Cost Leadership is the strategy that focuses on making the operations more efficient and cutting costs wherever possible. It may result from scale/scope efficiencies, tight overhead control, careful selection of customers, standardization and automation. Cost leadership aims at having the lowest costs in a market. This makes the company best placed to survive a price war and generates the highest margins if a price war does not occur. The largest retail chain in the world, Wal-Mart also believes in cost leadership.
“gives the firm defense against rivalry from competitors because its lower cost means that it can still earn returns after competitors have competed away their profits through rivalry. A low cost position defends the firm against powerful buyers because buyers can exert power only to drive down process to the level of the next most efficient competitor. Low cost provides defense against powerful suppliers by providing more flexibility to cope with input cost increases. The factors that lead to a low cost position . . . also provide substantial entry barriers in terms of scale . . . Finally, a low cost position places the firm in favorable position vis-à-vis substitutes . . . Thus a low cost position protects the firm against all five competitive forces” (Porter, 1980, pp. 35-6)
Controlling costs systematically can lead to competitive advantage in industries where price is an important factor. If a company offers a standard product or service at a lower cost when compared to the industry average, the company will earn higher profits. Low cost can enable the company to compete on price if that is required. It can also generate profits that can be reinvested to improve the product quality while charging the same price as the average in the industry. Low cost producers are more likely to survive a price war. If suppliers hike prices, the low cost leader will not be squeezed as much as the other players. The firm’s low cost position may also act as an entry barrier, particularly if the potential entrant hopes to compete on price. A cost leader can also use price as a weapon to ward off threats from substitute products.
To become the cost leader, a company must make choices about its product, market, and distinctive competencies.
- The cost leader chooses low product differentiation, aiming for a level of product differentiation obtainable at low cost.
- The cost leader chooses to serve the needs of the average customer to avoid the high costs of serving different market segments. Perhaps no one is wholly satisfied with the product, but because its price is lower, some customers choose it.
- The cost leader chooses to develop competencies in manufacturing, because it must ride down the experience curve to lower costs. Materials management and information technology are other important sources of cost savings. Other functions tailor their distinctive competencies to meet the needs of these three areas.
The cost leadership strategy provides businesses with some advantages, as discussed in terms of Porter’s five forces model.
- In the area of competitors, the cost leader is protected by its cost advantage.
- Lower costs mean that the cost leader will be less affected by powerful suppliers than competitors. Also, the cost leader’s large volume purchases give the firm an advantage over suppliers.
- The cost leader is less affected by buyers’ power to set prices, because its prices are already low.
- The cost leader is better able than its competitors to reduce its price in order to compete against potential substitutes.
- Potential entrants face high barriers to entry because of the cost leader’s low-price advantage.
There are some risks associated with the cost leadership strategy:
- If the buyer perceives the product to be cheap or of low quality, then the company would have to reduce the price to sell it. In that case, cost leadership will not lead to superior profitability.
- Too much focus on costs can lead to the firm losing touch with the changing requirements of the customer.
- Many routes to a low cost position can be easily copied. Competitors can purchase the most efficient scale of plant. As industries mature, the experience curve effect confers fewer benefits. But perhaps the greatest threat comes from competitors who are able to price at marginal cost in the industry because they have other, higher profit-earning product lines to recover the fixed costs.