Costco Financial Targets for 2016

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Costco Financial Targets for 2016
PRICING STRATEGIES
(Costco Wholesale Corporation, 2014)
Pricing Constraints
Our product is a luxury, as consumers do not need a Premium Plus membership or a basic
membership at all. Nevertheless, Costco appeals to the middle class and this membership appeals to
the upper range of our market. This type of product is new among competitors, so we are able to
charge a higher price on the product. There are minor variable and fixed costs for implementing the
program, such as labour and training for variable costs and store infrastructure changes for fixed costs.
The costs of producing and marketing the product are very low, as Costco does not traditionally rely on
promotional strategies but mostly on word of mouth. One possible setback to consider is the prices of
other warehouse memberships - Sam’s Club membership ($45) (Sam’s Club, 2015) and BJ’s
membership ($50) (BJ’s Wholesale Club, 2015) are cheaper than the basic Costco membership ($55)
(Costco Wholesale, 2014), so the premium price of this new product may deter customers.
The type of market competition differs depending on which perspective is taken. If the market
perspective is of all retailers, then the competition is monopolistic competition, as there are many
grocers and other retailers who offer the same types of products as Costco. If the market perspective is
inclusive of warehouse retailers, then the competition is an oligopoly, as there are few warehouse
retailers in the US. The market can also be a monopoly, because no other warehouses or retailers offer
this type of premium membership or benefits that come with this membership. The oligopoly and
monopoly markets will allow Costco to charge a premium for the membership and still attract
customers.
Pricing Objectives
Our profit objective is to maximize current profit; revenue from memberships would increase
our total profit. Our market share objective is to increase market share by attracting customers and
fulfill their needs with the premium membership, either by taking market share from competitors or by
attracting customers that are not currently members of any other warehouse retailers.
PRICING STRATEGIES(CONT'D)
(Costco Wholesale Corporation, 2014)
Elasticity of Demand
The product has an elastic demand that is sensitive to price changes (see Appendix: A. Price
Elasticity of Demand: Calculations). The primary reason is because the product is a luxury, not a
necessity. If it is too expensive, very few consumers will purchase it. If the price is lowered by 10 or 20
dollars, there will be an increase in quantity demanded of premium memberships. The elasticity of the
premium membership can also be explained by the availability to cheaper substitutes - prospective
customers can choose to sign up for a standard Costco membership that is much cheaper, or go to
another warehouse for cheaper memberships.
Price Level and statement of Final Price
Demand oriented approaches are the most appropriate for pricing because our product is based
on customer preferences, and there are few costs associated with the product so the cost oriented
approach is not optimal. Costco already has high profit margins so a profit oriented approach is not
necessary, and no other competitor has the same type of product so a competition oriented approach is
not optimal either.
Prestige pricing is appropriate for this premium membership product. Customers looking for a
specific high quality service and who are attracted to this product’s features will buy it. The
membership’s high price signifies better service. No discounts are necessary because no other
memberships at Costco or other warehouses have promotions at any time, even for new customers.
The final price of the Premium Plus membership will be $200 per year. The high price of
the product is justified by the 4% cash back reward in comparison to the 2% reward for the $110
Executive membership, in addition to the express check out and pick up services.
Break Even Point
An estimated 2,833,333 Premium memberships need be sold in order to break-even in terms of
profit (see Appendix: B. Break-Even Analysis).
APPENDIX
(Costco Wholesale Corporation, 2014)
A. Price Elasticity of Demand: Calculation
To calculate price elasticity of demand, we will integrate information from the previous section (see
Marketing Objectives: Financial Targets) and make the following assumptions:
1. Costco memberships share the same demand curve. The benefits and differences between
business, executive, and premium memberships are not considered. This is necessary because
Costco membership prices are stable over time and a demand equation can't be derived from
one set of data points.
2. Demand for memberships is linear because price elasticity changes as price changes. When
price of membership is $55 (basic membership), minor changes in price will not affect quantity
demand of memberships compared to when prices reach a higher range (Costco, 2014).
3. Quantity demanded and prices only consider U.S. operations. By the end of 2016, Premium
memberships are expected to be available all across the United States.
4. Assume that before introduction of premium membership, 40% of Costco members will be
Executive and 60% will be Business or Gold Star members.
5. Estimate that 10% of U.S. Costco members will convert to Premium. From Market-Product Grid,
2.2% of total will be upgraded from Business membership and 7.8% will be upgraded from
Executive membership.
6. Lastly, Business and Executive memberships will remain at $55 and $110 in 2016.
First, we construct the demand equation and curve. From our predictions in Financial Targets Marketing Objectives, we use the price and quantity demanded of particular memberships from total
U.S Costco members expected in 2016, 60,800,000. Here are the following quantities and prices that
we use to find our demand curve:

35,142,400 (57.8% of total) will be paying for Business membership at $55.

19,577,600 (32.2%) will be paying for Executive membership at $110.

The remaining 6,080,000 (10%) will represent quantity demanded for premium membership.
This membership has an undecided price, which we extrapolate from the base demand curve to
estimate.
Expected Number Of
Members in 2016 (Quantity
Demanded, Q)
% of Total*
60% - 2.2% =
35,142,400
57.8%
40% - 7.8% =
19,577,600
32.2%
Business
Membership
Executive
Membership
Premium
Membership
Total U.S Costco
Members
6,080,000
10%
60,800,000
100%
*Difference between
percentages from
Assumptions 4 and 5
Price (P)
**Current prices for
$55** Costco membership
assumed to not
$110** change from
To be Extrapolated Assumption 6
from Demand Curve
Figure 2: Table for Price and Quantity values used to make Demand Curve
Figure 3: Price Demand Curve Prediction for Costco Memberships using assumptions
A linear demand curve is denoted by P = a - bQ. From Figure 3 above, we get our demand equation
P = -0.0051Q + 233.59 where Q = 6,080, we get P = $202.58 or rounded to $200 which we will use as
our Premium membership price. From there:

We rearrange the equation:

Find the Derivative:

Use the formula for Price Elasticity:

Elasticity for Basic membership:
Demand for membership at $55 is inelastic and change in price will not significantly
affect quantity of demand.

Elasticity for Executive membership
Price for Executive Memberships is elastic, but close to unit elasticity, which Costco likely
priced around to optimize revenue.

Elasticity for Premium membership:
As shown, the demand for Premium Memberships is expected to be very elastic
and demand would be very sensitive to price changes.
B. Break Even Analysis
To do a Break Even Analysis, we will make the following assumptions:

The percentage of fixed cost to variable cost will be the same for net sales as for membership
revenue. Since Costco's annual report does not segment costs for membership revenue from
sales revenue, it is difficult to distinguish which expenses are directly related to membership.

We will not require any extraneous investment in terms of fixed costs for implementation,
employee training or advertisement that Costco does not already input for their current
membership model. Thus, percentage fixed and variable costs for membership revenue will
remain the same even with our addition of Premium membership.

Variable costs will include merchandise costs. Fixed costs include selling, general, administrative,
pre-opening, and interest expenses.
From the income statement, we find the percentage fixed and variable costs:
Figure 4: Table for percentage fixed and variable costs




Therefore, 2,833,333 Premium memberships need to be sold to break even.
*Note that since fixed costs were estimated a percentage of estimated membership revenue.
Estimation of membership revenue requires assumption of expected quantity. Thus, fixed costs are
understated when quantity of premium memberships sold is less than 6,080,000 and conversely
overstated if quantity of premium memberships exceeds 6,080,000.

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