Technology Upgrade Keeps Prices Down

When Vince Carney was hired by Costco Companies, Inc., in 1988, he promised to save the warehouse club chain over $1 million in his first year. "I actually took a pay cut to come to Costco from Wal*Mart," says Carney. "But Costco told me if I was half as good as I said I was, I would be rewarded. I liked Costco's attitude."

Costco, based in Issaquah, WA (near Seattle), is a warehouse club chain, whose net sales for 1997 were approximately $22 billion. Costco has 280 warehouses worldwide which sell directly to 25 million membership card-holding customers. Costco sells items such as groceries, appliances, automotive supplies, toys, hardware, sporting goods, jewelry, watches, cameras, books, and computer hardware and software.

Since he was hired, Carney has been rewarded with pay raises and bonuses. Costco, meanwhile, has received a minimum of $7 million in savings due the installation of a system for converting paper documents to a computer format. Carney, Costco's VP, merchandise accounting controller, spearheaded the installation. Carney says the system allows Costco's merchandise accounting department to do twice as much work as it could in 1988, (the company has almost tripled in size since then,) with half as much staff. "That's where the $7 million savings comes from," says Carney. "But the real benefit of the system is in the improved service it enables Costco's merchandise accounting department to provide. That improved service is worth several times that $7 million."

Processing 6-7 Million Documents Per Year
Carney admits when he was hired by Costco, he wasn't sure where that $1 million in savings he had promised was going to come from. "You don't get the chance to closely study a company's business before that company hires you," Carney relates. "But Costco was a new business (founded in 1983), and in a new business there are always ways to cut costs."

When Carney arrived, Costco's merchandise accounting department had the reputation of being a "black hole" for documents. "Either documents were sent there and never seen again, or requests were made for documents, and never fulfilled," says Carney.

This was quite a problem, as merchandise accounting was responsible for processing some 6 to 7 million documents per year. Merchandise accounting's job is to reconcile the paperwork for shipments received at Costco's warehouses. This paperwork includes purchase orders, freight bills and invoices.

How Costco's Document Process Works
When Costco places an order for a shipment, a purchase order is generated at its corporate headquarters in Issaquah. The information on this purchase order includes the quantity and price of items, and when they should arrive at a particular warehouse.

When the shipment arrives at a warehouse, the warehouse receives a freight bill containing a list of the items that were in the shipment. The warehouse sends this freight bill to Costco's corporate headquarters, where it is compared against the purchase order for the shipment. Costco's corporate headquarters also receives a bill, or invoice, for each shipment which must be compared against the purchase order and freight bill.

In 1988, employees in Costco's merchandise accounting department were manually keying information from all these documents into a data file kept on a mainframe computer. When a new document, such as an invoice, came in, a merchandise accounting employee would open the mainframe file on the document's shipment, compare the document to the data in the file, and then update the file with data from the new document. The document was then filed on microfilm.

Once a document was placed on microfilm, if it needed to be retrieved, 30 percent of the time it could either not be found or was illegible. "Costco requires these documents as proof in cases where there are discrepancies between the amount of items being billed for, and the amount that were actually received," says Carney. "If Costco orders and is billed for 1,000 hammers, but its warehouse receives only 500, a settlement has to be reached. If proper documentation can't be located to support Costco's position, then there is less chance of Costco's securing a favorable settlement."

Improving On Microfilm
While at Wal*Mart, Carney had been instrumental in the installation of a computer-assisted retrieval (CAR) system for microfilm in a department similar to Costco's merchandise accounting department. Shortly after he was hired by Costco, he began working with Eastman Kodak on designing a similar system.

That's when Terry Butler of Financial Systems Products (FSP) stepped in. FSP is a technology systems integrator located in Seattle, with 48 employees and annual revenues of about $7 million. "I heard that Costco was negotiating for a $200,000 CAR system with Kodak, and I immediately set up a meeting with Costco's managers, including Vince," says Butler. "I told them that there had to be a better way. I wasn't quite sure what it was at the time, but I knew it involved a document imaging system."

A document imaging system uses document scanners to make electronic pictures (images) of paper documents. These images are stored on computer disks. FSP had previously done a small imaging installation using Optika Imaging Systems, Inc.'s document and image management software.

Document and image management software enables a user to index a scanned image so it can be efficiently retrieved from the disk where it is stored. At Costco, for example, document and image management software would enable Costco to index the images of a freight bill, a purchase order and an invoice from the same shipment, under the same name, possibly the shipment's purchase order number.

"Our earlier application had given us a taste of imaging's capabilities," says Butler. "We felt that the accessibility of documents through Windows-based PCs, which Optika's software provides, could benefit Costco more than any sort of microfilm-based upgrade would."

Imaging Offers Automation That Microfilm Can't
FSP was not the only imaging integrator to contact Carney. "In all, 13, suppliers of imaging systems contacted us after word was out that we were considering upgrading our microfilm system. This included representatives from major companies such as IBM, Wang and Bell & Howell," says Carney.

From talking with these imaging suppliers, Carney says he learned imaging systems offered more features than a microfilm system. "Being able to automatically bring together three related documents, at the same time, on a PC screen, for example, provides an enormous benefit for Costco. This can be done through workflow software which can be added to an imaging system."

Through document and image management software, after an invoice for a shipment is scanned, its image is automatically routed to a PC workstation, where it is indexed. In Costco's case, this indexing could be done by keying in the correct purchase order number. When the imaging system receives the indexing information, workflow software can be programmed to collect all images with the same index and route them to a workstation. This way a workstation operator can automatically receive the images of a freight bill, a purchase order and an invoice from the same order, at the same time, for comparison.

Willingness To Study Business Wins Contract For Integrator
Carney realized that, while an imaging installation offered more potential return on investment than a CAR system, it was also going to cost about five times as much. "So I took my time," he says. "After two years of research, in late 1991, I finally decided to put together a presentation for the system."

That presentation would include a bid by FSP on the system's installation. Carney says FSP's commitment to understand Costco's merchandise accounting department's operations was the major reason he chose FSP for the installation. "FSP was the only integrator that came into our office and made an effort to understand our applications. Most of the others were selling out-of-the-box solutions - what you see is what you get. They weren't offering any personal commitment," says Carney. "FSP did time-and-motion studies of our document processes, and helped our information technology department design trial applications that interfaced with our existing system. FSP also helped us write a cost-benefit analysis."

Carney and technicians from Costco's management information systems (MIS) department were also impressed with Optika software's ability to operate in a Windows environment and to integrate into Costco's existing mainframe computer system. "We involved members of our MIS department from day one," says Carney. "That way when I made the presentation to get the system approved by our president and CEO, when he asked me what the MIS department thought of the installation, I was able to say, 'ask them.' I didn't have to go back and find out if this wonderful system I'd come up with would actually work."

Carney cautions, however, that although it is beneficial to have an MIS department assist a business manager in choosing and designing a system, ultimately an imaging installation should be a business manager's responsibility. "Any manager who sends his MIS department to a trade show such as Comdex or AIIM to find an imaging system is making a mistake," says Carney. "While the MIS department may understand how the technology in the system works, it takes the manager of a paper-intensive department to understand the application of a system. Only a manager understands the features a system should have to improve the operations within his department."

Using Imaging To Keep Prices Low
Taking things one step further, Carney went on to explain to Costco's president and CEO, James D. Sinegal, how an imaging installation would improve Costco's core business - offering low prices. "In our business, the typical markup on merchandise is only 8-12%," says Carney. "This contrasts with discount stores, such as Wal*Mart, whose markup can be up to 35%. Department stores, such as Nordstrom's, can markup their merchandise as much as 65%. Costco's competitive advantage is offering lower prices. Keeping overall operating expenses low, so we can charge lower prices, is the key to Costco's profits.

"Because of Sinegal's reputation, everyone in the company was betting against a quick sign-off," continues Carney. "But after I explained to him how an imaging system would improve the merchandise accounting department's service, and how that improved service would lower Costco's overall operating costs, he signed off almost immediately. The $4 million (at the time) in savings, which the imaging system offered, due mostly to staff reductions in our department, was icing on the cake."

Payoff Is In Lowering Operating Expenses
Improved service by Costco's merchandise accounting department offered the wholesale club chain savings in two major areas: settlements and negotiations with vendors, and in management of its warehouses.

According to Carney, Costco performs about 6 million transactions per year with over 12,000 vendors. "This presents a lot of opportunities for discrepancies among purchase orders, freight bills and invoices. Often, settlements for these discrepancies run into hundreds of thousands of dollars," says Carney. "If documentation can't be found to support a warehouse's position that the manufacturer or shipper was in error in a shipment, a typical settlement is to split the difference 50/50. Correct documentation that allows Costco to recoup 100% of its losses in just a couple of cases, pays for an imaging system."

Not being able to find documentation also was giving Costco a bad reputation with vendors. "Vendors typically offer a two to three percent discount if a customer pays its bills within a certain period of time," says Carney. "Vendors want to receive payment for their products as soon as possible so they can reinvest the money in their businesses. Settling discrepancies using the microfilm system was taking weeks, sometimes months. Vendors take this kind of reputation into account when they are negotiating deals with a company."

Costco's warehouses were also wary of the company's reputation for losing documents. "After Costco first installed the imaging system, the warehouse managers were still making copies of freight bills to keep on-site before sending the paper to corporate headquarters to be imaged," says Carney. "If a warehouse receives a bad shipment and there is no documentation to prove a low monthly return was caused by a mistake in shipping, the warehouse manager could lose his job. Settlements from vendors are designed to make up for low monthly returns, but if the settlement doesn't come across for several months because of poor documentation, it can also skew reports. Skewed monthly reports from warehouses make accounting at the corporate level more difficult."

System Lifts User To Top Position In Industry
Carney calls these savings brought about by improved service in Costco's merchandise accounting department "soft-dollar" savings. "They can't be quantified as easily as 'hard-dollar,' savings, such as reducing staff," says Carney. "I can't for sure say that service wouldn't have improved without the installation."

What is quantified, however, according to Discount Store News, is that since its imaging installation, Costco has become the warehouse club industry's leader in sales per warehouse, at $88 million per warehouse. Concludes Carney: "Our imaging system has been a key to Costco's advancing to that position in the marketplace."