its executives are proud of the fact that the company promotes almost exclusively from within. Even CEO Craig Jelinek, 62, plainspoken and without affectation, once collected shopping carts at a Costco predecessor, and 98% of the company's store managers have risen through the ranks. Its top executives have been working together for 30 years, more or less, which makes them family as much as colleagues. It also means there are a lot of gray heads now at those budget meetings.
And therein lies the concern. At that month's meetings, there were warm and wistful send-offs for six of those gray heads, all senior vice presidents, now retiring. And even though they would be replaced by younger Costco lifers, the succession raises a question: As the company approaches its 35th anniversary, will the replacements keep Costco as Costco?
At Costco that isn't just a question. It is the question. Lots of companies brag about their culture. But few are as proud of it or as dependent upon it as Costco is. Morgan Stanley retail analyst Simeon Gutman calls it a "super-culture," which he describes as, "If we continue to serve and delight our customers, they'll want to keep coming back."
Costco is a retailing colossus. Its worldwide sales trail only those of Walmart, which has 11,528 stores to Costco's 715, and Amazon, which just climbed into second place. Costco is the world's largest seller of choice and prime beef, organic foods, rotisserie chicken, and wine (!), and it moves more nuts than Planters. Its private label, Kirkland Signature, which sells everything from packaged goods and beverages to apparel, generates more revenues than the Coca-Cola Co.
But Costco, big as it is, prides itself on not being your typical multibillion-dollar company. That is where the culture comes in. Executives frequently answer their own phones. ("I may get a call from a cashier," admits CEO Jelinek, "who says, 'I'm not getting enough hours.' ") Its offices are open door. And it takes a journalist forever to arrange a visit, not because the company is secretive, but because it doesn't feel the need to have a public relations department to make arrangements.
Then there is the way it treats its employees. Costco pays them well—an average wage of $22 per hour, vs. $13.38 at Walmart—and provides generous benefits like full health and dental insurance even to its part-time employees; a 401(k) with stock options after a year; and liberal vacation time and family leave. Zeynep Ton, an adjunct associate professor at MIT's Sloan School of Management, says Costco employees are given greater responsibilities too, which makes them a happy and highly motivated workforce. "They are constantly innovating, constantly improving, and that's why Costco can pay them a lot," says Ton.
"People will bang down a door to come to work for Costco," says Craig Wilson, vice president of quality assurance and food safety, and an 18-year Costco veteran. And once there, just about no one leaves. The company's retention rate for employees who have been there a year is 94%. "You couldn't throw enough money at me to make me leave this company," says Paul Latham, VP of membership, marketing, and Costco Services, with 37 years under his belt. "I love it." And if nobody leaves, almost nobody gets fired either. When the recession hit and most companies were laying off employees, Costco's brain trust didn't let anyone go. "It wasn't even something that we thought about," Jelinek says. Instead, the company actually raised wages.
Claudine Adamo is one of those employees. And she is Costco's future. When Adamo, now 46, graduated from Western Washington University, where she majored in finance marketing, she applied to Costco because her two older sisters were working in the company's accounting department. Her initial dream was dashed when, hoping to land at headquarters, she was told that everyone at Costco starts in the warehouse, which is what the company calls its capacious stores. Adamo swallowed her pride and went to Kirkland, where she greeted members and checked receipts. "My friends thought I was crazy," she says.
Now, 25 years later, she is being groomed for the next executive cohort, which will one day replace Jelinek and his team, even as she and her fellow VPs are already identifying candidates for the cohort after her own. In many ways, her story is typical of Costco's leadership.
Adamo has spent her entire career at the company. After a year at the warehouse, she became an inventory-control specialist doling out candy to warehouses in the northwest region. Her company voyage continued: assistant buyer for candy, buyer for the company's mail-order operation (which morphed into Costco.com), computer buyer for all the warehouses, general merchandise manager to open a regional office in Southern California. Adamo then returned to Seattle as VP of the home division for furniture, small appliances, and housewares. She is now VP of consumer electronics, jewelry, and office.
It has been a long journey, but the journey is the reason she believes Costco won't succumb to the lure of the next trendy idea. "At Costco, you really start at the bottom, work your way through every position, learning along the way," as she puts it, "growing up within the environment."
Just about every executive has grown up that way, including CEO Jelinek. "I know what it's like to shag carts," he says. "I know what it's like to clean bathrooms. I can come in and tell you where you missed the tiles around the urinals. I know what it's like to cull produce or to grind beef. So when you talk to people, it's not somebody coming in off their white horse. They know you've been there and done that." Longtime CFO Richard Galanti has a term for the company's culture: "jerk-free."
To a person, everyone at Costco will tell you that its culture comes directly from Jim Sinegal, now 80, a short, grandfatherly man with a brush mustache. He was Costco's cofounder and its CEO from 1983 to 2012, and he is still a daily presence at the Issaquah headquarters. Sinegal in turn attributes his business philosophy to Sol Price, a gruff attorney who founded FedMart in 1954 in San Diego—the original warehouse store that sold in bulk, primarily to small businesses, at good value. Sinegal began working at FedMart as an 18-year-old college student and became Price's protégé, subscribing to the golden rule of business that Price drew after seeing people gouged during the Depression: Always do the right thing.
In 1983, Seattle attorney Jeffrey Brotman approached Sinegal with the idea of opening their own warehouse store. They conceived of it as more than a company. It was a mission—as much a way of doing business as a business itself. "Do the right thing" was and still is the company mantra. It may sound corny—or like an empty slogan—but employees really try to live up to it. (Adamo says she hears the phrase every day.)
It means never trying to gouge vendors or customers or employees. It means facing up to mistakes and making them right without being forced to do so or making excuses. (When they discovered that a shirt they had advertised as 100% silk wasn't actually silk, they contacted each purchaser and refunded the money.) It even means maintaining a return policy without restrictions, though they know it's abused by some customers. "I always thought I was pretty good and honest and reputable, and I do think I am," CFO Galanti says. "But then you meet Jim, and you go, 'Whoa!' " As Sinegal puts it, "Culture is not the most important thing. It's the only thing."
Though the moral imperative was stern, Sinegal's management style was anything but. He created an informal, unintimidating environment in which no one was afraid of making mistakes and no one was jockeying for position. Egalitarianism permeated everything, from Sinegal, and now Jelinek, taking a substantially lower salary than most other corporate executives of their standing ("I make more than I'll ever spend," says Jelinek, who earns a base salary of just under $700,000) to assigning parking spaces on the basis of seniority, not hierarchy.
Costco, says Zeynep Ton, has a "laser focus on creating value for the customer," and its operating system is dedicated to benefiting customers, not investors. "You look at a traditional retailer, and he'll say, 'I'm getting $29 for this item,' " says Sinegal. " 'I'd like to get $35 for it.' We look at it and say, 'I'm getting $90 for it. I'd like to get it down to $18 or $17.' And that's got to be the MO of running your business. You have to constantly think, How can we bring goods and services to market at a lower price?" Sure, he says, people like the fact that Costco pays its employees well. "But," he jokes, "if we raised the prices a little bit, I think they could get past that."
Costco is a lean company. The company's spending on basic overhead—the selling, general, and administrative category—is only 10% of revenues, compared, for example, with about 20% at Walmart. Among Costco's efficiencies are the fact that it doesn't advertise; it has a limited selection—only 3,700 products compared with 140,000 at a Walmart superstore and half a billion at Amazon. That allows Costco to drive hard bargains with suppliers. And it has created a distribution system that, according to Galanti, fills 95% of its freight capacity, an unheard-of number.
Costco has to be lean because Brotman and Sinegal long ago established a rule that no branded item could be marked up more than 14% and no Kirkland Signature item more than 15% over cost. It is an inviolate line: the very value proposition of the company. (Prices are partly offset by a $55-a-year membership fee, which customers pay for the privilege of shopping there and which constitutes 3% of Costco's profits.) As it has worked out, given the very low profit margins on items like gasoline and ground beef, the average markup at Costco is 11%, which compares with markups of nearly 24% at Walmart, 30% at supermarkets, and 35% at Home Depot and Lowe's.
Costco is determined not to let any store undersell it. "We look at anyone who beats our price," says Nancy Griese, VP of corporate food and sundries, and Costco will change its price to compete "by sundown." Still, Costco will never sell at a loss.
Sinegal had one other inviolate value proposition: Inexpensive couldn't mean cheap, because he knew Costco would lose customers that way. "Quality, quality, quality," says Doug Schutt, Costco's chief operating officer of merchandise. "Our biggest challenge is making sure the quality is what we say it is." Costco has a stringent quality-assurance program to test everything from the size of cashews to the amount of skin left on canned peaches. After the E. coli outbreak at Jack-in-the-Box in 1993, Costco was so concerned about its suppliers of ground beef that it built its own beef-processing plant, where the meat is tested every 15 minutes. Now it has even started a pilot project in Nebraska of its own cattle herd.
Costco profit margins are a whisper-thin 2%—a figure that has caused grumbling on Wall Street in the past. Most retailers, needless to say, aim to expand margins. "Our culture is counterintuitive," says Richard Liebenson, who came to Costco from Price Club and is now a member of the board, "paying people the highest wages possible and the best benefits in a business where you're working on a very low margin and you're trying to sell merchandise for as little as you can." But that's because Sinegal always felt if you satisfied customers and employees, you would eventually satisfy investors too.
Nowadays, Wall Street is nearly as smitten with Costco as its 81 million members are. Michael Lasser, a retail analyst at UBS, says it is a matter of the company being true to its founding principles: "delivering high-quality products at very value-oriented prices and being fair and treating its customers and employees with respect." And, he adds, Costco doesn't have to rethink itself to compete with hares like Amazon. "Costco's model remains as relevant today as it was 20 years ago," Lasser says, "and we don't think that is really going to change."
Change is usually considered a business necessity, but not in Issaquah. Costco executives occasionally invoke Sears as a cautionary tale of a company that was once great and then lost its sense of identity—basically, its culture.
Costco is determined not to let that happen. "The business will evolve," says Jelinek. "You'll make changes. Where they won't be able to change is how you treat people, how you engage people, how you include people. That can't change." Resisting change isn't easy. That topic tends to lead to talk about e-commerce, which Costco has been slow to adopt. For example, rival Sam's Club allows customers to order online, then pick up the order at the store without getting out of their cars. Costco does not offer such a service other than at its pharmacy. For its part, Walmart upped its online-selling arsenal, to better keep up with Amazon, with its purchase of e-commerce site Jet.com. But neither Costco nor Wall Street seems to think the acquisition poses a threat. Costco has its membership fees, and members seem to enjoy the physical shopping experience. Indeed, they've increased their visits from once every 3½ weeks just a few years ago to once every week now.
Galanti addressed Costco's e-commerce issues in some detail on a recent earnings call: "We recognize our site has had some challenges," he told analysts. "You're going to see in the next few months a big improvement in the number of clicks [needed to place an order]. You're going to see in the next six or eight months some big improvement on search." Galanti added, "We've never been big on convenience. Our success has been based on price and value, quality and quantity at the lowest possible price. We do appreciate that value also is convenience. We're going to greatly improve what we do. But it doesn't mean we're going to get something to you in two hours."
Still, if you think Costco should be emulating Amazon, consider this: Jeff Bezos's company has adopted Costco's membership model with Amazon Prime, as one analyst noted to me, rather than Costco adopting Amazon's e-commerce model. Ton even thinks that because Costco has such a well-trained workforce, it may actually be more adaptable in serving customers than e-commerce companies are. Even millennials, who, you might assume, would prefer shopping via their phones, are coming onboard. They're Costco's fastest-growing demographic. Overall, the company's membership is getting younger.
It isn't the millennials outside the company who are the issue; it is the ones in it. Wall Street remains bullish, but analysts have some concerns that Costco might age out of itself. "I think these transcendent cultures probably move from generation to generation," says Morgan Stanley's Gutman, "but we don't have a lot of examples because most retailers are relatively young. We haven't seen a retailer where this generation is going to be exiting at their peak," which is what is beginning to happen at Costco. "So I do worry when a changing of the guard happens."
When he retired, Sinegal finessed the problem by tapping Jelinek, then the company president. Jelinek says he is already planning for his own succession, though no one thinks it is imminent. He says the company has a 10-year plan for executive replacements. Before he left, Sinegal had already instituted a program in which he invited rising executives to "get to know each other," says Claudine Adamo, and Jelinek has continued it.
UBS's Lasser is reassured. "They have a very strong bench," he says, and in any case "the culture isn't based on a single person." Despite that, there is no guarantee successors will permanently resist the temptation to turn Costco into a cooler, faster, different company. "The people who are coming up underneath—do they know the culture as well? Were they born into it? Was it the only job they ever had?" asks board member Liebenson. Those are pressing questions.
Adamo's career answers all of them in the affirmative and adds one more fillip. "When it comes down to the extreme core of what we do," she says, "it truly is that you get not only to do the right thing at work, but it goes to all aspects of your life."
And that is why Costco is likely to remain Costco for a long time to come. It has taken decades to inculcate a philosophy that is now more fiercely held than ever—and it will likely take decades more, and events that are currently unforeseeable, to weaken it.
A version of this article appears in the December 15, 2016 issue of Fortune with the headline "The Magic in the Warehouse."
Correction: An earlier version of this article misidentified the investment bank that employs Simeon Gutman.