Cost Leadership Strategy (Low-Cost Strategy)

Cost Leadership StrategyCost leadership strategy is also known as ‘low-cost provider strategy’, or simply ‘low-cost strategy.’

We will use the term low- cost strategy’ in this book.

The company that follows this strategy intends to become the overall low-cost provider in the industry in which the company operates its business.

A company strategy of selling its products at a price lower than its competitors is known as a cost leadership strategy.

The emphasis is placed on the production of standardized products at a low per-unit cost for price-sensitive customers.

Charging lower price becomes possible when the company can ensure post-reduction by operating business in a highly cost-effective manner.

The strategic target of this strategy s a broad section of the, market where the company offers economical prices The company emphasizes cost reduction without reducing quality. The company intense to gain market share by underpricing the competitors.

Some widely known companies that employ low-cost strategy include Whirlpool and general electronic company in home appliances, Black and Decker in power tools, and more.

The key to sustaining low-cost strategies to manage costs down in every area of the company’s business. The goal of this study is to outperform competitors through low-cost leadership.

When a company becomes a low-cost leader it is likely to earn above-average profits.

Creating and then sustaining cost advantages RK to attaining success in a low-cost strategy. Accompany me a cheap cost advantage by

  • doing a better job than competitors in performing internal value chain activities efficiently,
  • Taking initiatives to cut down the cost of value chain activities, and
  • recognizing the value chain to avoid or bypass some cost producing activities.

Cost leadership implies that the organization has a lower cost structure than a competitor and therefore it is in a position to offer the cost advantage to customers by offering lower prices.

The sources of the cost advantage can be rare and inimitable. The organization designs the cost advantage.

Walmart, Air Asia, McDonald’s Timex, and Calvin Care are some examples of organizations competing based on costs lower than competitors.

Organization’s Cost Leadership Strategy or Low-Cost Structure are Designed to Leverage

Organization’s cost leadership strategy or low-cost structure leverages; size, learning advantages differential, access to resources reconfiguration of the value chain, technology-related cost advantages.

Size

Size implies the volume of production. As the volume of production increases per unit cost of production is lowered till an optimum volume is reached.

relationship between cost and the volume of production

A higher volume of production implies cost reductions across some of the key functions. The reduction in the cost of production is seen in operations such as production, marketing, and servicing.

Further, a higher volume of production enables an organization to use equipment and machines whose use is not possible in smaller production volumes.

For example, in a readymade garment workshop, there are many types of machines for finishing that one cannot afford to buy and use in a boutique stitching shop.

These machines reduce the cycle time, further lowering costs. Overhead costs are also apportioned over a larger volume.

Learning Advantages

As the volume of production increases so does the experience of the employees doing the task repeatedly. An increase in experience means fewer mistakes.

Organizations that may have the highest accumulated volume of the production are likely to have the lowest cost based on the learning curve.

With the increase in the cumulative volume of production, greater efficiency is obtained as production methods are fine-tuned and improved.

Differential Access to Resources

Organizations may have better access to resources than their competitors. It could be access to a natural resource, location advantage or better workforce by proximity to an educational hub.

Consider a fictional example of an organization sourcing its oil supply from Saudi Arabia versus another from the North Sea.

The one sourcing from Saudi Arabia has a distinctive cost advantage over the one sourcing from the North Sea where the cost of drilling and transportation is much higher.

The cost of gaining a differential advantage must be lower than the cost savings from using that advantage.

Reconfiguration of the Value Chain

Organizations can either alter the value chain incrementally or reconfigure it afresh by restating their competitive posture and strategy.

At times an organization is caught in cost traps serving no particular segment fully.

Let us consider the case of a fictional airline that serves neither the full-fare segment totally nor the low-cost segment. It offers something for everybody and its profitability is lower than that of rivals who either serve the full segment or the no-frills segment.

To improve its profitability it reconfigures routes, has more flying hours per day, operates early morning in and late night out flights to business destinations so that flyers can do a day trip, charges for food, seats based on first-come, first-served and focuses on being punctual.

This reconfiguration of the value chain creates cost advantages that weren’t realized earlier.

If, however, the organization is not caught up in the cost trap as the airline was, incremental changes are possible.

Technology Related Cost Advantages

Technology related cost advantages may be independent of scale economies.

An organization may have the ability to use computers, robots, information technology in a more efficient manner than its competitors.

It may use the same technology as is available to others to create for itself some distinction such as a more comprehensive database.

Sharing Information and Knowledge

The organization’s culture of sharing information and knowledge is an important aspect of creating a cost advantage.

Organizations that compete on the cost basis integrate the cost reduction thinking across all functions and activities not only in the key areas.

Cost advantage does not result from a few activities; it is the outcome of the cumulative activities an organization performs to be in a cost-competitive position.

There is an asymmetry in the cost advantages yielded by some functional areas over others but overall cost advantage is not achieved by a focus on a few areas. Cost-consciousness is built across the entire organization.

Costs deemed unnecessary are curtailed across the organization. The functional strategies have to be articulated to deliver in consonance with the cost focus strategy.

Benefits of Cost Leadership Strategy to Business Organizations

A business organization may derive the following benefits from pursuing a cost leadership strategy:

Overcoming threats from competitors

Because of its cost advantage, a company can protect itself from the business- attacks of the competitors. If competitors enter into a market with a low price, the company can even further cut down its prices.

This is possible because the company has already developed ways to reduce costs and sustain the cost advantage. Its cost- leadership position helps it dominate the competitors.

Effective dealing with powerful suppliers

When suppliers are few in number as well as powerful, they may try to increase prices of raw materials/other inputs. The company with a low- cost strategy can endure such price-increase because of its overall lower costs:

Facing powerful buyers effectively

Powerful big buyers (such as dealers and wholesalers or retail chains like Agora, Meena Bazaar of Wal-Mart) may dictate the prices of a company’s products. A company that follows a cost leadership strategy is less affected by such actions of buyers.

Encountering threats from substitute products

A low-cost leader can overcome threats from substitute products. It can reduce the price of its products if substitute products start entering the market. Low-cost leadership helps the company retain its market share.

Overcoming threats from the entry of potential competitors

A company with a low-cost strategy or cost leadership strategy can discourage other potential investors to come to the market. Its cost advantage automatically creates barriers to entry. Other, companies may find it difficult to match their costs with that of .the low-cost leader.

Cost leadership and Supply Chain.

The cost leadership strategy is realized by developing a highly efficient cost-responsive supply chain.

Low inventory levels are maintained, the inventory turnover is high, the plant lead time is less, the buyers are low­cost and match their value chain with the customer, they enable time-definite deliveries with low variability and orders are generally standardized.

Manufacturing avoids waste, error, and the use of unnecessary assets. Tasks that can be done at a cost advantage are sourced outside.

Maintenance for smooth functioning is done routinely as the cost of a breakdown may be high. Employees are trained to carry out standardized tasks and follow cost-efficient methods.

The suppliers are smaller organizations for whom the organization may be a major or a dominant buyer.

Cost Leadership and Research and Development

Research and development in a cost-focused environment aim to reduce the costs. Technology sourcing and adaptation are the preferred routes over a product or process-specific research.

The research and development efforts are more inclined towards the adaptation of the best practices leading to cost and efficiency advantages than fresh research.

A cost-focused strategy implies that the research and development focus is more on slower product releases and lesser investment in the R&D.

Cost leadership and Manufacturing/Operations

The manufacturing or the operations strategy has a significant implication on costs. The manufacturing system that is adapted to the cost focus will be configured to fit it so well that it may immediately be possible to configure it for any other focus.

Operations strategy is based on the extent of the product and process complexity. The low product complexity is more conducive to mass production as would be required to attain the desired cost position.

The production process may be complex to handle the large volume of standardized products.

A low-cost strategy is not synonymous with low quality and therefore the production process may be complex, as on a large volume base many different specifications have to be handled.

Production is continuous and generally with a high degree of automation. Maximum capacity utilization is the target to attain economies of scale.

Cost leadership and the Marketing Strategy

Cost leadership is based on the premise that the market is price sensitive. Marketing is aggressive and promotions and discounts are widely used.

The distribution channels have to be efficient and may be configured to the value chain of the manufacturer. The focus is on ‘push the product’.

Cost Leadership and Human Resources Strategy

Ideally, the human resource strategy is aimed at recruiting and retaining the best human resources within an organization.

The pursuit of a specific strategy determines the skill profile of the people who are required within the organization and the development of performance measures commensurate with the strategy. The cost leadership strategy requires a high degree of coordination among the key areas.

To be able to reap the benefits of scale advantage timing is another crucial determinant.

Employees who exhibit a high degree of focus energy, capacity to deliver sooner and focus on measurable results will be greater assets for such a strategy.

Cost Leadership and Finance Strategy

Corporate strategy has a greater bearing on the finance function than the functional strategy.

The finance and accounting strategy at the business level is concerned with apportioning cost to key activities, creating measures of financial control, managing the cash flows and short term fund requirements of the organization.

In the competitive domain, the responsibilities of the finance function remain the same. The choice of the competitive strategy determines the type and extent of financial control measures to be used.

The cost focus strategy uses key financial ratios to measure performance and as controls. Acquisitions to enhance capacity may be made on a more rigid appraisal of capacity and efficiency benefits.

Cost Leadership and Digitization

Digitization is an important source of creating efficiency and effectiveness in the organization. For cost control the synergy between the digitization and the information system of the organization is important.

The information system enables it to have a connected supplier network and work towards zero inventory goals.

For cost advantage, the supply chain systems are linked with an automated manufacturing system to reduce inventory and remove duplication of effort.

The organization uses enterprise-wide systems to facilitate standardization.

However, in the future, this might have to be linked with robotics for fully automated manufacturing.

Market Situations Favorable for Cost Leadership Strategy

A low-cost provider strategy works best under the following situations:

  1. When the brand differences from company to company are minor, and at the same time, the products are standardized and readily available
  2. When the market is composed of a large number of price-sensitive buyers who want to buy products, at the lowest possible price.
  3. When there are few ways to achieve product differentiation. It means that it is difficult to differentiate the company’s products from those of competitors due to the* nature of the product. Buyers become sensitive to price differences when produce-to-product differences are negligible. In such a situation, they will go for the lowest price.
  4. When switching costs from the company’s brand to competitors’ brands are low or even If buyers purchase another brand and this switching from the previous brand does not involve any additional cost (such as transportation or repair) they are likely to opt for the lower-priced brand.
  5. When there are a large number of buyers with significant bargaining power, i.e., they, have significant power to negotiate price-related terms and conditions.
  6. When price-competition among, the sellers/suppliers is very tough. A cost leadership strategy helps producers, to compete effectively based on the price.
  7. When the company is in a position to use the lower-cost edge to attract price-sensitive buyers in great enough numbers to influence total profits.

Reasons for Failure of Cost Leadership Strategy

The cost leadership strategy or low-cost strategy has some shortcomings or pitfalls. Managers need to take care of these pitfalls so that they cap, undertake appropriate measures to be successful with this strategy.

The shortcomings are as follows, which are responsible for the failure of the cost leadership strategy:

  • It may invite aggressive price-cutting by competitors. It may lead to a price-war that may lead to lower profitability.
  • Cost advantages may not sustain if competitors can easily imitate the strategy. When the competitors can copy the cost advantages, a cost leadership strategy will fail. So, the ways to achieve cost advantage need to be difficult for others to copy.
  • If a low-cost product does not contain enough attributes to be attractive to prospective buyers, the strategy may fail. Low price is not always appealing to buyers. Attractiveness may be lost if the product is features-poor or quality-deficient.
  • The cost leadership strategy may become ineffective when there are technological breakthroughs by the competitors in the industry.

Strategic Choice of Low-Cost Provider

To be successful with the cost leadership strategy, low-cost providers resort to various strategic choices:

  • They try to avoid product differentiation. If avoiding differentiation is difficult due to changes in the market, they willfully choose a low level of product differentiation to keep production costs at a low level. They wait and see when customers seriously Want to have differentiated features in the product.
  • They do not focus on elite customers in the market. Average customers are their main targets. They do not operate in different market segments with different types of products. This is because it is highly expensive to develop product lines for different market segments.
  • Their attention is more on reducing costs in each area of business activities. They want to increase efficiency in production and service activities to reduce wastage of resources. They develop distinctive competencies in manufacturing and materials management to reduce manufacturing costs and thereby increasing efficiency.
  • They develop skills in flexible manufacturing/lean manufacturing, just-in-time (JIT) production and total quality management. They also adopt efficient materials management techniques.
  • They emphasize on strict production control and rigorously use budgets to control the production process.