Risk 1: Increase in production cost
Costco has a supplier diversification strategy for its supply chain management area of operations management. However, the company’s supply chain management is focused on quality and low prices which is in line with the Company’s mission. If the production cost increases, Costco may have to supply items at a lower quantity to be able to sell the products at a given price.
Risk Event: Trade War
The Trade War has affected many states in the US mainly because it has become more expensive to import goods from China which results in some economic factors such as increase unemployment and interest rate in the US and decrease in consumer confidence index.
The Trade War is expected to affect Costco’s production cost significantly since Costco imports manufactured goods from China. Based on Costco’s analysis, if the 25% tariffs go into effect this year on two segments, travel goods and furniture, consumers would have to pay $6 billion more nationwide. Moreover, the plan to levy tariff of 300 billion worth of goods like footwear, apparel and electronics can cause Costco higher production cost since that’s mostly where the majority of consumer spending is.
Although Costco’s main source of revenue is its membership, the members will then buy Costco’s goods in bulk at the best price. This will in turn affect Costco’s production cost as they will rely on their suppliers.
However, Costco still sees strength in patio furniture even with certain tariff price increases. Trade war could also result in an increase of Producer Price Index [PPI].
Key Risk Indicators: Producer Price Index [PPI] and Consumer Price Index [CPI]
The Producer Price Index measures the average changes in prices received by domestic producers for their output. Its importance is being undermined by the steady decline in manufactured goods as a share of spending.
In this case, the Producer Price Index triggers the Consumer Price Index to go up. This causes product prices to increase, demand to decrease which in turn decline the profit. s.
If selling price is not increased, demand will be the same, profit margin decrease s.
Risk Response:
Before deciding if Costco should continue to import goods made from China, Costco can use the key risk indicators that would determine if rise in production costs would affect its profit margin.
If production cost continues to increase to the extent that it affects Costco’s budget, if any; since Costco focuses on lower cost but high quality, Costco can choose to import similar manufactured goods of different brands from diverse range of countries that have lower or no tariffs or the ones that are cost-efficient for the company.
Risk 2: Decreased profit due to exchange rate loss
Risk Event: Strengthening of US Dollar
As a multinational corporation, the strength of the USD, domestic currency of Costco, could adverse the profitability of the company.
Although Costco is a major wholesaler, the strength of the USD may not affect the cost of their product as more than a third of their product sales come from their private label, Kirkland Signatures as well as most of the others being major US retail brands. Their private labels may be sourced from places outside of the US, but Costco could leverage on the volume of import to negotiate lower prices as well as choosing to import from markets with weaker currencies.
Despite Costco being able to circumvent high product costs, as it is a variable cost, Costco is not able to control their profit loss due to exchange rates easily, as it is a fixed income from their overseas operations. With Canada alone attributing to 35% of operating income and having more than 30% of its store overseas as well as their plan for rapid expansion in their international operations to achieve a 50/50 split of domestic and international sales, Costco has to make sure they can predict future market volatility to be well prepared to overcome profit loss.
As the 2019-nCOV hit the Asia-Pacific Market which makes up 8.54% and Brexit which will affect the UK Market which makes up 3.7%, these currencies could weaken against the US dollar. With the stronger than expected US economy in 2019 and optimistic economic growth in the US which is in addition to the phase one US trade deal and the Fed appearing to be likely to stay hold, the USD could further appreciate against all the other currencies.
Key Risk Indicator: Simple Cross-Section Regression Crisis Index
The main key risk indicator Costco can use to analyse future market volatility is using the Simple Cross-Section Regression Analysis.
The indicator is most constructive to serve as an early indicator for a currency crisis when the timing of the currency crisis is largely unpredictable. During a predictable currency fluctuation such as the US-China trade war, it is most straight-forward for companies to predict future currency trends, however, what is unfavourable is when the company is being caught off guard. Therefore, this indicator would serve an effective purpose.
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As Costco serves mainly in the US-Canada-Mexico and the East Asian & Pacific Market. An examination of cross-section data of markets which includes US, Canada, Mexico, China, EU, Japan - key economies of the US-Canada-Mexico market and Indonesia, South Korea, Taiwan, Vietnam, Hong Kong, India, Thailand, Singapore and Malaysia - key economies in the East Asian & Pacfic Market could indicate the future volatility of the market’s that Costco operates in.
Comparing the past 5 years of data to the preceding 5 years of the weighted average of these 3 factors:
Growth in credit in credit to the private sector
Percentage of real appreciation in exchange rate of the past five years compared to the preceding 5 years
Level of international reserves relative to the M2
This shows the overvaluation of real exchange rate, weak banking system and low reserves, which is the perfect formula for a disaster.
With at least 21% variance of the data of both sets, it could indicate a currency crisis of the currencies that will affect Costco’s profitability. (Sachs et al., 1996)
Risk Response:
Upon maturity or expiration of previous hedging tools, Costco should use their Key Risk Indicators to estimate the future exchange rate fluctuation as well as the current position of exchange rates. Early in 2015, as the company rose it’s membership fees by 2.2% amid a 1% fall in sales, Costco’s share price has dipped by nearly 12%. Costco has attributed its performance decline to it's the weakened profits from overseas operations amid the rising dollar. Therefore, for possible future foreign exchange translation losses, Costco should devise a more comprehensive hedging strategy by using tools such as forwards and options. A forward could be used when the US market is doing well and the USD is strong against other currencies, or when other markets, especially Canada, Europe and the expanding Asian market are weak. However, if the US market is currently gloomy, or when there is sign of a currency crisis, as indicated by the KRI, Costco can use options as a hedging tool against a declining USD or/and a potentially appreciating USD as well as in times of uncertainty.
- https://www.seattletimes.com/business/retail/costco-blames-disappointing-earnings-on-strong-dollar-other-one-time-issues/
- https://www.businessinsider.com/costco-has-a-massive-overseas-expansion-plan-2015-7?IR=T
- https://www.quora.com/Is-Costcos-Kirkland-Signature-brand-really-just-repackaged-brand-name-products
- https://www.wsj.com/articles/how-kirkland-signature-became-one-of-costcos-biggest-success-stories-1505041202
Risk 3: Decline in Costco’s members
Risk Event: Recession
Membership loyalty and growth are essential to Costco’s business. The extent to which they achieve growth in their membership base and sustain high renewal rates significantly impacts their profitability.
A recession arises when there is a marked decrease in consumer and business spending and this includes less demand for Costco’s membership and goods, leading to a drop in membership renewals and gross margin. Costco’s income from membership comprised 17% of their overall revenue in 2019.
When a recession occurs, general economic factors such as levels of unemployment, GDP growth, and reduced consumer confidence would have an adverse impact on the demand for their goods and services. Consumers and businesses alike could lose their membership in order to cut cost, going for other cheap alternatives such as Amazon where memberships are not required.
Due to Costco’s business model, which requires customers to pay for a membership card to shop at their warehouses, a decline in membership would similarly result in a decline in their sales revenue.
With the possibility of an oncoming recession, Costco’s could lose their increasing trend of memberships, and see a decline in their overall sales as well.
Key risk indicator:
The main key risk indicator the company should observe is the USA treasury yield curves. The company should be aware of when the Us yield curves become inverted as they are a closely monitored indicator for an oncoming recession. When the yield curves are inverted, it means that shorter-dated yields have become higher than longer-dated ones, implying a weaker growth in the future. It is a classic signal of a looming recession and has accurately predicted past recessions.
Risk response:
Before the onset of a recession, Costco should use Key risk indicators to estimate its arrival to restructure and cut costs before its impact. Early in the 2008 financial crisis, Costco had a forward-looking strategy of cutting costs in various areas. Costco had shifted from hard goods to more consumer staples and non-perishable goods to reduce inventory costs, limited the number of variations of goods in each category, especially branded products, in order to get bigger wholesale discounts, reducing its average Storage-keeping unit to 3,700. (A storage-keeping unit is a distinct type of item for sale)
For possible future recessions, the company should continue to effectively cut costs and be forward-looking in cutting costs through the investment in newer technologies such as digitizing its in-store experience. One effective way the company can reduce cost is to adopt Kroger’s digital price tags which digitally displays pricing and nutritional information, allowing the store to instantly and remotely update it. This tech runs on renewable energy, allowing Costco to effectively cut energy costs while improving customer in-store experience. Additionally, its environmentally-friendly nature could prove an added benefit to attract more customers.
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