Managing Strategy Lecture 5

Cost Advantage Strategies

Objectives
After pre-reading, class participation and reflection, you will be able to:

Explain the concept of generic strategies in relation to competitive advantage Discuss how an organisation can build and sustain cost advantages Discuss how an organisation can design appropriate structure and control systems to support a cost leadership strategy

The Strategy Process

External Analysis Strategic Choice Strategy Implementation Competitive Advantage

Mission

Objectives

Internal Analysis

Barney and Hesterly (2008:5)

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Strategic Choice
Grant (2010:19)
INDUSTRY ATTRACTIVENESS RATE OF RETURN TO EXCEED THE COST OF CAPITAL

Which businesses should we be in?

CORPORATE STRATEGY

How do we make money?

COMPETITIVE ADVANTAGE (positioning)

How should we compete?

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BUSINESS STRATEGY

The Concept of Competitive Advantage

Porter, M.E. (1985) Competitive Advantage. New York: Free Press Extract in de Wit and Meyer (2004), Reading 5.1

The advantage that the firm aims to establish and sustain vis-a-vis competitors through:

delivering a combination of price & quality valued by the target group of buyers better than the competition

hence generating superior profit levels for the firm

The value pyramid

White (2004:275-277) The price the customer is willing to pay Price the producer actually charge

Consumer surplus

Profit margin Additional costs of the producer Costs of the lowest cost producer
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Lowest cost the producer can achieve

High volume business vs. high margin business

Grant (2010:222-224)

Michael Porters Generic Strategies

(1980) Competitive Strategy (1985) Competitive Advantage

COMPETITIVE ADVANTAGE Lower Cost Differentiation

COMPETITIVE SCOPE

Broad Target

Cost Leadership

Differentiation
Focus

Narrow Target
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Market Positioning: Bowmans Clock:

High Hybrid Differentiation 4 Focused differentiation 5

PERCEIVED ADDED VALUE

Low price 2

Low

1 Low price/ low added value

Low

Strategies destined for ultimate failure High

PRICE

Based on: Bowman, C. and Faulkner, D.O. (1996) Competitive and Corporate Strategy. 8

Bowmans Strategy Clock

Sources of Competitive Advantage

Grant (2010:223) COST ADVANTAGE COMPETITIVE ADVANTAGE DIFFERENTIATION ADVANTAGE

Cost advantage: a firms unit costs (costs per unit of output) are lower relative to its competitors unit costs. Cost advantage is the result of multiple determinants of unit costs (cost drivers).
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Cost Drivers (1)

Grant (2010:231-234); White (2004:305-309)

Economies of scale & scope

o
o

How much of each product - unit costs fall as volume increases Sources of cost reduction: input-output relationships; indivisibilities; specialization How many products - fixed costs can be spread

Learning curve economies

o o

Individual level: increased skills & improved problem solving Organizational level: improved coordination & development of routines

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Cost Drivers (2)

Grant (2010:234-237)

Process technologies
o

A superior process technology uses, for each unit of output, less of some inputs without using more of others

Product design
o

Must be consistent with the generic strategy, e.g. inexpensive to deliver

Design-for-manufacture designing products for ease of production, e.g. through reduction of the number of component inputs

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Cost Drivers (3)

Grant (2010:238-239)

Capacity utilization
o o

particularly important if the ratio of fixed to variable costs is high goal: optimal matching of supply and demand

Input costs
o

Locational differences, e.g. offshoring to low-wage countries, closeness to raw materials or sources of intermediate inputs Strong bargaining power or good supplier relationships

The balance of cost drivers varies greatly across industries, firms, and activities within a firm.
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Value Chain (Porter 1985)

The value chain within an organisation

Source: Adapted with the permission of The Free Press, a Division of Simon & Schuster Adult Publishing Group, from Competitive Advantage: Creating and Sustaining Superior Performance by Michael E. Porter. Copyright 1985, 1998 by Michael E. Porter. All rights reserved

Using the Value Chain to Analyse Costs

Each activity in the value chain has a distinct cost structure determined by different cost drivers...

Establish for each activity:

o o o

Its relative importance in the total unit cost Its cost drivers Linkages, i.e. how its costs influence costs in other activities and vice verse Opportunities for reducing costs based on the identified linkages & cost drivers

o
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Cost Advantage Strategy

A business level strategy intended to decrease the firms cost per output unit relative to the competitors cost per output unit

Hence cost leadership strategy is about:

understanding the factors (cost drivers) that influence the firms unit costs in the particular industry context & relative to competitors
o

searching for new ways to improve the firms cost efficiency

o
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The Value of Cost Advantages

Barney & Hesterly (2008:126-128)

Threat of Entry: economies of scale increase capital requirements for entrants

Threat of Substitutes: limit attractiveness of substitutes

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Threat of Buyers: lower incentives for buyers to switch suppliers or vertically Rivalry: integrate competitors avoid price Threat of competition Suppliers:

larger volumes increase the importance of the firm to suppliers

Building Cost Advantage

Study the competition typical costs & how they are achieved

Adopt best-practice technology it can impact cost levels & may secure a first mover advantage
Consider locations and manage relationships Improve the cost structure Encourage efficiency (cost savings)

in all parts of the value chain involving every employee motivate them & employ individual knowledge

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The Challenges of Organization

Strategy Implementation Grant (2010:180-191)

Specialization defining organizational units to achieve optimal efficiency, e.g. on the basis of common tasks, product, geography, etc. Cooperation creating incentives & controls to encourage pursuit of organizational objectives & deal with potentially conflicting goals Coordination - creating controls to achieve optimal combination of specialization & operational autonomy for each unit The adopted strategy defines how these challenges need to be addressed
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The Question of Organization

Strategy Implementation

The VRIO framework: A firm must be appropriately organized to exploit the potential competitive advantage stemming from its resources & capabilities. Organization refers to reporting structures, formal & informal management controls, and compensation policies. The firms organization must reinforce the business strategy it complements the other resources of the firm by defining the ability & incentive of the HR to exploit them o e.g. the full benefits from new process technologies typically require system-wide changes in organization
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Organizing for Cost Advantage:

Functional Structure (1)

Grant (2010:191-192)

AKA U-form (unitary) hierarchy Management responsibilities divided by function

Chief Executive Officer

Finance

Accounting

Marketing

Human Resources
R&D

Production
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Organizing for Cost Advantage:

Functional Structure (2)

Specialization facilitates cost reduction Centralization - the CEO is the only executive with enterprise-wide perspective & responsible for strategy can ensure:
o o

efficient decision-making

coordination of functions efforts in pursuit of a common strategy sharing of the best cost reduction practices among divisions
o
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Organizing for Cost Advantage:

Management Controls
The agency problem: Do the agents (staff) act in the principals (the organization) interest? Management controls are policies that address the challenges of coordination & cooperation through aligning individual interests with the interests of the organization Management controls can be:
Formal - budgeting, spending policies, travel policies, purchasing policies o Informal - company culture & shared values (commonality of purpose)
o

Cost advantage strategy requires centralized & standardized controls aimed at tight cost control
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Organizing for Cost Advantage:

Compensation Policies
Reinforce management controls through performance incentives, e.g.:

o o o

bonuses vacations office perks

Focused on cost reduction: performance incentives are directly tied to cost-reducing efforts, i.e. link rewards to output based on:

o o
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cost reduction financial performance

Limitations of Cost Advantage Strategies

White (2004:325-329)

Standardized products - the firm must be one of the leaders to gain above normal profits
Cost drivers are often easily imitated

Many cost factors change quickly, e.g. exchange rates, technology & design
It neglects the growing importance of customization, which involves:
increased costs o more attention to the customer
o

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Competitive Strategy
Risks of the Generic Strategies