What is a cost competitive advantage strategy?
A low-cost competitive advantage strategy (also known as a cost leadership strategy) is a way of establishing a competitive advantage in business. A business achieves a low-cost competitive advantage when it’s able to manufacture goods and take them to the point of sale at a lower cost than competitors, while maintaining (or surpassing) competing products or services in quality.
A business with a cost advantage has lower outgoings. This gives it an advantage in one of two ways. It’s able to either:
- Pass those savings onto the customer, enticing more market share as a result of its lower prices, or…
- Keep prices comparable to competitors’, increasing profit margins and opportunities for reinvestment.
Most typically, a business will combine a cost competitive advantage with some other source of competitive advantage to solidify that advantage, and to make it more likely to sustain over time.
How to implement a cost advantage strategy
So, how do you implement a cost leadership strategy in an effort to establish your own cost competitive advantage?
In practice, it’s not simple:
• The competitive pricing trap
Imagine you’ve just entered an established industry, and you believe your competitors have a cost advantage. How do you catch up?
Will you need to invest money in new manufacturing processes? Invest time in finding and improving inefficient processes?
Investment today needs to be offset by a greater return on that investment in the future. If you just level the playing field, there’s no guarantee you’ll do anything but slow the steady erosion of your customer base as users flock to cheaper competitors.
In his 5,000-word Harvard Business Review article from 1984, Strategies for Staying Cost Competitive, Arthur A. Thompson, Jr. calls this a “competitive pricing trap.”
• Escaping from pricing traps using strategic cost analysis
According to Thompson, to escape this, you must perform a strategic cost analysis. This involves spelling out your business’ “value chain.”
A value chain is like a list of everything that’s involved in getting your goods or services off the drawing board and in front of the customer. Specifically, everything in that process that costs money.
That means:
- Raw materials,
- Research and development,
- Manufacturing costs...
...and so on, and takes you “all the way from the raw materials stage to the final price paid by the ultimate consumer.”
If you want to pursue a cost advantage strategy, you’ll need to construct a value chain like the one described above. Preferably, before you find yourself in a competitive pricing trap.
From there, you’ll look for opportunities to save on costs.
Where to find cost-saving opportunities in the value chain (6 places)
Perhaps you can strike a better deal with your suppliers. Perhaps there are unnecessary steps and inefficiencies in the manufacturing process you can cut out.
These are the kinds of cost savings you’ll be looking for, but you’ll need to examine the entire value chain. Remember, the value chain includes every step of the process that costs you money.
Here are some of the best places to look, either to establish savings, or to establish economies of scale so you can drive down costs by expanding, rather than shrinking, operations:
- Raw materials
- Processes
- Automation
- R&D
- Distribution
- Patenting
1) Raw materials
If you can get the raw materials your product is made of more cheaply, you’ll also bring down overall production costs.
Here’s a tip: If you’re able to sustainably place very large orders with suppliers when rivals can’t, you may gain a bulk-buy discount competitors cannot get.
2) Processes
Improving processes means increasing your output per unit of time, or reducing your error rate during production, which improves efficiency by cutting down waste.
Economies of scale apply here. The initial costs of getting a factory, for example, up and running become easier to offset as the factory begins to produce more products per unit of time.
3) Automation
Automating tasks frees up spend that would have gone toward salaried individuals performing those tasks.
Automation also enables production to run around the clock, rather than in line with two or three daily work shifts.
4) Research and development (R&D)
R&D and other internal departmental expertise can drive a cost competitive advantage too.
Once a team has performed initial, expensive research, the costs of applying those findings to increase efficiencies in production processes, or technology usage, can reduce the costs of getting a product onto store shelves.
5) Distribution
Transporting your products to the end consumer isn’t a zero-cost exercise, either.
If you can hold inventory for less, package your goods for less, or transport your goods for less, you can free up spend and increase your cost competitive advantage.
Again, economies of scale apply here. Companies can secure discounts for chartering more trucks, ships, or cargo planes at once. Fuller loads mean more efficient spend per product transported, too.
6) Patenting
When you have control over ideas, processes, or technologies your rivals are barred from using, it’s much easier to maintain and sustain any competitive advantage you have.
Cost advantage benefits ✅
Okay, so we’ve covered what a cost competitive advantage is. Why might you want to achieve this kind of advantage instead of, say, a niche competitive advantage?
Opportunities for reinvestment and growth
When you successfully cut costs by identifying inefficiencies, or using economies of scale, you widen your profit margins. Either by attracting more market share with your lower prices (if you decide to pass those savings onto the customer), or by simply widening the gap between what it costs you to get the product to market, and what your customers pay for it.
Naturally, you’ll want to reinvest your excess returns in other areas of the business to further cement your competitive edge. Whether you invest in better understanding your target audience, in better machinery, in better processes, or in building out new arms of the business (like a marketing team), these will lead to even greater efficiency and greater profits in the future.
Increased productivity
When you identify (and stamp out) inefficiencies, and implement economies of scale, you make your entire operation more efficient.
More efficiency means you’re able to produce more products per unit of time. This in itself plays into your cost advantage, since it reduces the overall impact of your manufacturing costs.
When you’re more productive, you’re better able to meet the demand you’re generating thanks to the hard work of other departments around the business.
Win more market share
Remember: one of the two ways a cost competitive strategy works is that it gives you the chance to pass savings onto the consumer. Do this, and you’re almost certain to attract more market share thanks to your lower costs relative to competitors (or, at the very least, relative to what you were charging previously.)
Of course, pricing strategy isn’t as simple as “she who charges the least, wins.” Price can act as a value signal, and some customers prefer to pay higher prices for what they perceive to be higher-quality products (this is known as a prestige pricing strategy).
For more on pricing strategy, check out these resources:
- The Pricing to Win Podcast
- Competitive pricing strategy: Your ultimate guide
- Loss leader pricing strategy: Definition, examples, pros, and cons
Disadvantages of a cost advantage strategy ⛔
But a cost advantage strategy isn’t for everyone.
Less viable for young businesses
In some industries, it may be difficult to go to market cheaply enough early on for it to be practical to pursue a cost competitive advantage until much later.
This makes cost advantage strategies difficult for startups and other small, young businesses to implement.
In competitive environments where entrenched competitors already have economies of scale and other efficiencies in place that lend themselves to a cost competitive advantage, it can make more sense for newcomers to pursue other strategies early on, like a niche differentiation strategy.
Alex Walton
High-cost industries
Other industries cost a lot to operate in. High costs for raw materials, or the assets needed to acquire them, can make it difficult or impossible to cut overall costs down enough to gain an advantage over the competition.
Investopedia lists examples of high-cost industries as “automotive, airline, oil, and gas.” Businesses in all these industries have to pay for expensive assets before they can even operate.
Cost competitive advantages are difficult to sustain
What you can do, your competitors can (almost always) do too.
It’s only a matter of time until younger companies are able to start using economies of scale to cut costs; to develop better relationships with suppliers and secure better deals; to improve their own knowledge and expertise of the field and apply those learnings across the entire business to improve overall efficiency.
Apply the VRIO framework to many sources of cost competitive advantage, and you’ll find they don’t perform too well.
They might be Valuable, they might even be Rare, but if they’re not Inimitable (difficult or impossible for competitors to imitate), then they’re temporary competitive advantages. Most sources of cost advantage aren’t impossible for competitors to imitate, even if they’re tricky to replicate. That makes them sources of temporary advantage you may one day lose.
By contrast, differentiation-based competitive advantages are often rooted in a product’s having been engineered to solve a specific customer problem, giving the business first-mover advantage. (Once a solution exists, replica solutions hold less value unless they can themselves adequately differentiate from what exists already.)
Example of a cost competitive advantage: SpaceX
Elon Musk famously tackled his rocket problem by going back to First Principles.
How much do the raw materials for a rocket cost? Much less, it turns out, when you buy them straight from the source.
Suppliers and manufacturers were marking up the prices of rocket components so drastically, it turned the act of building a rocket into a financial black hole.
Musk set aggressive, often impossible deadlines for his staff, always pressuring them to get things done more quickly and more cheaply. The pressure produced incredible results, and paved the way for the first-ever reusable rockets.
Being able to produce space-faring rockets for so much less than their government-backed rivals kept SpaceX in the game despite a string of early public failures, and eventually won them government contracts that would keep the company alive.
TL;DR
Okay, so what have we learned?
- A cost competitive advantage is achieved when a business is able to successfully cut costs in its value chain so that it can produce goods for less than its rivals can.
- Opportunities to save on costs and use economies of scale include: procurement of raw materials, processes, automation, R&D, distribution, and securing patents for intellectual property.
- Cost advantages benefit businesses through higher margins and opportunities for reinvestment, increased productivity, and greater market share.
- Cost advantages can, though, be less viable for younger businesses, are entirely less viable in certain industries, and are often harder to sustain over time.
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