Pitfalls in Cost Leadership Strategies

Many firms do not fully understand the behavior of their costs from a strategic perspective and fail to exploit opportunities to improve their relative cost position. Some of the most common errors made by firms in assessing and acting upon cost position include:

Exclusive Focus on the Cost of Manufacturing Activities. When one mentions “cost,” most managers instinctively think of manufacturing. However, a significant, if not overwhelming, share of total cost is generated in activities such as marketing, sales, service, technology development, and infrastructure. These often receive too little attention in cost analysis. An examination of the entire value chain often results in relatively simple steps that can significantly reduce cost position. For example, recent advances in computers and computer-aided design are having dramatic impacts on the cost of performing research.

Ignoring Procurement. Many firms work diligently to reduce labor costs but pay scant attention to purchased inputs. They tend to view purchasing as a secondary staff function and devote few management resources to it. Analysis within the purchasing department too often centers solely on the purchase price of key raw materials. Firms often allow many items to be purchased by individuals with little expertise or motivation to reduce cost. Linkages between purchased inputs and the costs of other value activities go unrecognized. Modest changes in purchasing practices could yield major cost benefits for many firms.

Overlooking Indirect or Small Activities. Cost reduction programs usually concentrate on large cost activities and/or direct activities such as component fabrication and assembly. Activities that represent a small fraction of total cost seldom receive sufficient scrutiny. Indirect activities, such as maintenance and regulatory costs, often escape attention altogether.

False Perception of Cost Drivers. Firms often misdiagnose their cost drivers. For example, a firm with the largest national market share and the lowest costs may incorrectly assume that national market share drives cost. However, cost leadership may actually stem from the firm’s large regional share in the regions in which it operates. Failing to understand the sources of its cost advantage may lead the firm to attempt to lower cost by raising national share. As a result it may worsen its cost position by reducing regional focus. It may also concentrate its defensive strategies on national competitors and ignore the more significant threat posed by strong regional competitors.27

Failure to Exploit Linkages. Firms rarely recognize all the linkages that affect cost, particularly linkages with suppliers and linkages among activities such as quality assurance, inspection, and service. The ability to exploit linkages underlies the success of many Japanese firms. Matsushita and Canon, among others, recognize and exploit linkages despite the fact that their policies contradict traditional manufacturing and purchasing practices. Failure to recognize linkages also leads to such errors as requiring each department to cut costs by the same amount, even though raising cost in some departments may lower total costs.

Contradictory Cost Reduction. Firms often attempt to reduce cost in ways that are contradictory. They try to gain market share to reap the benefits of scale economies while at the same time dissipating scale economies through model proliferation. They locate close to buyers to save freight costs but emphasize weight reduction in new product development. Cost drivers sometimes work in opposite directions, and a firm must recognize the tradeoffs.

Unwitting Cross Subsidy. Firms often engage in unwitting cross subsidy when they fail to recognize the existence of segments in which costs behave differently.28 Conventional accounting systems rarely measure all the cost differences among products, buyers, channels, or geographic areas described above. Thus, a firm may charge excessive prices on some items in the line or to some buyers while subsidizing prices charged on others. For example, white wine requires less costly cooperage than red wine because of its lower aging requirements. If a winery sets equal prices for white and red wine based on average costs, then the price of lower-cost white wine will subsidize the price of red wine. Unwitting cross subsidy often provides an opening for competitors that understand costs and use them to undercut a firm’s prices and improve their market position. Cross subsidy also exposes the firm to focused competitors that only compete in the overpriced segments.29

Thinking Incrementally. Cost reduction efforts often strive for incremental cost improvements in the existing value chain, rather than finding ways to reconfigure the chain. Incremental improvement can reach the point of diminishing returns, while reconfiguring the chain can lead to a whole new cost plateau.

Undermining Differentiation. Cost reduction can undermine dif- ferentiation if it eliminates a firm’s sources of uniqueness to the buyer. Though doing so may be strategically desirable, it should be the result of a conscious choice. Cost reduction efforts should concentrate most on activities that do not contribute to a firm’s differentiation. A cost leader will improve performance, moreover, if it differentiates in activities wherever differentiation is not costly.

Source: Porter Michael E. (1998), Competitive Advantage: Creating and Sustaining Superior Performance, Free Press; Illustrated edition.

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