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