Gaining Cost Advantage

There are two m ajor 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 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 manage­ ment 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.


Once a firm has identified its value chain and diagnosed  the cost drivers of significant value activities, cost advantage grows out of con­ trolling those drivers better than competitors. A firm can potentially achieve superior  position   vis-a-vis   the   cost drivers of any   activity in the value chain. Activities that represent a significant or growing pro­ portion 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:


Gain the Appropriate Type o f Scale. Increasing scale through ac­ quisitions, 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 rais­ ing 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 im portant  activities in the particular industry. Scale increases in different activities must be bal­ anced, moreover, so that pursuing scale in one activity does not create diseconomies in another.

Set Policies to Reinforce Scale Economies in Scale-Sensitive Activi­ ties. Scale economies are partly  a function  of how activities are man­ aged. Eaton has maximized its scale economies in engine valves, for example, by simplifying its product line.

Exploit the Types o f 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 o f 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 introduc­ tion whose cost  is driven by national or global scale.


Manage with the Learning Curve. Learning does not occur auto­ matically 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.   W hen   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 im portant 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 engi­ neering 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.


Level Throughput. A firm can often increase average capacity utili­ zation   by finding   ways to   level   the   fluctuations  of  volume   through its value chain. For example, Sun-Diamond,  the agricultural coopera­ tive 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 differ­ ences between the Christmas season and the rest of the year. Similarly, credit card processors can level throughput  by serving a mix of ac­ counts 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 pat­ tern of needs (see Chapter 9).

Reduce the Penalty o f 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.

Exploit Cost Linkages  Within the Value Chain. A firm can im­ prove 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 inspec­ tion 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 com­ puter-aided design and m anufacturing 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, pro­ vides suppliers with its manufacturing schedule through computer ter­ minals, enabling suppliers to ship parts precisely when needed. Seeking out and pursuing such opportunities will require careful study of sup­ plier and channel value chains, as well as the determination  to over­ come 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.


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.


Examine Systematically Possibilities fo r Integration and De-in­ tegration. Both integration and de-integration offer the potential of lowering costs. As changes in management attitudes and new informa­ tion system technology  are making  supplier  linkages easier   to achieve, de-integration  is becoming  more  and more  attractive   in many industries.


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 m ajor  cost savings.   This is the case for many capital goods such as machinery, ships, and  even com­ plete plants.


Modify Expensive Policies That Do Not  Contribute to Differentia­ tion. 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 scru­ tiny   may also   reveal that  a policy   does   not  contribute  meaningfully to differentiation because its costs outweigh the price premium  it gen­ erates.   Both situations  offer opportunities  for cost reduction.  Chap­ ter 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-a-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 impor­-tant ways in which technology investment  lowers costs include:

  • Developing low-cost For example, Union Carbide’s Unipol process for making low-density polyethylene.
  • Facilitating For example, Iowa Beef’s massive beef processing plants and K M art’s autom ated distribution centers.
  • Low-cost product For example, Canon’s NP200 copier with fewer parts.

In some cases, the ability to apply new low-cost technology de­ pends 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 technol­ ogy 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.


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.


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 al­ ready committed to repealing their laws to avoid scaring away foreign investors.


Procurement practices have a potentially m ajor impact on cost position that cuts across activities. A number of possible changes in procurement can reduce costs:

Tune Specifications o f Purchased Inputs to Meet Needs More Pre­ cisely.    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 to­ ward automotive grade components for some lift truck models, rather than more expensive and unnecessarily high-quality truck grade com­ ponents.

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 mak­ ing frequent smaller purchases.
  • Seek out opportunities to combine purchases with sister business units.
  • Appoint high-quality purchasing executives to allow more so­ phisticated 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. Pur­ chasing practices should also include  promoting  supplier cost reduc­ tion, aiding suppliers where necessary   with technology  development, and encouraging supplier practices that lower the firm’s cost through linkages. M arks 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 m odem 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 im portant to cost position as enhancing bar­ gaining power over suppliers.


Dramatic shifts in relative cost position most  often arise from a firm adopting a value chain that is significantly different from its com­ petitors’. 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
  • m ajor differences in forward  or backward  vertical integration
  • shifting the location of facilities relative to suppliers and custom­ ers
  • 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 signifi­ cant 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 abat­ toirs in m ajor rail centers like Chicago. After  the animal  was slaugh­ tered 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 m ajor  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 opera­ tions 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 com- pany-owned trucks. Other dram atic reconfigurations of the value chain include the early discount  retailers, discount  stockbrokers,  and new long distance telephone companies such as M CI 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 advan­ tage 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 differ­ ently can change  its susceptibility to scale economies, interrelation­ ships, 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 im portant 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 elimi­ nated?
  • How can a group of linked value activities be reordered or regrouped?
  • How might coalitions with other firms lower or eliminate costs?


Where channel costs or other downstream costs represent a signifi­ cant fraction of cost to the buyer, reconfiguration of downstream activi­ ties can reduce cost substantially. Gallo’s heavy use of the supermarket channel for wine provides an example. A superm arket’s costs of distri­ bution 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 super­ markets 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 automo­ bile 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 chan­ nels has an im portant 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.


A focus strategy may also provide a means for achieving a cost advantage that rests on using focus to control  cost drivers, reconfigu­ ring 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 re­ configuration 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/m otel indus­ try, La Quinta offers only guest rooms, and  has lowered its investment and operating costs per room by eliminating costly restaurants, confer­ ence facilities, and  other  services not  desired by   its target  buyer— the middle-level manager who travels frequently to the same area.

The most dram atic 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 competi­ tors with small shares in the particular region.

Successful focus strategies frequently stem from innovative seg­ mentation 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.

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