Analysis of Operating Activities Costco

Costco has five sources of revenue. Four traditional discount store categories: Sundries, Hardlines, Softlines, Food, and Fresh Food; as well as a category for all other sources of revenue, Ancillary.

Ancillary includes pharmacies, gas station, optical, and other services not normally found in the business model of a discount store. From 2004 to 2006 Costco has increased its percentage of overall sales in the ancillary category from 11% to 14%. It remains to be seen if this divergence from the traditional model will benefit the company. However it is clear that ancillary operations are becoming more integral to Costco’s Business model. Possible reasons for the increased concentrations may include more demand for the services or the market for the other categories is seeing decreasing growth of profits.

Although gross profit increased by 12% from 2005 to 2006, total revenue increased by 13.6%. Indicating a disproportionably greater increase in the costs of merchandise relative to the amount of revenue earned, as shown by the 1.30% decrease in gross profit as a percentage of total revenue. This decrease may be indicative of rising merchandise costs, or it may indicate diseconomies of scale created by the continued growth of the corporation. If the latter is true, investors should be weary of purchasing Costco stock, as diseconomies of scale may indicate the peak of the growth phase in a corporation.

Diseconomies of scale occur when a company no longer receives any further economic benefit from increasing in size (i.e. bulk orders from manufactures.) Costco may be experiencing this effect due to increased transportation costs or increased carrying costs due to increased number of stores or decreasing number of customers per store respectively. The 8.65% decrease in net profit margin corroborates the speculation of diseconomies of scale.

One may consider the 8.26% increase in the asset turnover ratio as contrary evidence to the slowing growth of Costco. However, the ratio was increased by a decrease in assets (26.75% decrease in cash) by a greater margin than increases in account receivables or net sales (6.85 and 13.66% increase respectively.)

Please review the horizontal and vertical analysis of the balance sheet and income statement. Also note the supplementary ratio analysis to the right of each financial statement.