Tuesday, June 21, 2011

Ways of Achieving a Cost Leadership Strategy


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


To achieve cost leadership may require a high relative market share, which compels heavy capital investment in equipment and manufacturing/R&D, aggressive pricing, as well as a workforce committed to the low-cost strategy (Malburg, 2000; Hyatt, 2001; Kling & Smith, 1995).  The organisation must be willing to discontinue any activities in which they do not have a cost advantage and should consider outsourcing activities to other organisations with a cost advantage (Malburg, 2000).  Cost reduction becomes the major theme running throughout strategy (Hlavacka et al., 2001).

Furthermore, Miller (1986) and Speed (1989) maintained that cost leaders try to supply a standard, no-frills, high volume product at the most competitive selling price.  The innovations of competitors will only be imitated after a considerable risk-reducing lag.  Process, R&D, backward vertical integrations, and production automation may be pursued to reduce costs (Akan et al., 2006; Hooley et al., 2004).  Similarly, Reid et al. (1993) indicate that a low cost leader has a standardised product range and therefore amendable to mass production techniques. 

Firms do not have to sacrifice revenue to be the cost leader since high revenue is achieved through obtaining a large market share (Porter, 1979, 1987, 1996; Hooley et al., 2004; Bauer and Colgan, 2001; Hackett, 1996; Reid et al., 1993).  Lower prices lead to higher demand and, therefore, to a larger market share (Helms et al., 1997).  As a low cost leader, an organisation can present barriers against new market entrants who would need large amounts of capital to enter the market (Hyatt, 2001).  The leader then is somewhat insulated from industry wide price reductions (Porter, 1980; Hlavacka et al., 2001; Malburg, 2000).

 

In addition, Allen et al. (2007) stated that a cost leadership strategy is effectively implemented when the business designs, produces, and markets a comparable product more efficiently than its competitors.  The firm may have access to raw materials or superior proprietary technology to lower costs.  There are many areas to achieve cost leadership such as mass production, mass distribution, the construction of efficient scale facilities (economies of scale), rigorous pursuit of cost reductions from experience (experience curve), tight cost and overhead control, capacity utilisation of resources, avoidance of marginal customer accounts, cost minimisation in areas like R&D, service, sales force, advertising, jobs based on limited and specialised tasks, increase of repetition and routine tasks, short-term focus, low risk activity, and high degree of comfort with stability (Prajogo, 2007; Venu, 2001; Davidson, 2001; Malburg, 2000; Hooley et al., 2004; Beatty & Schneier, 1997; Youndt et al., 1996; Arthur, 1992; Schuler & Jackson, 1987, Miller & Friesen, 1986).

 

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). 

 

Last but not least, Porter (1985) purports only one firm in an industry can be the cost leader (Venu, 2001; Sy, 2002) and if this is the only difference between a firm and competitors, the best strategic choice is the low cost leadership role (Malburg, 2000).

To conclude, when a company employs a cost leadership strategy strives to be the lowest cost supplier in a given industry and thus achieve superior profitability from an above-average price-cost margin. 


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). 

 

Scale economies arise from principal sources:
1.    Technical input/output relationships: In some activities, increases in output do not require proportionate increases in input. A similar relationship exists in inventory requirements: as sales and output increase, inventories do not need to be increased proportionately (Grant, 1996);
2.    Indivisibilities: Many inputs are not available in small sizes. Hence, they offer economies of scale as firms are able to amortise the costs of these items over larger volumes of output.  According to Grant (1996), indivisibilities also arise in: (i) people (a plant needs only one medical officer per shift); (ii) activities (accounting audits only once per accounting period); and (iii) specialist units (there is a minimum feasible size to an effective R&D team seeking to develop specialised products);

3.    Specialisation: Larger volumes of output require the employment of more inputs, which permits increased specialisation of the tasks of individual inputs (Hill & Jones, 2001; Grant, 1996)
4.    Fixed Costs: The ability to spread fixed costs over a large production volume:  Fixed costs can be defined as those costs that occur during the process in producing a product regardless of the level of input and include the costs of purchasing machinery, the costs of setting up machinery for individual production runs, the costs of facilities, the costs of advertising and promotion, and the costs of R&D (Hill & Jones, 2001)

 

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. 


Another way of reducing costs is through ‘Capacity Utilisation’.  This term refers to the value of production capacity being utilised over a specific period of time.  Porter (1985) argues that capacity utilisation at a certain point in time is a function of seasonal, cyclical and other demand or supply fluctuations, which have no influence on the competitive position of a company, and rather capacity utilisation over the entire cycle is the correct cost driver.  Thus: (i) over a short-medium term period, plant capacity is fixed and hence variations in output relate to variations in capacity utilisation (Grant, 1996; Hax & Majluf, 1996);  (ii) during periods of ‘low demand’ fixed costs are spread over fewer units of production and as a result it raises the cost per unit (Grant, 1996);  (iii) during periods of high demand, output may be pushed beyond the normal full-capacity operation, and hence will result to the increase of cost per unit (Grant, 1996)..

‘Linkages’ consist of another set of cost drivers.  Various activities within an organisation are linked to each other and therefore are affected by those that link with it.  Porter (1985) state two types of linkages: (i) Internal Linkages: among the activities of the value chain that have an effect on the costs and exist between direct and indirect activities (for instance, quality control and audits can have a significant impact on servicing costs). According to Porter (1985), changing the way of performing a linked activity will not only have an impact on the cost of another activity but also on the total cost of the linked activities.  To infer, a company must optimise such linkages in order to obtain competitive advantage; and (ii) External Linkages: in relation to suppliers and channels.  External linkages with suppliers of factors inputs or distributors of the firm's final products can affect the costs of a firm's activities.  Porter states that external linkages with suppliers and channels can lower costs by improving coordination and joint optimisation between a firm's activities and the value chains of suppliers and channels.  For instance, frequent supplier shipments can reduce a firm's inventory needs, appropriate packaging of supplier products can lower handling cost, and supplier inspection can remove the need for incoming inspection.

‘Interrelationships’ refer to the relationships of mutual dependence between one business and other parts of a company’s operations that could affect costs.  Porter (1985) identifies three types: (i) ‘Tangible Interrelationships’ arising from opportunities to share activities within the value chain of an organisation.  Thus, companies can identify sources of competitive advantage traced on the actual sharing of various assets, managerial capabilities, know-how in one or more activities of the value chain (Hax & Majluf, 1996).  On the other hand, this type of interrelationships can occur costs relating to the cost of coordination, cost of compromising, and cost of inflexibility created when businesses have to share outdated activities (Hax & Majluf, 1996);  (ii) ‘Intangible Interrelationship’, referring to the conveyance of ‘know-how’ to similar but separate value activities in a number of business units (one expertise gained in one division can be utilised in another. For instance, cost reduction expertise);  and (iii) ‘Sharing know-how Interrelationships’ arising when costs of various activities that are similar can be reduced by sharing and improving know-how and expertise.  In this case sharing the generic skill represents transferring the successful results of learning from one activity to another (Hax & Majluf, 1996).  Hence, interrelationships with other strategic business units in the overall corporate portfolio can help to share experience and gain economies of scale in functional activities, such as marketing, research and development, quality control, ordering and purchasing.  Businesses can frequently reduce their costs by transferring knowledge within the group to other strategic business units who share similar technology or problems (Porter, 1985).

‘Degree of Integration’ refers to three different types of integration: (i) ‘Vertical Integration involves ownership or control of inputs to the firm's processes or the channels of product distribution (Hax & Majluf, 1996; Rue & Holland 1989).  Hence, the ‘degree of vertical integration’ in a value activity can influence its costs (Hax & Majluf; 1996; Porter, 1985).  Cost reductions can be achieved by generating economies from combined operations, and sharing of activities within the value chain (Hax & Majluf, 1996).  In addition, vertical integration can help avoid high transaction costs from many sources (for instance, expensive physical transfer of goods and rendering of services).  Yet, companies should be aware that vertical integration can raise costs, for example, through creating inflexibility, bringing activities in-house that suppliers can perform more cheaply, and undermining incentives for efficiency because the relationship with the supplying unit becomes captive.  Porter (1985) argues that integration may lower cost, raise cost, or has no effect on cost and that will depend on the activities and purchased inputs involved;  (ii) ‘Backward Integration’ arises when a company gains control over cost, availability and quality of the raw materials that are used in producing its products and services;  and (iii) ‘Forward Integration’ occurs when a company tries to gain control of its outputs.  This type of integration gives a company control over its sales and distribution channels and as a result can assist in avoiding costs of using market, such as procurement and transportation costs (Oster, 1994).

‘Timing’. Porter (1985) argues that ‘the cost of value activity often reflects timing’.  The role of timing in cost position of a company may depend on timing with respect to the business cycle or market conditions than on timing in absolute terms (Porter, 1985).  Timing may lead to either sustainable cost advantage or a short-term cost advantage (for instance, when a company may have low cost assets because of a good timing).  Moreover, there are a number of occasions when the "first mover" in an industry can gain significant cost advantages (Lowe & Atkins 1994; Porter, 1985).  ‘First mover advantages in relation to cost could arise from: (i) securing the right to the lowest costs of materials;  (ii) attracting the best employees, technology, or finding the best location;  and (iii) moving quickly into volume production.  However, the advantage does not always rest with the first mover. Sometimes there are significant advances in the technology or product design that a later entrant can exploit.  The first mover may either be unwilling to spend heavily again so soon, or simply not have money to do so.

‘Policy Choices’ can affect the costs of various value activities as many of the decision taken within an organisation are based on discretionary policies (Porter, 1985).  For instance, decisions on the product line, the product itself, quality levels, service, features, credit facilities, and the actual and perceived uniqueness of the product to the customer all affect costs (Porter 1985).  In addition, although policy choices play an independent role in determining the cost of value activities, they also may be affected by other cost drivers (Porter 1985).  Thus, decision on process technology choices may be affected partly by scale, timing, or by what product characteristics are desired.

‘Location Factors’ refers to value activities that can affect costs based on: (i) the geographic location of an activity taking place, and (ii) the location of an activity relative to other value activities.  Location can affect costs through many ways (Porter, 1985):  (i) the cost of labour and tax rates vary obviously by country and also by location within a country or region;  and (ii) influence on logistical costs, where location relative to suppliers is an important factor in inbound logistical cost, while location relative to buyers affects outbound logistical cost.  Therefore, it is essential for companies to investigate the importance and impact of location on the costs and recognise opportunities for reducing costs by establishing new patterns of location of facilities relative to each other (Porter, 1985).

‘Institutional Factors’ relate to regulations imposed by governments and can have important effects on a firm's ability to produce economically (Porter, 1985).  Such institutional factors can influence a business’s costs.  For instance: (i) the laws about unionisation can affect a plant’s relative costs;  (ii) health and safety at work may be introduced by new regulations that will result to additional costs to a company’s operations for safety;  (iii) environment protection can introduce added costs (for instance, disposal of electrical equipment, recycling, and similar);  and (iii) Power costs that are determined through the rates charged by power companies, a highly political issue in areas where governments own power companies.  Last but not least, institutional factors often remain outside a company's control and have a direct and an indirect impact on the costs in the company (Porter, 1985).

The list of cost drivers by Porter (1985) has made an important contribution to the research of the cost drivers and is considered as a milestone and a useful tool for further works about cost drivers (Shank & Govindarajan, 1993).  There are however, other studies (Grant, 1996; Shank & Govindarajan, 1993) that have identified additional cost drivers that companies should take into consideration. 

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).


Similarly, Shank & Govindarajan (1993) present their list of cost drivers of two categories: structural and executional cost drivers.  The Structural Cost drivers refer to strategic drivers and they are:
·           Economies of Scale: How big an investment to make in facilities for research and development, manufacturing and marketing?
·           Scope: Degree of vertical integration. Horizontal integration is related to scale.
·           Experience: How many times in the past, the firm has already done what it is doing now?
·           Technology: What process technologies are used at each step of the firm value chain? (State of the Art).
·           Complexity: How wide a line of products or services to offer to the customers.

The second category of cost drivers is called "executional" cost drivers that constitute determinants of a successful cost position.  The most important executional cost drivers include:
·           Workforce involvement (participation) - work force commitment to continuous improvement.
·           Total quality management (beliefs and achievement regarding product and process quality).
·           Capacity utilisation (given the scale choice on plant location).
·           Plant layout efficiency (how efficient against current norms, is the plant layout?).
·           Product configuration (is the design or formulation effective?).
·           Exploiting linkages with suppliers and /or customers, in the firm’s value chain.

To conclude, companies intending on become low cost leaders in a given industry have to fully understand the nature and characteristics of those factors (as discussed in the previous paragraphs) driving the costs of each activity in the value chain.   To do so, companies need on the one hand use their knowledge about the cost drivers to reduce costs for each activity in the value chain (Thompson & Strickland III, 2003).  On the other hand, managers need to focus on identifying those drivers with resourcefulness and constant investigations with purpose to outperform their rivals (Thompson & Strickland III, 2003). 


For any questions do not hesitate to contact me at: info@antonymichail.com 

Dr. A. Michail 

PS. The references have been removed from this text

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