According to Porter (1980), the low cost leadership strategy attempts to increase market share by emphasising low cost relative to competitors. Porter states the following:
“gives the firm defence against rivalry from competitors because its lower cost means that it can still earn returns after competitors have competed away their profits through rivalry. A low cost position defends the firm against powerful buyers because buyers can exert power only to drive down process to the level of the next most efficient competitor. Low cost provides defence against powerful suppliers by providing more flexibility to cope with input cost increases. The factors that lead to a low cost position . . . also provide substantial entry barriers in terms of scale . . . Finally, a low cost position places the firm in favourable position vis-à-vis substitutes . . . Thus a low cost position protects the firm against all five competitive forces” (Porter, 1980, pp. 35-6)
Overall cost leadership is employed when a firm sets out to become the low-cost producer in its industry for a given level of quality and entails a great attention to cost control. Above average returns are attainable because cost leaders can match the prices of their most efficient competitors, while fending off both powerful customers and suppliers (Rubach & McGee, 1998; Reid et al, 1993). The following shows that a company that focus on the cost leadership strategy does not indicate that will offer lower prices than its rival, but on the contrary, profits can be made by selling the same product as others and earning a bigger margin per unit or by undercutting rivals’ pricing for a lower margin on a larger volume (Rubach & McGee, 1998; Reid et al, 1993). .
Figure: The Purpose of a Low Cost Strategy
In terms of industry environments, a cost leadership strategy is most effective in stable and predictable ones (Thompson & Strickland III, 2003; Marlin et al., 1994). Thus, companies operating within unpredictable environments or subject to continuous change will create severe diseconomies for those pursuing a low cost strategy, which will result to threaten a cost leader’s efforts at efficiency and cost control (Miller, 1988).
To succeed with a low-cost strategy company managers need to investigate in depth each cost-creating activity and determine what drives its cost (Thompson & Strickland III, 2003). Moreover, a cost leadership strategy is likely to be successful when the demand is price sensitive and other firms within an industry produce standardised products and buyers are not willing to pay an additional amount for differentiated products, or have common user requirements (Thompson & Strickland III, 2003; Dobson & Starkey, 1993). Thus, the competition is mainly based on pricing (Thompson & Strickland III, 2003; Dobson & Starkey, 1993).
Ways of Achieving a Cost Leadership Strategy & Cost Drivers
Companies have unit costs that are different from their rivals that produce a similar product in a given industry environment (Grant, 2002; Sadler, 1993). Understanding the nature of these costs and their drivers it is essential to define a firm’s cost positioning (Porter, 1985). Thus, “cost driver” is a characteristic of an activity or event that causes that activity or event to incur costs and can be more or less under a firm's control (Blocher et al. 1999:57). Moreover, Grant (2002) states that the relative importance of the cost drivers varies: (i) across industries; (ii) across firms within an industry; and (iii) across the different activities within a firm. Thus, by identifying the different cost drivers, a company can detect its cost position in relation to its rivals (and how it differs), and investigate ways of how they could improve its cost efficiency (Grant, 2002).
Porter (1985) introduces various cost drivers, their nature and characteristics within a business. These are: (i) Economies of scale: exist when the costs of performing an activity decrease as the scale of the activity increases; (ii) Economies of Learning: are cost savings that derive from “learning by doing”; (iii) Capacity Utilisation: refers to the relationship between the ‘potential output’ that could be produced and the ‘actual output’ that is produced with the existing installed equipment, if the capacity was fully used; (iv) Linkages: costs with a company interrelate to each other. Linkages (internal and external) refer to the costs incurred by most activities that are significantly affected by those activities that ‘link’ with it; (v) Interrelationships: refers to those costs occurring from the relationships of mutual dependence between a company’s part of its business with another; (vi) Degree of Integration: involves ownership or control of ‘inputs’ to a company’s processes or the channels of product distribution; (vii) Timing: in relation to a company’s choices in relation to its business cycle (i.e. introduction of new technology) or market conditions (i.e. ‘first mover’ advantage); (viii) Policy Choices: refers to the cost of various value activities that are affected by policy choices a company makes; (ix) Location: relates to the geographic location of a value activity that can affect its cost; and (x) Institutional factors: refer to a number of regulations imposed by governments that can affect a company’s ability to produce economically.
‘Economies of scale’ in general terms stem from doing things more efficiently. Sanchez and Heene (2004) state that economies of scale exist when the costs of performing an activity decrease as the scale of the activity increases. The term Scale refers to capacity; that is, the maximum level of output that the assets used to carry out an activity are capable of sustaining (Sanchez & Heene, 2004). Similarly, Hill & Jones (2001) maintain that economies of scale are “unit-cost” reductions associated with a large scale of output.
According to Hooley et al. (2004) economies of scale are the single most effective cost driver in many industries and stem from doing things more efficiently or differently in volume. Economies of scale arise by increases in outputs that do not require proportionate increases in inputs (technical input-output relationships); many resources are unavailable in small sizes and therefore offer economies of scale. In that sense, firms can spread the costs of these items over larger volumes of output. An example is the units that are available only above a certain minimum size; these are capital equipment, research facilities, advertising campaigns, and distributions systems; and specialisation by expanding the number of inputs (Sanchez & Heene, 2004; Aaker, 1998).
Another cost driver is the ‘Learning Curve’, where cost reductions can be achieved through learning and experience effects (Porter, 1985). ‘Learning’ indicates the increased efficiency that could be achieved through the successful repetition of numerous tasks by a company’s employees (Ghemawat, 1985). Hence, costs can be reduced by various systematic ways: (i) improved scheduling; (ii) labour efficiency improvement; (iii) product design modifications that facilitate manufacturing; (iv) various output improvements; (v) processes and procedures that allow utilisation of assets; and (vi) better tailoring of raw materials to relevant processes (Porter, 1985). In terms of measuring the continuous effectiveness of ‘learning’ in relation to falling costs companies need to investigate both at the individual and activity levels. Porter (1985) states that the rate of learning can explain the fall in costs over the time in a value activity.
Grant (2002) states that there are four cost drivers that could affect a company’s costs. These are:
1. Cost reductions through experience curve and consist of:
(i) Economies of scale;
(ii) Economies of learning;
(iii) Improved Process Technology & Process Design: refers to the adoption of new production technology that could be an important source of cost advantage; and
(iv) Product Design: relates to manufacturing costs regarding a product design. Different product designs relate to different costs in manufacturing.
2 Capacity Utilisation;
3 Input Costs: refers to costs occurring because of the labour involved, and access to raw materials; and
4 Residual Efficiency: relates to costs regarding the effectiveness of employees (organisational slack).
Dr. A. Michail