Cost Leadership

Chapter 4
Cost Leadership
Copyright © 2008 Pearson Prentice Hall. All rights reserved. 4-1

Cost
Cost Leadership
Leadership
The Strategic Management Process

External
Analysis
Strategic Strategy Competitive

Mission Objectives
Choice Implementation Advantage
Internal
Analysis
Business Level Corporate Level

Strategy Strategy
How to Position a Which Businesses

Business to Enter?
in the Market?
2
Cost
Cost Leadership
Leadership
Business Level Strategies
Two Generic Business Level Strategies

Cost Leadership:
• generate economic value by having lower costs
than competitors
Example: Wal-Mart
Product Differentiation:
• generate economic value by offering a product
that customers prefer over competitors’ product
Example: Harley-Davidson
3
Cost
Cost Leadership
Leadership
Why Cost Leadership Matters

Competitive Market
ATCind
ATCff
P D
Above Normal
Economic
Returns Q

4
Cost
Cost Leadership
Leadership
Understanding Cost Advantage
Managers need to understand who has

the cost advantage in their market
• it could be the focal firm

• develop a strategy to exploit the advantage
• it could be a competitor
• develop a strategy to either capture the

advantage or compete on some other basis

5
Cost
Cost Leadership
Leadership
Sources of Cost Advantage
Economies of Scale
• average cost per unit falls as quantity increases
-until the minimum efficient scale is reached
• are a cost advantage because competitors may

not be able to match the scale because of capital
requirements (barrier to entry)
• international expansion may allow a firm to have

enough sales to justify investing in additional
capacity to capture economies of scale

6
Cost
Cost Leadership
Leadership
Diseconomies of Scale
• are an advantage for those who do not have
diseconomies of scale
• occur when firms become too large and bureaucratic
• are a risk of international expansion
Example: Nucor Steel

7
Cost
Cost Leadership
Leadership
Learning Curve Economies
• a firm gets more efficient at a process with experience
• the more complicated/technical the process,

the greater the experience advantage
• international expansion may propel a firm down the

experience curve because of higher volumes
Example: Fuel Injectors

8
Cost
Cost Leadership
Leadership
Differential Low-Cost Access to Productive Inputs
• may result from:

• history—being in the right place at the right time
• being first into a market—esp. foreign markets
• natural endowment—owning a mineral deposit
• locking up a source—buying all of its output
Example: Quantity Carpet Buys

9
Cost
Cost Leadership
Leadership
Technology Independent of Scale

• may allow small firms to become cost competitive
• advantage typically accrues to the ‘owner’ of the

technology—may or may not be the ones who actually
use the technology
• size of the advantage depends both on how valuable

and protectable the technology is
Example: Vegetable Inspection

10
Cost
Cost Leadership
Leadership
Policy Choices
• firms get to choose how they will serve the market

• we’ll offer level of quality that is inexpensive to
produce
• firms can make policy choices that give people
incentives to reduce cost at every opportunity
Example: Southwest Airlines

11
Cost
Cost Leadership
Leadership
Cost Leadership & Competitive Advantage
A source of cost advantage will lead to

competitive advantage if that source is:
• Valuable
• Rare
• Costly to Imitate
• Organized (Implemented Appropriately)

12
Cost
Cost Leadership
Leadership
Value of a Cost Advantage
Entry Buyers
• increases capital • lowers incentives
requirements for buyers to
for entrants vertically
integrate
Rivalry
Substitutes • competitors rationally Suppliers

avoid price competition
• limits • increases
attractiveness importance of the
of substitutes focal firm to the
supplier

13
Cost
Cost Leadership
Leadership
Rareness of a Cost Advantage

The rareness of a source of cost advantage
depends heavily on the industry life cycle:
Generally…
Emerging Mature
Economies of Scale Not Rare Rare
Diseconomies of Scale Rare Rare
Learning Curve Economies Rare Not Rare
Differential Input Access Rare Rare

Technology Rare Not Rare
Policy Choices Rare Rare
14
Cost
Cost Leadership
Leadership
Imitability of Sources of Cost Advantage
Conditions largely determine if a source of cost

advantage will be costly to imitate
Low Cost Conditions
Unbalanced Industry Capacity and Demand
Non-Proprietary Technology
Highly Observable Technology
Transactional Exchange
(A cost advantage can be easily imitated)

15
Cost
Cost Leadership
Leadership
Imitability of Sources of Cost Advantage

High Cost Conditions
Balanced Industry Capacity and Demand
Path Dependence (Historical Uniqueness)
Protected Technology
Highly Unobservable Technology (Causal Ambiguity)
Relational Exchange (Social Complexity)
(A cost advantage cannot be easily imitated)

16
Cost
Cost Leadership
Leadership
Implementing a Cost Leadership Strategy
A strategy is only as good as its implementation
Strategy is implemented through organizational

structure and control:
• structure: 1) the division of management

responsibilities, and 2) the establishment of
reporting relationships
• control: policies intended to influence behavior—align

the interests of the individual with the interests of the
organization

17
Cost
Cost Leadership
Leadership
Organizational Structure
Three Organizational Structures
Simple
Functional
Multi-Divisional

18
Cost
Cost Leadership
Leadership
Simple Structure
Owner / Manager
• Owner/Manager makes all major decisions

directly and monitors all activities
• difficult to maintain this structure as the firm

grows in size and complexity

19
Cost
Cost Leadership
Leadership
Functional Structure (U-Form: Unitary)

• divides management responsibilities by function
• marketing • procurement • HR
• finance • production • logistics
• accounting • R&D • etc.
• CEO is the only executive with enterprise-wide

perspective
• CEO is responsible for strategy & coordination
of functions
20
Cost
Cost Leadership
Leadership
Functional Structure
Chief Executive Officer
Human
Finance Accounting Marketing
Resources
Production R&D

21
Cost
Cost Leadership
Leadership
Multi-Divisional Structure (M-Form)
• functions are replicated in each division as appropriate
• this structure makes sense when the firm is involved

in more than one business or has grown large enough
to justify geographic divisions
• CEO has strategic responsibility with the help of

vice presidents, etc.—information is filtered through layers
• CEO balances coordination & competition among

divisions

22
Cost
Cost Leadership
Leadership
Multi-Divisional Structure (M-Form)
Chief Executive Officer
Corporate
Corporate Corporate Strategic Corporate
Human
R&D Finance Planning Marketing
Resources
Division Division Division
Finance Production R&D Accounting
Marketing Human
Resources
23
Cost
Cost Leadership
Leadership
The Functional Structure and Cost Leadership
• specialization within functions facilitates cost reduction
• CEO can use this structure to:
• ensure best cost reduction practices are
shared among divisions
• allow and encourage decision-making by those
who are in the best positions to do so—those
close to decisions
• ensure that functions are coordinating efforts in
pursuit of a common strategy

24
Cost
Cost Leadership
Leadership
Organizational Controls
Policies intended to influence behavior by aligning
the interests of the individual with the interests of
the organization
Management Controls
Formal Informal
• budgeting policies • culture
• credit policies • attitudes
• spending policies • leadership styles
• travel policies
• purchasing policies

25
Cost
Cost Leadership
Leadership
Compensation Policies
• stock options • non-monetary awards
• vacations
• bonuses based on:
• parking places
• cost reduction • office decor
• financial performance
Compensation Policies Should Reinforce

Formal and Informal Management Controls

26
Cost
Cost Leadership
Leadership
Organizational Controls and Cost Leadership
• management controls and compensation
policies can be focused on cost reduction
• supply contracts that stipulate cost reductions

over time
• tight credit policies
• austere travel policies (e.g., no first class)
• bonuses tied to cost reduction targets
Example: Wal-Mart & Southwest Airlines

27
Cost
Cost Leadership
Leadership
Summary
Business Level Strategy
Cost Leadership Product Differentiation

Cost Advantages
Competitive Advantage
Depends on Meeting
Economies of Scale VRIO Criteria
Diseconomies of Scale
Emphasis on
Learning Curve Economies Organization
Differential Input Access (Implementation)
Technology
Structure &
Policy Choices Control

28

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Chapter 4

Copyright © 2008 Pearson Prentice Hall. All rights reserved. 4-1

The Strategic Management Process

Strategic Strategy Competitive

Business Level Corporate Level

How to Position a Which Businesses

Business Level Strategies

Two Generic Business Level Strategies

Why Cost Leadership Matters

Copyright © 2008 Pearson Prentice Hall. All rights reserved. 4-4

Understanding Cost Advantage

Managers need to understand who has

• it could be the focal firm

• develop a strategy to either capture the

Copyright © 2008 Pearson Prentice Hall. All rights reserved. 4-5

Sources of Cost Advantage

• are a cost advantage because competitors may

• international expansion may allow a firm to have

Copyright © 2008 Pearson Prentice Hall. All rights reserved. 4-6

Sources of Cost Advantage

• occur when firms become too large and bureaucratic

• are a risk of international expansion

Example: Nucor Steel

Copyright © 2008 Pearson Prentice Hall. All rights reserved. 4-7

Sources of Cost Advantage

Learning Curve Economies

• a firm gets more efficient at a process with experience

• the more complicated/technical the process,

• international expansion may propel a firm down the

Example: Fuel Injectors

Copyright © 2008 Pearson Prentice Hall. All rights reserved. 4-8

Sources of Cost Advantage

Differential Low-Cost Access to Productive Inputs

• may result from:

Example: Quantity Carpet Buys

Copyright © 2008 Pearson Prentice Hall. All rights reserved. 4-9

Sources of Cost Advantage

Technology Independent of Scale

• advantage typically accrues to the ‘owner’ of the

• size of the advantage depends both on how valuable

Copyright © 2008 Pearson Prentice Hall. All rights reserved. 4-10

Sources of Cost Advantage

• firms get to choose how they will serve the market

Example: Southwest Airlines

Copyright © 2008 Pearson Prentice Hall. All rights reserved. 4-11

Cost Leadership & Competitive Advantage

A source of cost advantage will lead to

• Organized (Implemented Appropriately)

Copyright © 2008 Pearson Prentice Hall. All rights reserved. 4-12

Value of a Cost Advantage

Substitutes • competitors rationally Suppliers

Copyright © 2008 Pearson Prentice Hall. All rights reserved. 4-13

Rareness of a Cost Advantage

Learning Curve Economies Rare Not Rare

Differential Input Access Rare Rare

Imitability of Sources of Cost Advantage

Conditions largely determine if a source of cost

Highly Observable Technology

(A cost advantage can be easily imitated)

Imitability of Sources of Cost Advantage

Balanced Industry Capacity and Demand

Path Dependence (Historical Uniqueness)

Highly Unobservable Technology (Causal Ambiguity)

Relational Exchange (Social Complexity)