Cost Leadership

INTRODUCTION

Cost leadership and product differentiation are the business level strategies. These
two strategies are sometimes referred to as generic business level strategies because they
represent heuristically two extremes that a firm could choose to pursue. However, as with
most of the concepts covered in this course, some firms are better able to gain competitive
advantage by pursuing these generic strategies than other firms.

THE BENEFITS OF COST LEADERSHIP

Define Cost Leadership

As the name implies, a cost leadership strategy is intended to generate competitive

advantage by achieving costs that are lower than all competitors. Our definition of
competitive advantage is: the ability to create more economic value than competitors. A
firm with lower costs than competitors creates more value because of the greater difference
between the firm’s costs and the price the firm is able to charge (i.e., higher profit margins).

1) Cost leadership is not necessarily synonymous with low price. It is true, by

definition, that the cost leader in a market can charge the lowest price and still
have a positive profit. However, a firm pursuing a cost leadership strategy would
want to have the advantage of the lowest costs without being forced to charge
the lowest price.
2) Firms in a market have a strong incentive not to compete on price with the low
cost leader. This is akin to the old boxing adage that: One’s success in the ring
has a lot to do with choosing one’s opponent.

Firms have a strong incentive to compete on cost (not price) because of the
advantages explained above. Therefore, firms enjoying cost advantages typically face strong
competitive pressures on their cost positions. The durability of cost advantages will be
discussed later in the Cost Leadership and Competitive Advantage section.

► Example: Wal-Mart’s Cost Advantages

Wal-Mart has always been focused on achieving the lowest possible costs.
As the firm began to expand and grow there were two main sources of cost
advantage: 1) a growth pattern of rural locations surrounding distribution
centers, and 2) information technology. Wal-Mart’s careful selection of rural
locations created cost advantages because of relatively cheap land and very
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efficient distribution through its distribution centers. Stores were typically

located along interstate highways and/or heavily traveled crossroads. There
was usually very low demand for the land purchased for these locations
because other retailers were uninterested in rural locations. However, these
stores had incredible drawing power. People flocked to the stores in search
of low prices and a wide product offering. Distribution was also relatively
inexpensive because Wal-Mart’s trucks could easily get to these locations
from interstate highways. One large distribution center could efficiently
handle all the stores within a day’s drive.
These location advantages were coupled with Wal-Mart’s information
technology which was always state-of-the-art. Highly efficient inventory
management, facilitated by IT systems, allowed Wal-Mart to achieve costs
significantly lower than its competitors. Wal-Mart knew which items were
selling and which were not. It knew how much of which products were
needed and where they were needed. And, it could distribute these products
quickly and efficiently.
Wal-Mart has heavily advertised low prices. People tend to associate
Wal-Mart with low prices. However, careful shoppers in some markets have
realized that competitors sometimes offer lower prices, especially on food
items. Thus, it would appear that Wal-Mart is in the enviable position of
having low costs but not having to charge the lowest prices on all products
all the time.
This pricing advantage can be very frustrating for competitors. Wal-
Mart has a policy of beating competitors’ prices whenever a customer points
out that a competitor has a lower price. If a competitor attempts to compete
vigorously on price, Wal-Mart will simply lower its price and it can better
afford to do so. One store manager from a competing food retailer stated
his frustration this way:
“People just assume that Wal-Mart has the lowest prices on everything, but
they don’t. I have sent professional shoppers to compare prices and we have
better prices on many items. But, if I advertise lower prices on any specific
item, Wal-Mart will beat my price and I’m worse off.”
Wal-Mart is able to offer low prices and still make a profit because of
its low costs. One remarkable aspect of Wal-Mart’s success is that it has
operated in a business that is highly competitive. Wal-Mart appears to have
achieved competitive advantage with its cost leadership strategy.

SOURCES OF COST ADVANTAGES

Identify Six Reasons Firms Can Differ in Their Costs

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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Six Sources of Cost Advantage

Economies of Scale
• exist if the average per unit cost of production falls with an increase in the
quantity produced
• exist because of the ‘fixed’ nature of some costs
• suppose the investment cost of a machine is $50,000—whether the machine
produces 1,000 pieces or 10,000 pieces the investment cost is the same, the
per unit cost falls from $50 to $5
• fixed overhead costs may be spread over larger volumes of production—
lowering per unit cost of production
• imply that there is some minimum efficient scale—firms that operate at the
minimum per unit cost will have an advantage over firms that have not
reached the minimum efficient scale
• exist because of specialized machines and the specialization of employees
• may be achieved through international expansion that increases sales to the
point that minimum efficient scale may be reached

Diseconomies of Scale
• arise as production moves beyond the minimum efficient scale—average per
unit cost increases as quantity produced increases
• the firm (or business) has become too large
• physical diminishing returns to scale—machines able to handle larger
volumes may be prone to more defective pieces and/or may be so
expensive as to result in higher average per unit costs
• transportation costs—trying to cover a vast geographic area from a
very large plant may contribute to diseconomies of scale
• human factors—overly bureaucratic, de-motivated
• may result from international expansion if bureaucracy increases and/or if
the necessary scale of production exceeds the minimum efficient scale

Learning Curve Economies

• result from people learning a production process so that they get better at the
process
• result from cumulative experience
• do not suffer from diseconomies—costs continue to fall with increasing
cumulative experience
• typically increase as market share increases—however, market share may be
expensive to acquire, potentially offsetting learning curve economies
• may be accelerated through international expansion because of larger
volumes

Differential Low-Cost Access to Productive Inputs

• result when firms are able to access inputs at less cost than competitors
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• are one of the main motivations behind international expansion—low cost

labor and raw materials have often been the target of international expansion
• 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
Technological Advantages Independent of Scale
• arise when a technology allows a firm to produce something at lower cost
than competitors who do not possess the technology
• fresh vegetable packing operations have traditionally relied on manual
inspection of the produce—new technology allows much faster,
more reliable, lower cost inspection by passing ultra-violet light
through the produce and using pneumatic devices to discard bad
produce from the production line
• can sometimes be acquired by firms from developing economies by
partnering with international partners from developed economies
Policy Choices
• may create cost advantages in two ways:
1) firms may decide to produce low cost, highly standardized products and
compete on price, and/or,
2) firms may develop a cost conscious culture in which managers and other
employees are given incentives to constantly look for ways to reduce per
unit costs (increase efficiency)

COST LEADERSHIP AND COMPETITIVE ADVANTAGE

The Value of Cost Leadership

Five Forces Model. The value of a cost advantage can be explained, at least in part,
by showing how the cost advantage may help to neutralize threats in the external
environment. If a cost advantage helps to neutralize one or more of the threats, then the
cost advantage would be considered ‘valuable’ within the VRIO model.

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
• incumbents typically face lower opportunity costs because they have made
a series of investments over time that are now sunk costs whereas entrants
face relatively higher opportunity costs with a large one-time investment
to enter a new business
• the threat of entry by international competitors should be taken into account

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
• an unrecognized cost leader can choose to either:
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1) meet the competitive price and enjoy wider margins than competitors
without alarming competitors with lower prices, or
2) offer a lower price to gain market share from competitors—this is
rational only if the increased market share offsets the lower margins
• if a firm chooses to offer lower prices, then it can expect increased rivalry
• a lower price strategy gives competitors incentive to focus on lowering
costs which may put the focal firm’s cost advantage in jeopardy
• thus, the focal firm should carefully analyze the likely responses of
competitors

Threat of Substitutes
• a cost leader’s market offering is more attractive if the price to consumers is less
than the price of substitutes
• cost leaders are in a position to respond with lower prices, if necessary, to
keep their offerings more attractive vis-à-vis substitutes

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
• cost leaders will be better able to absorb price increases than higher cost
competitors, thus the threat of suppliers is greater for higher cost competitors
than for the cost leader

Threat of Buyers
• cost leaders in a market typically have large market share—meaning they will
probably be among the largest, most powerful suppliers in an industry
• buyers will naturally be more dependent on such supplier firms
• a cost leadership position will create a disincentive for buyers to vertically
integrate backwards for all the reasons listed in the Threat of Entry section
• cost leaders can more easily absorb demands for lower prices or increased service
and/or quality from powerful buyers compared to higher cost competitors

Rareness of Sources of Cost Advantage

The source of a cost advantage will confer competitive advantage only if the source is rare.
Remember that we said the starting point in this competitive advantage analysis of a cost
advantage is at the point where it has been determined that the focal firm has a cost
advantage. Well, by definition, if a firm has a cost advantage it must be relatively rare. The
real question then becomes, “How long is it likely to remain rare?” Of course, answering
this question is really a matter of assessing the costs of imitation, which will be addressed in
the next sub-section. However, it is useful to understand why a source of cost advantage is
rare at a given point in time.
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In most cases the rareness of a source of cost advantage at a given point in time is
dependent on the interaction of two things: 1) the life cycle stage of the industry, and 2) the
imitability of the source of the cost advantage. Some sources of cost advantage will be rare
in the emerging stages of an industry and then become less rare as the industry matures—
some will remain rare. Yet other sources may be rather common in the emerging stage of an
industry and become more rare as the industry matures—some will remain common.
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The Six Sources of 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

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
(Remember diseconomies of scale refer to other firms, not
the focal firm)

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
• 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

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

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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for competitors because of path dependency—other airlines face a large cost

disadvantage in attempting to adopt some of Southwest Airlines’ human
resource policies

Imitability of Sources of Cost Advantage

The resource-based view logic introduced in Chapter 3 holds that a firm’s cost advantage
will generate competitive advantage only if competitors face a cost disadvantage in
attempting to imitate the cost advantage. Understanding the imitability of a source of cost
advantage is important from at least two perspectives. First, if the focal firm is found to
have a cost advantage, managers would want to know if that advantage is costly for
competitors to imitate. Second, if a competitor is found to have a cost advantage, managers
of the focal firm would want to know if the focal firm faces a cost disadvantage in imitating
the source of cost advantage.

Low Cost Imitation Conditions

Unbalanced Industry Capacity and Demand

• when an industry has excess demand, economies of scale advantages are
imitated at relatively low cost because competitors have an incentive to
expand capacity
• when an industry has excess demand, learning curve advantages are less costly
to imitate because there is room in the market for several firms to be moving
down the learning curve simultaneously (this is observed in the memory chip
industry)
• when an industry has excess capacity, diseconomies of scale advantages will
disappear more rapidly because firms operating beyond the minimum
efficient scale will quickly realize their diseconomies and correct them

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)

Transactional Exchange
• cost advantages such as differential low cost access to inputs and policy
choices that are based on transactional exchanges (purely arm’s length
transactions) 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 Imitation Conditions

Balanced Industry Capacity and Demand

• economies of scale advantages are more costly to imitate in balanced
industries because would-be imitators face a lower net benefit if they add
industry capacity (excess capacity will lead to lower overall prices for output,
lowering the net benefit of entry)—economies of scale present a barrier to
entry
• diseconomies of scale may be more difficult to recognize for firms that have
expanded beyond the minimum efficient scale, making the advantage for the
focal firm more durable

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

Highly Unobservable Technology (Causal Ambiguity)

• 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 (Social Complexity)

• 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.

► Example: Low Cost Advantage of U.S. Catfish Gets Challenged

Although catfish was a regional favorite in parts of the Southern U.S., it was
generally considered an undesirable ‘trash’ fish by many consumers in the
U.S. until the 1980s. Based on the knowledge that catfish are hardy
creatures, enterprising farmers began digging ponds on their land to raise
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catfish in a controlled environment. These farmers soon discovered that

catfish could be produced at a considerable cost advantage compared to
other species of fish. Consumers had to be convinced that farm-raised
catfish was good tasting and healthy. In time the marketing efforts of catfish
producers and processors paid off. By 2000, the catfish market had grown to
over $600 million in the U.S. Catfish was widely available in grocery stores
and restaurants. It was widely viewed as a low cost alternative to farm raised
trout and salmon.
The successful development of the catfish market in the U.S. was a
direct result of the cost leadership strategy pursued by producers. Catfish are
very efficient at converting low cost feed into body mass, making their
cultivation a natural ‘cost leadership’ strategy. The feed used to grow catfish
is primarily a by-product of other food manufacturing operations, thus
making the feed relatively inexpensive. Furthermore, the cost of the land
used in catfish production is typically very low. Labor costs in the rural
South further enhanced the cost advantage of raising catfish.
In 1994, the U.S. began to normalize trade relations with Vietnam.
By 1998, trade barriers that had made the export of catfish to the U.S.
unprofitable for Vietnamese producers had been removed. Imports of
Vietnamese catfish into the U.S. exploded between 1998 and 2001 from 0.6
million pounds to 17 millions pounds. Early on this imported catfish was
sold primarily in ethnic markets to Vietnamese immigrants. However, the
low price of Vietnamese catfish soon caught the attention of large U.S.
grocers.
Vietnamese catfish producers had several important cost advantages
over U.S. producers. In fact, the very cost advantages that U.S. catfish
producers had over the producers of other farm-raised fish were now
advantages enjoyed by Vietnamese producers. Feed was less costly in
Vietnam. Labor was a fraction of the U.S. cost. For many Vietnamese
farmers there were no land costs associated with catfish production because
the farmers simply used nets that floated under their houseboats—they were
already living on the Mekong River.
U.S. catfish producers quickly became suspicious that Vietnamese
producers were ‘dumping’ (selling below cost) catfish in the U.S. market.
This was very difficult to prove because it was impossible to get actual
production costs because of the industry structure (1000’s of very small
producers) and Vietnamese government policy. Production costs in India
and Bangladesh were used to impute production costs to Vietnam. Based on
these imputed costs it was determined that the Vietnamese were guilty of
dumping. Penalties ranging from about 32% to 65% were imposed on
various Vietnamese importers. Vietnamese producers were also prohibited
from calling their product catfish. They were forced to use the traditional
names of Basa and Tra. (Aguiar, Anh, & Davies, 2005, The Agifish Case:
International Trade Dispute and Market Opportunities for Catfish in the
Mekong Delta. Royal Agriculture College, Cirencester, UK).
There is no question that Vietnamese producers have a significant
cost advantage over U.S. producers. Capital requirements and labor costs in
Vietnam are a small fraction of U.S. costs. Most of these cost differences
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stem from cultural and lifestyle differences. The standard of living

demanded by Vietnamese producers and laborers is vastly different from that
demanded by U.S. producers and laborers.
The catfish market is a good example of how cost leadership
positions may change with new market entrants. In this case, we observe
that economies of scale and learning curve cost advantages may become
obsolete in the face of competitors who face a different set of constraints.
Whereas large U.S. producers benefited from economies of scale and
learning curve advantages, extremely small Vietnamese producers quickly
learned to produce at much lower costs in a market environment that was
fundamentally different from that faced by U.S. producers.

Implementing Cost Leadership through Organizational Structure and Control

Managers intending to pursue a cost leadership strategy must consider several important
organizational issues. Recall the experiences of General Lee at Gettysburg during the Civil
War. Great strategy without sound implementation is not great strategy at all. The eventual
success of a cost leadership strategy depends on the appropriate implementation of that
strategy within an organization.
Organizational structure refers to how management responsibilities are divided and
the reporting relationships among various managers. Organization control refers to the
policies a firm adopts to give people incentives to behave in certain ways. These policies are
intended to align the interests of employees with the interests of the organization. Structure
and control issues must be addressed if a strategy is to be successfully implemented.

Organizational Structure. Students will understand the functional structure best if

they understand the organizational structure alternatives. Three basic organizational
structures are: simple, functional, and multi-divisional. An organization in which one
person, or perhaps a 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.

The functional structure simply means that the organization is structured around
the business functions that must take place for the firm to succeed. Suppose the family-
owned grocery store has expanded to several stores. Now it makes sense to have one person
responsible for purchasing, one person responsible for all the accounting, one person
responsible for all the marketing, etc. A manager is assigned responsibility for each business
function. This manager reports to the CEO who has overall responsibility for the company.

The multi-divisional structure is a replication of the functional structure across two

or more divisions. Each division has a manager of each of the functions who report to a
division manager who then reports to the CEO of the company. Suppose the family-owned
grocery business has grown to the point that it makes sense for the company to have its own
warehousing and transportation business. The multi-division structure would be adopted by
appointing a division manager for the grocery business and a division manager for the
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transportation business. Within each division there would be an accounting manager, a

purchasing manager, a finance manager, a marketing manager, etc.

The functional structure and cost leadership. It should be noted that functional
structure is used to implement strategy at the business level in organizations of significant
size whether the overall organization is using a functional or multi-divisional structure. If
the organization is using the functional structure (meaning there are no divisions), then the
CEO is the only person who has an enterprise-wide perspective. If the organization is using
the multi-divisional structure, then within each division the division manager is the only
executive with a division- or business-level perspective. This arrangement implies two
notable characteristics of the functional structure. First, the CEO or division manager is the
only executive tasked with responsibility for the whole enterprise or business. The
functional structure is sometimes referred to as the U-form structure, which stands for
“unitary” because of the singularity of the CEO’s perspective. Second, the functional heads
are able to specialize in their respective functions. The specialization within functions is a
large part of what makes this structure attractive to firms pursuing cost leadership strategies.

SUMMARY OF COST LEADERSHIP

The main things that you want students to go away from this class session with are:

1) an understanding of the concept of business level strategy

• the positioning of a single business, even if the firm is involved in more than
one business
2) an understanding of the benefits of a cost leadership strategy
• in a competitive market, a cost advantage may be the only way to achieve
above normal economic returns
• a cost leadership position will allow a firm to enjoy greater margins
• a cost leadership position may be a valuable barrier to competitive threats by
other firms
3) the six sources of cost advantage
• economies of scale
• diseconomies of scale
• learning curve advantages
• differential low cost access to inputs
• technology advantages independent of scale
• policy choices
4) an understanding of how a cost leadership position allows a firm to respond to the
five industry forces
5) an appreciation of the fact that a cost leadership position will lead to competitive
advantage only if the cost advantage is rare and costly to imitate
6) an understanding that a cost leadership strategy must be implemented appropriately
within the organization
7) a basic understanding of organizational structure and control
(Source: Hooley, Saunders and Piercy, ‘Marketing Strategy and Competitive Positioning’, 3rd Ed., Prenhall,
2004)