There are two major ways that a firm can gain a cost advantage:
- Control cost drivers. A firm can gain an advantage with respect to the cost drivers of value activities representing a significant proportion of total costs.
- Reconfigure the value chain. A firm can adopt a different and more efficient way to design, produce, distribute, or market the product.
The two sources of cost advantage are not mutually exclusive. Even a firm with a very different value chain from its competitors will have some common activities, and its relative cost position in them can enhance or detract from overall cost position.
Successful cost leaders usually derive their cost advantage from multiple sources within the value chain. Sustainable cost advantage stems not from one activity but from many, and reconfiguring the chain frequently plays a role in creating cost advantage. Cost leadership requires an examination of every activity in a firm for opportunities to reduce cost, and the consistent pursuit of all of them. More often than not, cost leaders have a culture emanating from senior management that reinforces such behavior. It often includes symbolic practices such as spartan facilities and limited executive perquisites.
Cost reduction may or may not erode differentiation. Every firm should aggressively pursue cost reduction in activities that do not influence differentiation (see Chapter 4). In activities that contribute to differentiation, a conscious choice may still be made to sacrifice all or part of differentiation in favor of improving relative cost position.
1. CONTROLLING COST DRIVERS
Once a firm has identified its value chain and diagnosed the cost drivers of significant value activities, cost advantage grows out of controlling those drivers better than competitors. A firm can potentially achieve superior position vis-à- vis the cost drivers of any activity in the value chain. Activities that represent a significant or growing proportion of cost will offer the greatest potential for improving relative cost position. While the appropriate cost drivers will vary for each activity, some generalizations about how controlling each of the ten cost drivers can lead to cost advantage in an activity are as follows:
2. CONTROLLING SCALE
Gain the Appropriate Type of Scale. Increasing scale through acquisitions, product line extensions, market expansion, or marketing activity can lower cost. However, the type of scale that drives cost differs by activity. Boosting local or regional scale in an existing region will usually lower sales force or physical distribution costs, while raising national scale by entering a new region may actually raise these costs. By looking throughout the value chain for the types of scale that drive cost, the value of scale (and hence market share) of different types can be assessed. Pursuit of scale should be selectively tuned to the type of scale that drives the cost of important activities in the particular industry. Scale increases in different activities must be balanced, moreover, so that pursuing scale in one activity does not create diseconomies in another.
Set Policies to Reinforce Scale Economies in Scale-Sensitive Activities. Scale economies are partly a function of how activities are managed. Eaton has maximized its scale economies in engine valves, for example, by simplifying its product line.
Exploit the Types of Scale Economies Where the Firm Is Favored. A firm should manage activities in ways that bring out the types of scale economies that most favor it. A firm with high global share should manage product development to emphasize global scale, for example, by stressing world products rather than country-tailored ones.
Emphasize Value Activities Driven by Types of Scale Where the Firm Has an Advantage. Since different types of scale drive the cost of different value activities, a firm should set its strategy to emphasize as much as possible the activities in which it has superior scale of the appropriate type. For a regional producer competing with national firms, for example, this may imply that sales force assistance and service should be emphasized, rather than rapid new product introduction whose cost is driven by national or global scale.
3. CONTROLLING LEARNING
Manage with the Learning Curve. Learning does not occur automatically but results from the effort and attention of management and employees. Attention to learning should not be confined to labor costs but also to the cost of constructing facilities, the cost of scrap, and other significant value activities. Every premise and every practice must be examined for possible revision. Management must demand learning improvements and establish targets for them, rather than simply hope that learning will occur. When setting targets, the rate of learning should be compared across facilities and regions, as well as to industry standards. A firm must also establish mechanisms to facilitate the sharing of learning across facilities and business units. The sharing of learning is often impeded by geographic distance and internal rivalry.
Keep Learning Proprietary. Learning can lower a firm’s relative cost position if the firm minimizes the spillover rate to competitors. Keeping learning proprietary can become an important means of achieving cost advantage in learning-sensitive value activities. Means for accomplishing this include:
- backward integration to protect know-how, such as by building or modifying production equipment in-house
- controlling employee publications or other forms of information dissemination
- retaining key employees
- strict non-disclosure provisions in employment contracts
Learn from Competitors. Pride should not interfere with exploiting the learning of competitors. Analysis of competitor value chains allows a firm to uncover good ideas that can be applied in-house. There are many ways to acquire competitor learning, including reverse engineering of competitor products, studying published material including patent filings and articles about competitors, and maintaining relation-ships with competitors’ suppliers to gain access to knowhow and to the latest purchased inputs.
4. CONTROLLING THE EFFECT OF CAPACITY UTILIZATION
Level Throughput. A firm can often increase average capacity utilization by finding ways to level the fluctuations of volume through its value chain. For example, Sun-Diamond, the agricultural cooperative that produces Sun Maid raisins, Diamond walnuts, and other products, has reduced the cost of underutilization by promoting year- round baking uses for its products. These have reduced demand differences between the Christmas season and the rest of the year. Similarly, credit card processors can level throughput by serving a mix of accounts that have peak volumes spread throughout the year, e.g., beach clubs and ski areas.
A firm can level throughput through a variety of means, including:
- peak load or contribution pricing
- marketing activity, such as increasing promotion during slack periods and finding off-season uses for the products
- line extensions into less cyclical products, or into products that can intermittently utilize excess capacity (e.g., private label)
- selecting buyers with more stable demand or demands that are counterseasonal or countercyclical
- ceding share in high demand periods and regaining it in low demand periods
- letting competitors serve fluctuating segments12
- sharing activities with sister business units with a different pattern of needs (see Chapter 9).
Reduce the Penalty of Throughput Fluctuations. In addition to smoothing throughput fluctuations, a firm can sometimes reduce the costs associated with fluctuations in the volume of activity. Tapered integration, for example, is a means of using suppliers to cover peak needs rather than satisfying them in- house. Canadian steel producers, for example, have avoided excess capacity despite fluctuating sales by adding capacity for trendline demand growth rather than year- to-year demand. They sell steel produced by subcontractors and foreign firms to cover shortfalls.
5. CONTROLLING LINKAGES
Exploit Cost Linkages Within the Value Chain. A firm can improve its cost position if it recognizes linkages among value activities and exploits them. The additional cost of achieving higher precision in machining parts may, for example, be offset by a reduction in inspection costs of the finished products. Recent technological advances are making linkages stronger and more possible to achieve. Information systems are making coordination among activities easier, while computer-aided design and manufacturing is just one example of how microelectronics is linking other activities.
Work with Suppliers and Channels to Exploit Vertical Linkages. Vertical linkages imply that relations with suppliers and channels offer possibilities for all parties to gain through the coordination and joint optimization of their respective value chains. Xerox, for example, provides suppliers with its manufacturing schedule through computer terminals, enabling suppliers to ship parts precisely when needed. Seeking out and pursuing such opportunities will require careful study of supplier and channel value chains, as well as the determination to overcome suspicion, greed, and other barriers to joint action. A firm must be prepared to share the gains of linkages with suppliers and channels in order to ensure that they can be achieved.
6. CONTROLLING INTERRELATIONSHIPS
Share Appropriate Activities. A firm can often reduce its relative costs significantly by sharing value activities with sister business units, or by entering new businesses in which opportunities for sharing exist. Chapter 9 describes in detail how to identify opportunities for sharing that lower cost.
Transfer Know-how in Managing Similar Activities. A diversified firm may also be able to transfer know-how gained in managing a value activity to other business units with generically similar activities. The issues involved in doing so are also discussed in Chapter 9.
7. CONTROLLING INTEGRATION
Examine Systematically Possibilities for Integration and De-integration. Both integration and de-integration offer the potential of lowering costs. As changes in management attitudes and new information system technology are making supplier linkages easier to achieve, de- integration is becoming more and more attractive in many industries.
8. CONTROLLING TIMING
Exploit First-mover or Late-mover Advantages. The first mover in an industry often reaps a long-lasting cost advantage by tying up the best locations, preempting the best personnel, gaining access to preferred suppliers, or securing patents. In some industries, in fact, only the first mover can gain a significant cost advantage. In other industries, late-movers may gain cost advantages because technology is changing rapidly or they can observe and cheaply imitate the actions of the pioneer. First-mover and late-mover advantages are discussed in Chapter 5.
Time Purchases in the Business Cycle. Purchasing assets during periods of soft demand can yield a major cost savings. This is the case for many capital goods such as machinery, ships, and even complete plants.
9. CONTROLLING DISCRETIONARY POLICIES
Modify Expensive Policies That Do Not Contribute to Differentiation. Many policies that govern a firm’s activities raise cost. Sometimes a firm consciously does so in the hope of creating differentiation. Often, however, firms fail to recognize the cost of a policy. Cost analysis will often highlight the need to modify such policies, and careful scrutiny may also reveal that a policy does not contribute meaningfully to differentiation because its costs outweigh the price premium it generates. Both situations offer opportunities for cost reduction. Chapter 4 will describe how to evaluate the role of value activities in differentiation.
Invest in Technology to Skew Cost Drivers in the Firm’s Favor. New technology often underlies cost advantage. Technology can also allow a firm to make its competitor’s advantages vis-à-vis cost drivers obsolete. The level of technology investment is a policy choice and most cost leaders invest aggressively. Iowa Beef, for example, spends $20 million or more on plant renovations annually. Some of the important ways in which technology investment lowers costs include:13
- Developing low-cost processes. For example, Union Carbide’s Unipol process for making low-density
- Facilitating automation. For example, Iowa Beef’s massive beef processing plants and K Mart’s automated distribution
- Low-cost product designs. For example, Canon’s NP200 copier with fewer
In some cases, the ability to apply new low-cost technology depends on scale. In soft contact lenses, for example, Bausch and Lomb’s dramatically lower-cost spin casting technology for manufacturing lenses is much more scale-sensitive than lathe technology. However, the choice of technology can also be related to other cost drivers such as timing, location, or integration. A firm should invest in technology development in areas that will skew cost drivers the most in its favor.
Avoid Frills. Most cost leaders control discretionary expenses throughout their value chains. National Semiconductor executives work in spartan surroundings with few private offices, and similar characteristics apply to other cost leaders including Lincoln Electric, People Express, and Crown Cork and Seal. Such policy choices not only reduce costs in their own right but also seem to have important symbolic value.
10. CONTROLLING LOCATION
Optimize Location. The location of activities in relation to each other as well as to buyers and suppliers often contributes significantly to such things as labor rates, logistical efficiency, and supplier access. The firm that locates its facilities well will often gain a significant cost advantage. The optimal location of activities changes over time, as is happening today in the steel industry with the emergence of mini-mills.
11. CONTROLLING INSTITUTIONAL FACTORS
Do Not Take Institutional Factors as a Given. Firms can influence institutional factors such as government policies and unionization, despite a tendency to view institutional factors as beyond their control. For example, many unionized trucking companies have established nonunion subsidiaries. Firms can also frequently influence regulation through lobbying, as Japanese firms are actively seeking to do in states that have begun taxing foreign profits. A number of states are already committed to repealing their laws to avoid scaring away foreign investors.
12. PROCUREMENT AND COST ADVANTAGE
Procurement practices have a potentially major impact on cost position that cuts across activities. A number of possible changes in procurement can reduce costs:
Tune Specifications of Purchased Inputs to Meet Needs More Precisely. A firm can improve its cost position by ensuring that the quality of purchased inputs meets, but does not exceed, the firm’s requirements. Clark Equipment, for example, has begun to move toward automotive grade components for some lift truck models, rather than more expensive and unnecessarily high-quality truck grade components.
Enhance Bargaining Leverage Through Purchasing Policies. Firms rarely view purchasing strategically or as a bargaining problem, though purchasing practices can significantly affect cost. Firms can take a number of specific actions to enhance their bargaining power with suppliers:
- Increase bargaining power in purchasing by keeping the number of sources sufficient to ensure competition, but small enough to be an im portant buyer to each source.
- Select suppliers who are especially competitive with each other, and divide purchases among them.
- Vary the proportion of business awarded to suppliers over time to ensure that they do not view it as an entitlement.
- Solicit occasional proposals from new suppliers, both to test market prices and gather technological intelligence.
- Enhance the leverage of purchasing scale through contracting based on annual volume with phased deliveries, instead of making frequent smaller purchases.
- Seek out opportunities to combine purchases with sister business units.
- Appoint high-quality purchasing executives to allow more sophisticated buying practices.
- Invest in information to understand suppliers’ costs and market conditions better.
- Pursue technology development to eliminate or reduce the need for expensive inputs where unit costs cannot be reduced.
Select Appropriate Suppliers and Manage Their Costs. A firm should select those suppliers which are most efficient or those that offer the least costly product to use given the firm’s value chain. Purchasing practices should also include promoting supplier cost reduction, aiding suppliers where necessary with technology development, and encouraging supplier practices that lower the firm’s cost through linkages. Marks and Spencer, for example, has achieved a low cost position in retailing in the United Kingdom through active efforts to help suppliers adopt the most modem technology. Managing the efficiency or effectiveness of the supplier base, using an analysis of supplier value chains essentially the same as the analysis of its own chain, can be equally as important to cost position as enhancing bargaining power over suppliers.
13. RECONFIGURING THE VALUE CHAIN
Dramatic shifts in relative cost position most often arise from a firm adopting a value chain that is significantly different from its competitors’. Reconfigured value chains stem from a number of sources, including:
- a different production process
- differences in automation
- direct sales instead of indirect sales
- a new distribution channel
- a new raw material
- major differences in forward or backward vertical integration
- shifting the location of facilities relative to suppliers and customers
- new advertising media
No-frills airlines such as People Express and Southwest Airlines provide a striking example of strategies based on reconfiguring the value chain. They have adopted chains that differ markedly from trunk carriers, as shown in Table 3-4.
Two other examples from different industries illustrate the significant cost advantage to be gained through reconfiguration of the value chain. In beef packing, the traditional value chain involved raising cattle on isolated farms and shipping them live to labor-intensive abattoirs in major rail centers like Chicago. After the animal was slaughtered and broken, whole sides of beef were shipped to markets where they were cut into smaller pieces by retailers. Pursuing an innovative strategy, Iowa Beef Packers built large automated plants near the cattle supply and processed the meat there into smaller “boxed” cuts. This significantly reduced transportation expense, a major cost, as well as raised yield by avoiding the weight loss that occurred when live animals were shipped. Iowa Beef also reduced costs in the operations activities in the value chain by using cheaper nonunion labor, readily available in rural areas where its new plants were located.14
Federal Express similarly redefined the value chain for air delivery of small parcels. Traditional competitors such as Emery and Airborne collected freight of varying sizes, shipped it via the airlines, and then delivered it to the addressee. Federal Express limited itself to small packages and flew them on company-owned planes to its central hub in Memphis where the parcels were sorted. It then flew the parcels to their destinations on the same planes and delivered them in company-owned trucks. Other dramatic reconfigurations of the value chain include the early discount retailers, discount stockbrokers, and new long distance telephone companies such as MCI and Sprint.
Reconfiguring the value chain can lead to cost advantage for two reasons. First, reconfiguration frequently presents the opportunity to fundamentally restructure a firm’s cost, compared to settling for incremental improvements. The new value chain may prove inherently more efficient than the old one. The success of the no-frills airlines vividly illustrates how adopting a different value chain that is inherently cheaper can allow a firm to establish a new cost standard for an industry. On some routes, no-frills airlines have achieved costs that are as much as 50 percent lower than those of trunk carriers. Not only are activities performed more cheaply in the new value chain, but linkages are exploited. By ticketing on-board, for example, People Express significantly reduces cost in other value activities such as gate operations and ticket counter operations.
The second way an alternate value chain can lead to cost advantage is by altering the basis of competition in a way that favors a firm’s strengths. Reconfiguration of the chain may change the important cost drivers in a way that favors a firm. Performing an activity differently can change its susceptibility to scale economies, interrelationships, locational effects, and virtually every other cost driver. In aluminum, for example, Japanese firms are investing in the new carbo- thermic reduction process that converts bauxite and related ore directly into metal, skipping the intermediate alumina stage. This would nullify the Japanese firms’ serious disadvantage in power costs. In the beef processing case, Iowa Beef redefined the role of location as a cost driver and increased scale sensitivity. A firm with a large market share, like Iowa Beef, often benefits from shifting to a more scale- sensitive value chain. In the case of the no-frills airlines, the new value chain is less scale-sensitive than the old one because of the reduction in indirect activities. This has been important to the success of the newly established no- frills carriers.
Coalitions and other interfirm agreements sometimes provide firms with a way to reconfigure the value chain even if they cannot do so independently. A number of multiple system operators of cable television franchises have traded franchises to increase marketing and operating efficiency, for example. Similarly, Allied Chemical and Church & Dwight have worked out a deal to swap identical raw materials produced in different locations to save transportation costs.
To identify a new value chain, a firm must examine everything it does, as well as its competitors’ value chains, in search of creative options to do things differently. A firm should ask questions such as the following for every activity:
- How can the activity be performed differently or even eliminated?
- How can a group of linked value activities be reordered or regrouped?
- How might coalitions with other firms lower or eliminate costs?
14. RECONFIGURING DOWNSTREAM
Where channel costs or other downstream costs represent a significant fraction of cost to the buyer, reconfiguration of downstream activities can reduce cost substantially. Gallo’s heavy use of the supermarket channel for wine provides an example. A supermarket’s costs of distribution are less than that of the liquor store channel which involves distributors. By emphasizing supermarkets, Gallo has lowered the cost of getting wine to buyers. Gallo’s high sales volume and faster turnover also reduce its relative cost to the supermarket. This has made supermarkets willing to accept lower margins from Gallo than from its competitors.
The efficiency of downstream channels reflects their strategies and degree of fragmentation. Chain stores are often more efficient than single outlets, for example, and large office equipment or automobile dealers are often more efficient than smaller ones. A firm can not only choose more efficient downstream routes to the end user, but also take actions to promote consolidation or otherwise improve the efficiency of downstream entities. In extreme cases, a firm may have to integrate forward to achieve downstream efficiency.
The relative bargaining power of a firm and its downstream channels has an important influence on whether the firm will reduce its relative cost position through downstream reconfiguration. In Gallo’s case, supermarkets would reap the benefits of their greater efficiency if they priced wines the same as liquor stores. However, Gallo’s “pull- through” effect and intense competition among supermarkets have led to low prices and allowed Gallo to reap most of the benefits.
15. COST ADVANTAGE THROUGH FOCUS
A focus strategy may also provide a means for achieving a cost advantage that rests on using focus to control cost drivers, reconfiguring the value chain, or both. Since the cost of value activities as well as the most efficient value chain may differ for different segments, a firm that dedicates its efforts to a well-chosen segment of an industry can often lower its costs significantly. Federal Express based its reconfiguration of the air parcel delivery value chain on small packages requiring rapid delivery. People Express has focused on price-sensitive buyers, allowing it to eliminate many costs. In the hotel/motel industry, La Quinta offers only guest rooms, and has lowered its investment and operating costs per room by eliminating costly restaurants, conference facilities, and other services not desired by its target buyer— the middle-level manager who travels frequently to the same area.
The most dramatic improvements in relative cost position through focus usually stem from employing a different and tailored value chain to serve the target segment. The Federal Express, People Express, and La Quinta examples all share this characteristic. Focus can also lower costs if the target segment is associated with a key cost driver. If regional market share is a key cost driver, for example, a regional focus strategy can yield a cost advantage over larger national competitors with small shares in the particular region.
Successful focus strategies frequently stem from innovative segmentation of an industry. Chapter 7 will describe how to segment industries and how to choose appropriate focus strategies. Industry segments grow, in part, out of product varieties, buyer groups, or geographic areas that require a different value chain or in which cost drivers differ.
Source: Porter Michael E. (1998), Competitive Advantage: Creating and Sustaining Superior Performance, Free Press; Illustrated edition.