In my career as a business leader, I have learnt the importance of having a proper cost strategy. Working with your costs have proven successful many times, but it has its challenges. In this article, we will elaborate on the concept of cost leadership. We will explain the concept, provide its advantages and disadvantages as well as describe how cost leadership can be established.
What is cost leadership?
Cost leadership is when a company has the lowest production costs in their market. If you have the lowest cost, it means that you can lower the price so much that all other sellers are making a loss, while you are still making a profit. Essentially, if you are the cost leader, you will win each and every price war in your niche. That does not mean that cost leadership needs to lead to price war of course.
Besides having the lowest cost, the company in the cost leadership position need to be able to charge the same price as competitors with higher costs. If this is not the case, we are merely talking about two different products with different pricing and different costs.
Let us illustrate this by use of a simplified numbers example:
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|Company||Sales price/unit||Cost price/unit||Profit/unit|
|Company A||$100||$50||$50 or 50%|
|Company B||$80||$40||$40 or 50%|
In this example, company B has a product with a lower price at a lower cost. This is not true cost leadership since the customers are willing to pay more for the product from company A.
|Company||Sales price/unit||Cost price/unit||Profit/unit|
|Company C||$100||$50||$50 or 50%|
|Company D||$100||$40||$60 or 60%|
In this case, company D has the cost leadership position. If company D drops the sales price to $49, company C is likely to be forced to follow since the products are comparable. At $49, company D would still be making money, where as company C would be making a loss for sure.
Where does the concept of cost leadership come from?
Cost leadership was defined and described by Michael Porter. The concept is one out of four generic strategies outlined in Porters 1985 book called “Competitive advantage: Creating and Sustaining Superior Performance”.
These four generic strategies are aimed at achieving a competitive advantage in a market and they are as follows:
- Cost Leadership
- Cost Focus
- Differentiation Focus
Each of these is an avenue towards getting an advantage versus competing companies within the same market.
How can cost leadership be used?
Cost leadership can be used to get a gain on competition in two primary ways. The first one is to have similar pricing but enjoy the advantage of cost leadership which results in higher profits. These profits could come in handy in the future or can be spent to defend market share and similar things. The second way is to be able to lower price temporarily or permanently to grow the company market share. Being the cost leader means competitors will hurt more from a lower price than the cost leader. It deserves to be pointed out that lowering prices with the purpose to drive competitors into bankruptcy is illegal in many parts of the world.
Cost leadership strategy
A cost leadership strategy is when a company actively pursues the cost leadership position in a broad market. This is not an easy thing to accomplish due to competition and customer requirements. A successful cost leadership strategy involves offering products and/or services that have:
- Satisfactory quality
- Acceptable features and attributes
- Low price
- A large number of customers (since scale is an enabler in lowering costs)
The key is to get a good product that customers are willing to buy combined with the lowest possible cost. The difficulty is in reaching the lowest cost without sacrificing product performance, features, quality etc. Each aspect and how to achieve it is outlined below.
How to achieve cost leadership
There are some commonalities between companies that succeed in obtaining cost leadership within their markets. Having very low priced products or services while retaining the required quality and features of the offering is difficult. These are some actions you can implement to increase your chances of success:
1. Economies of scale
Larger companies with larger volumes are likely to be more efficient than their smaller adversaries thanks to economies of scale. Large volume enabled lower overheads per sold unit and makes it easier to negotiate lower pricing on raw material, components as well as logistics arrangements. If you build one million bookshelves you will get a lower price on wood than if you build 10 000 bookshelves. Your other processes will be more cost efficient as well since support functions like payroll do not need to be ten times larger simply because the number of workers is ten times more.
Although economies of scale bring better efficiency, it might not be enough to become the cost leader. To take that position in a market, you need to be very cost efficient in all aspects. This includes assembly, cleaning your factory, power consumption, staffing, waste, quality claims etc. A heavily optimized operation will in general lead to lower cost per unit, it is as simple as that.
3. Purchasing and sourcing
One of the more important parts in a product oriented company is the sourcing and purchasing activities. By proper negotiation, using several sources, buying in bulk, ordering early and many other sourcing and purchasing activities, a company can lower their material costs. Volumes through economies scale is one thing, but when and how you buy are also major factors. A professional sourcing and purchasing function can do magic to your direct and indirect costs, moving you closer and closer to a cost leadership position.
Having too low quality will risk a drop in your volume and value perception. Low quality can hit you with warranty claims, returns and other costly activities. Furthermore, it might reduce your ability to charge a high price for your product. Cost leadership is not about having the cheapest low quality product in the market, it is about having the right quality. This means having satisfactory quality meeting the customer expectations. Higher quality than what is expected should also be avoided since it is value added to the product that the customer is not willing to pay for. Hence, you should not have too low or too high quality, but simply the right quality. This keeps costs at the right level and the customers satisfied.
Cost Leadership Pros and Cons
As with everything, a cost leadership position has both advantages and disadvantages
Cost leadership advantages
There are some substantial advantages for a company in a cost leadership position. Although only a few are listed below, they are all examples of very powerful advantages.
1. High profits
For as long as the cost leader has and sustains a sizeable market share and high volume, it will likely have high profits thanks to the low costs.
2. Price wars are unlikely
It is highly unlikely that someone else will start and win a price war against a company in a cost leadership position. This will result in some safety for the cost leader since they pretty much control the market price.
3. Entry to market is more difficult
If a company is in the cost leader, it is more difficult and less likely for new competitors to form and grow. It is simply a less attractive market, so fewer players are likely to enter it.
Cost leadership disadvantages
On the downside, cost leadership can bring some problems as well. By knowing them before hand, you can mitigate them better, thereby reducing the risks.
1. Perception on Quality
It is a human thing to sometimes associate low prices with low quality. If the cost leader is having low prices (often the case) and not just low costs, there is a risk of customers assuming and perceiving the products as lower quality.
2. Risk of Cost changes
If you build a large portion of your capability on having low costs, you will be in big trouble if the costs go up. If raw materials and other commodities used for manufacturing increase in price, or if the efficiency of the company starts sliding due to any reason, the cost leadership is in jeopardy.
3. The large volumes must be sustained
In most cases, the cost leader has the largest volumes. Having a big hold on the market is difficult since virtually everyone else is trying to get some market share from you. If the company having the cost leadership cannot play defense well enough, they will lose volumes and lost volumes put the cost leadership in itself at risk.
4. High efficiency can mean lack of flexibility
A company in cost leadership position has likely trimmed every single part of their supply chain, including procurement, logistics, warehousing and manufacturing. A highly trimmed large scale system is inflexible by nature so it can be difficult for the company to handle external as well as internal changes.
5. Low spending on Marketing and R&D
It is likely that costs on marketing and research and development are minimized to reach a cost leadership position. Heavily limiting spending on these functions could become long term risks if brand awareness and brand loyalty drop or if falling behind in product development versus competitors.
6. Not all products are suitable
Some products and services simply do not fit to a cost leadership strategy. In low volume markets, price tend to be less important and these markets might be better handled with another approach and fit the Differentiation strategy better. This does not mean you should not try to limit your costs of course..
Cost leadership Examples
An article on cost leadership would not be complete without some examples of companies pursuing a cost leadership strategy.
Walmart – Cost leadership in retail
The low pricing offered by Walmart would have been impossible without lower costs in the supply chain end of the company. Economies of scale, efficiency through IT and close partnerships with suppliers are instrumental for Walmart to keep the costs down. The whole company has been engineered to enable low costs and low prices with retained quality.
Walmart was founded in 1962, focused on discounts already back then. The company currently operates more than 8 500 stores and employs more than two million people. Truly a company of immense proportions.
Amazon – Cost leader online
Cost leadership in the new digital age? Amazon is the perfect example. They have enormous economies of scale advantages since they are a big global player selling so many different products but still using similar and standardized processes. Amazon have also managed to keep their operational costs very low bringing great operational efficiency to the list of items qualifying them for cost leadership.
Southwest Airlines – Cost leadership in the air
Since 1971, Southwest Airlines have been in the business of air transportation. By keeping overhead costs down and obtaining low cost maintenance, the company is pursuing a cost leadership strategy. Southwest airlines use only one kind of airplane in their operations, namely Boeing 737, which reduces costs for training both crews and maintenance staff. They have also managed to reduce their turn around time making it much lower than that of competing airlines – again providing increased efficiency.
Despite a simplistic and heavily optimized way of operating, Southwest have managed to keep costs down while also pushing customer satisfaction.
Departmental examples of cost leadership strategy
We figured a few examples on how different departments or functions can contribute to a cost leadership strategy would be beneficial to provide wider examples of the concept. Examples from manufacturing and logistics might feel a bit more straight forward so we decided to go into less obvious areas such as Sales and HR.
Cost leadership strategy in Sales
Let us say you are the head of a sales department; how can you contribute to a cost leadership strategy besides the obvious one of increasing the sales volumes. You could try one or more of the following actions:
- Keep free samples and giveaways to a minimum
- Plan customer visits in an efficient way to reduce travel time and costs
- Find the optimum value point for customers and deliver that, nothing more, nothing less
- Sell in quantities that keep logistics costs down
- Keep administration and waiting time for your staff to a minimum – that way they can spend a higher proportion of their time selling
Cost leadership strategy in HR
There are many ways of deploying a cost leadership strategy in the HR function, not just the perhaps obvious one of keeping salaries low. Here are a few examples.
- Reduce costs by providing standardized training for staff in an efficient manner
- Optimize processes within the HR scope – ensure maximize output with the resources used
- Increase retention, reducing hiring and training costs in the work force
- Find ways of incentivizing people to contribute to a cost leadership strategy