Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-1 Chapter...

Cost LeadershipCost Leadership

Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-4-11

Chapter 4Chapter 4

Cost Leadership

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Mission Objectives

ExternalAnalysis

InternalAnalysis

StrategicChoice

StrategyImplementation

CompetitiveAdvantage

The Strategic Management Process

Business LevelStrategy

Corporate LevelStrategy

How to Position aBusiness

in the Market?

Which Businessesto Enter?

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Business level strategy• Business level strategy refers to the

strategic choices managers make about how to position a specific business and/or product line to gain competitive advantage in a single market or industry.

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Business Level Strategies

Two Generic Business Level Strategies

Cost Leadership:

• cost leadership strategy is intended to generate competitive advantage by achieving costs that are lower than all competitors

Product Differentiation:

• generate economic value by offering a productthat customers prefer over competitors’ product

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Understanding Cost Advantage

Managers need to understand who hasthe cost advantage in their market

• it could be the focal firm

• it could be a competitor

• develop a strategy to exploit the advantage

• develop a strategy to either capture theadvantage or compete on some other basis

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SOURCES OF COST ADVANTAGES

• Managers facing a strategic decision about how to position a business within an industry need to understand several fundamental cost issues.

• A sound understanding of these issues will help managers determine whether their focal firm is likely to generate competitive advantage by competing on cost.

• Alternatively, managers may recognize that other firms have a clear cost advantage and therefore their focal firm should choose to compete on some other basis—such as product differentiation.

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Sources of Cost Advantage

Economies of Scale

• average cost per unit falls as quantity increases-until the minimum efficient scale is reached

• fixed overhead costs may be spread over larger volumes of production—lowering per unit cost of production

• exist because of specialized machines and the specialization of employees

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Diseconomies of Scale

• are an advantage for those who do not havediseconomies of scale

• occur when firms become too large and bureaucratic•Transportation costs•Human factors—overly bureaucratic, de-motivated

NUCOR Nucor Steel had several cost advantages, one of which was the fact that the large integrated mills were experiencing diseconomies of scale in the parts of the market that Nucor served

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Sources of Cost AdvantageLearning Curve Economies• a firm gets more efficient at a process with experience

• the more complicated/technical the process,the greater the experience advantage

Example: Fuel Injectors One of the Big Three U.S. auto makers licensed technology from Robert Bosch, a German company, to produce fuel injectors. The basic terms of the agreement were that Bosch would share new technology within six months of any such new technology being put into production. As a result of this agreement the U.S. company was always behind Bosch in both quality and price because Bosch was essentially guaranteed a learning curve advantage. Eventually the U.S. company exited the fuel injector business and purchased its fuel injectors from Bosch and/or Nippondenso, a Japanese manufacturer.

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• Differential Low-Cost Access to Productive Inputs

• result when firms are able to access inputs at less cost than competitors

• are one of the main motivations behind international expansion—low cost labor and raw materials have often been the target of international expansion

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• usually result from some historical artifact—being the first firm to discover the value of a raw material and being able to lock up the source

• are very difficult to achieve if the input is found in competitive markets where the value of the input is known and is subject to any form of bidding

• One practice in the carpet business that is indicative of a differential low-cast access to inputs-advantage occurs when a retail flooring chain buys all the output of a mill in a particular style of carpet. The retail chain gets a low price on the carpet and no competitor can sell that particular carpet.

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Technology Independent of Scale

Example: Vegetable Inspection This technology is in use in the potato packing business. Instead of paying several laborers to inspect potatoes as they pass over a conveyor, processing companies can invest in this technology that greatly reduces cost. While there is certainly economic value in the technology for potato processors, most of the value is being captured by the firm that invented and produces the inspection machinery.

• arise when a technology allows a firm to produce something at lower cost than competitors who do notpossess the technology

• size of the advantage depends both on how valuableand protectable the technology is

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Policy Choices

• firms get to choose how they will serve the market

• we’ll offer level of quality that is inexpensive toproduce

• firms can make policy choices that give people incentives to reduce cost at every opportunity

Example: Southwest Airlines

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Cost Leadership & Competitive Advantage

A source of cost advantage will lead to competitive advantage if that source is:

• Valuable

• Rare

• Costly to Imitate

• Organized (Implemented Appropriately)

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Value of a Cost Advantage

• Threat of Entry• A cost advantage presents a barrier to entry because would-be

entrants face the investment cost of matching an incumbent’s cost position

• Threat of Rivalry• a cost advantage can be used to manage the threat of rivalry• a recognized cost leader can establish a price in a competitive market

and other firms will not rationally go below that price, thus attenuating rivalry

• if a firm chooses to offer lower prices, then it can expect increased rivalry

• Threat of Substitutes• a cost leader’s market offering is more attractive if the price to

consumers is less than the price of substitutes

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Value of a Cost Advantage

• Threat of Suppliers• cost leaders in a market typically have large market share—

meaning they will be important customers to the suppliers in the industry

• the threat of suppliers will be reduced because of the suppliers desire to keep the cost leader as a customer—nobody wants to lose their best customers

• Threat of Buyers• cost leaders can reduce the threat of buyers.• lowers incentives for buyers to vertically integrate because they will

often not have costs as low as an incumbent cost leader.

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Rareness of a Cost AdvantageThe rareness of a source of cost advantagedepends heavily on the industry life cycle:

Economies of Scale

Diseconomies of Scale

Learning Curve Economies

Technology

Policy Choices

Differential Input Access

Not Rare Rare

Emerging Mature

Rare Rare

Not RareRare

Rare Rare

Not RareRare

Rare Rare

Generally…

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Rareness of a Cost Advantage

• Economies of Scale:• are less likely to be rare in emerging industries because

multiple firms are discovering where the minimum efficient scale is

• may become more rare as the industry matures if the minimum efficient scale is discovered to be quite large and if industry demand roughly equals industry capacity—such that an incremental plant at minimum efficient scale would vastly exceed industry demand—this is even more likely as an industry declines

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• Diseconomies of Scale:• are likely to be rare in emerging and mature industries

because most firms will not exceed the minimum efficient scale

• may become less rare in a declining industry if demand falls sharply leaving most firms with excess capacity—this is not a likely scenario

• Learning Curve Economies:• are likely to be rare in an emerging industry because the

first-mover is moving along the learning curve ahead of competitors

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• are likely to become less rare as the industry matures as competitors also move along the learning curve—as the learning curve flattens the advantage of more cumulative experience lessens

• Differential Low-Cost Access to Inputs:• may be rare in emerging industries if the inputs themselves

are rare, such as mineral deposits or input factor markets that are of limited size, otherwise there is not likely to differential low-cost access

• may arise (and be rare by definition) as the industry matures if a firm is able to tie-up sources of supply by acquiring suppliers or forming exclusivity agreements with suppliers

•

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• Technology Advantages:• are likely to be rare in emerging industries as the new

technologies are developed• usually become less rare over time as duplication occurs

or as competitors are able to buy the same technology—some technology can remain rare if the firm is able to protect its proprietary nature, especially software technology as opposed to hardware technology

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• Policy Choices:• valuable policies may be rare in emerging industries as

many different firms establish various policies—some firms will adopt policies that prove to be valuable and others will adopt policies that prove to have little, if any, value

• some valuable policy choices will remain rare if those policies are 1) difficult to observe and/or understand, or 2) if the adoption of those policies is costly

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Imitability of Sources of Cost Advantage

Conditions largely determine if a source of cost advantage will be costly to imitate

• Low Cost Conditions• Non-Proprietary Technology• technology cost advantages based on technology that is not owned and

tightly controlled by the focal firm will be less costly to imitate, especially if vendors can sell the technology to the focal firm’s competitors

• Highly Observable Technology• technology advantages based on technology that is highly observable can

be imitated at lower cost, even when the technology is proprietary because competitors can more easily see a way around the protection (patents)

•

•

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Conditions largely determine if a source of cost advantage will be costly to imitate

• Low Cost Conditions

• Transactional Exchange• cost advantages such as differential low cost access to inputs and

policy choices that are based on transactional exchanges are easily imitated

• Example: The bonus policy of an appliance manufacturer that has a cost advantage because it uses a bonus system with production line employees to reduce defective parts can easily be imitated.

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• High Cost Conditions• Path Dependence (Historical Uniqueness)• cost advantages that developed through a set of unique historical

circumstances may be very costly, if not impossible, to imitate

Example: A grain elevator built decades ago along the Columbia River in Washington State provides a cost advantage for its owners. The elevator occupies the only location for miles along the river in which an elevator could be built without incurring tremendous earth-moving expenses.

• Protected Technology• a technology protected by patent, copyright, trademark, etc. will present a

higher cost of imitation than unprotected technologies—although such protection does not guarantee that imitation will not occur

•

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• High Cost Conditions• Highly Unobservable Technology• a cost advantage based on a relatively unobservable technology will

present a high cost of imitation to competitors because they will not know what to imitate

• Relational Exchange• cost advantages that stem from socially embedded exchanges are

more costly to imitate because competitors face the cost (or impossibility) of recreating socially complex relationships

• Example: Suppose the appliance manufacturer in the example above had a corporate culture based on years of experience and life long employees that encouraged low defect rates. Such an advantage would be much more difficult to imitate than an advantage based simply on paying people for lower defect rates.

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Implementing a Cost Leadership Strategy

A strategy is only as good as its implementation

Strategy is implemented through organizationalstructure and control:

• structure: 1) refers to how management responsibilities are divided and the reporting relationships among various managers.

• control: refers to the policies a firm adopts to give people incentives to behave in certain ways. Align

the interests of the individual with the interests of theorganization

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Organizational Structure

Three Organizational Structures

Simple

Functional

Multi-Divisional

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An organization in which one person, or perhapsa small partnership, performs all business functions is using a simple organizational

structure. A small family-owned (mom and pop) grocery store is a good example. One or two people

handle all the necessary business functions. One or two people can handle the purchasing, merchandising, bookkeeping, financing,

marketing, etc.

Simple Structure


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Functional Structure (U-Form: Unitary)

• divides management responsibilities by function

• marketing

• finance

• accounting

• procurement

• production

• R&D

• HR

• logistics

• etc.

• CEO is the only executive with enterprise-wideperspective

• CEO is responsible for strategy & coordinationof functions

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Production

Finance

R&D

Accounting MarketingHuman

Resources

Chief Executive Officer

Functional Structure


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Multi-Divisional Structure (M-Form)

• functions are replicated in each division as appropriate

• this structure makes sense when the firm is involvedin more than one business or has grown large enoughto justify geographic divisions

• CEO has strategic responsibility with the help ofvice presidents, etc.—information is filtered through layers

• CEO balances coordination & competition amongdivisions

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Multi-Divisional Structure (M-Form)

Strategic Planning

Corporate Finance

Corporate R&D

Corporate Marketing

ProductionFinance R&D Accounting

Human Resources

Division Division Division

Marketing

Chief Executive Officer

CorporateHuman

Resources

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The Functional Structure and Cost Leadership

• specialization within functions facilitates cost reduction

• CEO can use this structure to:

• ensure best cost reduction practices are shared among divisions

• allow and encourage decision-making by thosewho are in the best positions to do so—thoseclose to decisions

• ensure that functions are coordinating efforts inpursuit of a common strategy

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Organizational Controls

Policies intended to influence behavior by aligningthe interests of the individual with the interests ofthe organization

Management ControlsFormal Informal

• culture• budgeting policies

• credit policies

• spending policies

• travel policies

• purchasing policies

• attitudes

• leadership styles

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Compensation Policies

• stock options

• bonuses based on:

• cost reduction

• financial performance

• non-monetary awards• vacations

• parking places

Compensation Policies Should Reinforce Formal and Informal Management Controls

• office decor

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Organizational Controls and Cost Leadership

• management controls and compensationpolicies can be focused on cost reduction

• supply contracts that stipulate cost reductionsover time

• tight credit policies

• austere travel policies (e.g., no first class)

• bonuses tied to cost reduction targets

Example: Wal-Mart & Southwest Airlines

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United States of America.

Copyright ©2012 Pearson Education, Inc. publishing as Prentice Hall

Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-1 Chapter...

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