{"id":144,"date":"2014-05-13T17:44:45","date_gmt":"2014-05-13T17:44:45","guid":{"rendered":"http:\/\/opentextbc.ca\/strategicmanagement\/?post_type=chapter&p=144"},"modified":"2019-07-02T22:48:23","modified_gmt":"2019-07-02T22:48:23","slug":"cost-leadership","status":"publish","type":"chapter","link":"https:\/\/opentextbc.ca\/strategicmanagement\/chapter\/cost-leadership\/","title":{"raw":"Cost Leadership","rendered":"Cost Leadership"},"content":{"raw":"
\r\n

Learning Objectives<\/p>\r\n\r\n<\/header>\r\n

\r\n
    \r\n \t
  1. Describe the nature of cost leadership.<\/li>\r\n \t
  2. Understand how economies of scale help contribute to a cost-leadership strategy.<\/li>\r\n \t
  3. Know the advantages and disadvantages of a cost-leadership strategy.<\/li>\r\n<\/ol>\r\n<\/div>\r\n<\/div>\r\n

    The Nature of the Cost-Leadership Strategy<\/h1>\r\nIt is tempting to think of cost leaders as companies that sell inferior, poor-quality goods and services for rock-bottom prices. The Yugo, for example, was an extremely unreliable car that was made in Eastern Europe and sold in the United States for about $4,000 in the 1980s. Despite its attractive price tag, the Yugo was a dismal failure because the car was so poorly made that drivers simply could not depend on the car for transportation. Yugo exited North America in the early 1990s and closed down entirely in 2008.<\/a>\r\n\r\n[caption id=\"attachment_1972\" align=\"aligncenter\" width=\"400\"]\"Figure<\/a> Figure 5.3 Cost Leadership [Image description]<\/a>[\/caption]<\/a>In contrast to firms such as Yugo whose failure was inevitable, cost leaders can be very successful. A firm following a [pb_glossary id=\"2892\"]cost leadership[\/pb_glossary]<\/strong>\u00a0<\/strong>strategy offers products or services with acceptable quality and features to a broad set of customers at a low price (Figure 5.3 \"Cost Leadership\"<\/a>). \u00a0This combination of an appropriate price and value is sometimes referred to as a strong value proposition. Payless ShoeSource, for example, sells name-brand shoes at inexpensive prices. Its low-price strategy is communicated to customers through advertising slogans such as \u201cWhy pay more when you can Payless?\u201d and \u201cYou could pay more, but why?\u201d\r\n\r\nFirms engaging in cost-leadership strategy seek to combine low per-unit profit with large sales to make a profit. \u00a0Typically, but not always,\u00a0they tend to market to a large population base or a niche with a high demand volume.\r\n\r\n[caption id=\"attachment_1313\" align=\"aligncenter\" width=\"400\"]\"Yugo\"<\/a> Figure 5.4: Listeners of the popular radio show Car Talk voted the Yugo as the \u201cworst car of the millennium.\u201d[\/caption]\r\n\r\nPerhaps the most famous cost leader is Walmart, which has used a cost-leadership strategy to become the largest company in the world. The firm\u2019s advertising slogans such as \u201cAlways Low Prices\u201d and \u201cSave Money. Live Better\u201d communicate Walmart\u2019s emphasis on price slashing to potential customers. Meanwhile, Walmart has the broadest customer base of any firm in North America. Approximately 100 million of us visit a Walmart in a typical week (Zimmerman & Hudson, 2006).\u00a0Incredibly, this means that roughly one-third of Americans are frequent Walmart customers. This huge customer base includes people from all demographic and social groups within society.\r\n\r\nIn 2014, Walmart\u00a0faced stiff completion from dollar store chains coupled with growing competition from Amazon.com and Internet shopping as more and more people shop online. Walmart has been sharpening its focus on everyday low prices and further pushing that strategy abroad. Interestingly, Walmart's success has been somewhat limited in their international expansion efforts. Having exhausted the potential sales market for big-box stores, with over 90\u00a0percent\u00a0of North Americans living within fifteen\u00a0minutes of a Walmart, the company is planning to accelerate growth plans for smaller Neighborhood Markets and Walmart Express stores that cater to shoppers looking for more convenience with fresh produce and meat and household and beauty products (Anderson, 2014).\r\n\r\nCost leaders tend to share some important characteristics. The ability to charge low prices and still make a profit is challenging. Cost leaders manage to do so by emphasizing efficiency at every step of the value chain: production, manufacturing, sales, and customer service. At Smitty's Restaurants, for example, customers are served cheap meals\u00a0quickly to keep booths available for later customers. As part of the effort to be efficient, most cost leaders spend little on advertising, market research, or research and development. Smitty's, for example, limits its advertising to billboards along highways, a $2 membership card for 10 percent\u00a0discounts, and its website. Meanwhile, the simplicity of Smitty's menu requires little research and development.\u00a0Walmart spent approximately $2.3 billion on advertising in 2013.\u00a0 This is a huge number, but Walmart is so large that its advertising expenses equal just a tiny fraction of its sales.<\/span>\r\n\r\nMany cost leaders rely on [pb_glossary id=\"2530\"]economies of scale[\/pb_glossary]<\/strong>\u00a0<\/strong>to achieve efficiency. Economies of scale are created when the cost of goods and services decreases as a firm is able to increase production. Most companies do experience some economics of scale initially; for a coffee shop, the most expensive cup of coffee they make every day is the first! \u00a0However, for some firms such as a new hydro generation plant or the latest Lady Gaga CD,\u00a0there are huge start-up or fixed costs (think, the cost of making the first\u00a0Lady Gaga CD is maybe $250,000; the\u00a0second, one\u00a0cent;\u00a0the third, one\u00a0cent...). \u00a0T<\/span>he average costs fall the more electricity is generated or CDs are printed\u2014economies of scale. \u00a0<\/span>\r\n\r\nWhen cost leaders become large companies, it can give them sufficient market power to demand price concessions from their suppliers. Walmart is notorious for requiring\u00a0suppliers, such as Procter & Gamble, to sell goods to Walmart for lower and lower prices over time. In its\u00a0defence, Walmart invests considerable resources and efforts to help suppliers find ways to reduce costs. Walmart then seeks to pass on most of these savings to customers in the form of reduced prices.\r\n

    Advantages and Disadvantages of Cost Leadership<\/h1>\r\nEach generic strategy offers advantages that firms can potentially leverage to enhance their success as well as disadvantages that may undermine their success. In the case of cost leadership, one advantage is that cost leaders\u2019 emphasis on efficiency makes them well positioned to withstand price competition from rivals (Figure 5.5 \"Executing a Low-Cost Strategy\"<\/a>). Kmart and Zellers\u2019s ill-fated attempt to engage Walmart in a price war ended in disaster, in part because Walmart was so efficient in its operations that it could live with smaller profit margins far more easily than Kmart or Zellers could.<\/a>\r\n\r\n[caption id=\"attachment_1962\" align=\"aligncenter\" width=\"400\"]\"Figure<\/a> Figure 5.5 Executing a Low-Cost Strategy [Image description]<\/a>[\/caption]Beyond existing competitors, a cost-leadership strategy also creates benefits relative to potential new entrants. Specifically, the presence of a cost leader in an industry tends to discourage new firms from entering the business because a new firm would struggle to attract customers by matching or even undercutting the cost leaders\u2019 prices. Thus a cost-leadership strategy helps create barriers to entry that protect the firm\u2014and its existing rivals\u2014from new competition.\r\n\r\n[caption id=\"attachment_1317\" align=\"aligncenter\" width=\"400\"]\"Store<\/a> Figure 5.6: Challenging a cost leader in a price war may end up destroying a company.[\/caption]\r\n\r\nIn many settings, cost leaders attract a large market share because a large portion of potential customers find paying low prices for goods and services of acceptable quality to be very appealing. This is certainly true for Walmart, for example. The need for efficiency means that cost leaders\u2019 profit margins are often slimmer than the margins enjoyed by other firms. However, cost leaders\u2019 ability to make a little bit of profit from each of a large number of customers means that the total profits of cost leaders can be substantial.\r\n\r\nIn some settings, the need for high sales volume is a critical disadvantage of a cost-leadership strategy. Highly fragmented markets and markets that involve a lot of brand loyalty may not offer much of an opportunity to attract a large segment of customers. In both the soft-drink and\u00a0beer industries, for example, customers appear to be willing to pay a little extra to enjoy the brand of their choice. Lower-end brands of soda and beer appeal to a minority of consumers, but famous brands such as Coca-Cola, Pepsi, Budweiser, and Molsons still dominate these markets. A related concern is that achieving a high sales volume usually requires significant upfront investments in production and\/or distribution capacity. Not every firm is willing and able to make such investments.\r\n\r\nCost leaders tend to keep their costs low by minimizing advertising, market research, and research and development, but this approach can prove to be expensive in the long run. A relative lack of market research can lead cost leaders to be less skilled than other firms at detecting important environmental changes and trends. Meanwhile, downplaying research and development can slow cost leaders\u2019 ability to respond to changes once they are detected. Lagging rivals in terms of detecting and reacting to external shifts can prove to be a deadly combination that leaves cost leaders out of touch with the market and out of answers.\r\n
    \r\n

    Key Takeaways<\/p>\r\n\r\n<\/header>\r\n

    \r\n