Competitive Strategy Professor Neil Kay

2.4 Cost Leadership

Cost leadership is a strategy that may be feasible if a firm’s costs are lower
than those of its competitors. In searching for sources of cost advantage
that may help create and reinforce cost leadership there are several cost
drivers (structural determinants of the cost of an activity) that may impact
on different parts of the value chain. The main cost drivers identified by
Porter are as follows:
 Economies of scale. If a firm can pursue scale to increase
specialisation and division opportunities and make better use of
indivisible resources, then it may be able to move further down the
average cost curve than its competitors. The car industry is a good
example, where a substantial level of output (generally 500 000 to 1
million units) is required before production economies are fully
exploited.
 Learning and experience curve gains. Economies of scale refer to
level of output which a firm can achieve in a given time period. Learning
and experience curve effects refer to the cumulative output of a product
which the firm has achieved over time. In building their first 747,
Boeing had to set up a new production line, a new work plan, and new
tasks for managers and workers. The high costs of producing the first
unit to roll out from Boeing’s production hander reflected the novelty
and unfamiliarity of many of the managerial and workforce tasks
involved. As time went on, management found short cuts and
improved methods of organisation, workforce skills and productivity
improved through practice and repetition, and opportunities for
improved teamwork and co-ordination were realised. The real cost per
unit for Boeing 747s tended to fall over time as these learning and
experience curve effects were realised, helping to generate considerable
cost advantages for Boeing versus actual or potential competitors. Such
learning curve gains are often important considerations in cases of

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complex high-technology products with a reasonably high degree of

standardisation, and produced in batches or limited numbers.
 Capacity utilization. Capacity utilisation can be an important driver
of costs, especially in capital-intensive industries characterised by a high
level of fixed costs and unpredictable or variable demand. The airline
industry is a good example of an industry where capacity utilisation is
an important driver of costs (per passenger) with each flight being
characterised by high fixed costs (cost of plane, crew, fuel etc.) and the
marginal cost to the airline of each extra passenger being close to zero
(as long as there is a seat available). This sector is characterised by a
high degree of price discrimination, much of which is designed to bump
up capacity utilisation (or the ‘load factor’). This sector has been
characterised by the entry of a number of no-frills competitors in recent
years, seeking to push cost per passenger down by offering a no-frills
service as well as trying to maximise the load factor.
 Vertical links within the value chain, and links with suppliers’ and
buyers’ value chains. Cost drivers can impact on parts of the value
chain but the overall configuration of the chain and links between
different elements of the chain can also be important in helping to
generate cost advantage in the case of vertical integration. For example,
many firms have adopted an open plan office system to make sure that
communication between different functional specialists in the chain is
as effective and as easy as possible. The right arrangement and links
with suppliers’ and buyers’ value chains can also be an important source
of cost advantage, as evidenced by much of the concern with
outsourcing in recent years. We shall look at these issues further in
Module 4.
 Horizontal links with other value chains – economies of scope.
Links with other value chains can be important in helping generate cost
reduction through economies of scope. For example, BIC’s disposable
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pens, razors and lighters can share much of its competences in making
and selling light, cheap, disposable consumer products across these
different product lines. We shall look at the potential gains from sharing
resources between value chains further in Module 5.
 Timing. Being first-in to the market can give the entrant or innovator
certain cost advantages. For example, there may be network effects that
lead to decreased cost per user as the system grows and it may be
difficult or impractical for an entrant to duplicate or replicate (e.g.
railways). At the same time, there may be second-in benefits from
waiting and learning from others’ costly mistakes. We shall look at these
issues further in the context of innovation in Module 3.
 Location. Different locations may have different resource costs. Land,
labour and capital costs may differ from region to region and country
to country. There may be advantages in locating all or part of the value
chain in areas where a major resource is relatively cheap (e.g. labour-
intensive processes to low-wage countries). The danger is that this may
geographically fragment the value chain and make it difficult to co-
ordinate its various pieces.
 Institutional factors such as government regulation, taxation and
subsidies. Background institutional factors may also affect the cost
base of the firm; for example, many governments provide attractive
fiscal packages to attract inward investment. Conversely, other policies
may have an adverse effect on the cost base of the firm; for example,
the UK government’s decision to tax fuel heavily for environmental
reasons in the late-nineties had an adverse effect on many UK firms’
distribution costs.
 Discretionary policies. This is really a catch-all category reflecting the
firm’s choice of strategy and how it may impact on its costs. For
example, some PC manufacturers such as Dell sell computers direct
rather than go through retailers and so cut out the middle man (see
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Exhibit 2.2). Limiting the variety of products produced is another

device to reduce costs through standardisation (e.g. Apple iPhone).
 External economies. A possible source of cost advantage not
explicitly separated out by Porter is that the firm may be able to take
advantage of external factors to reduce its costs, such as the existence
of a well-qualified labour pool due to the presence of other firms in a
local area. External economies are an essential ingredient in the creation
of clusters, an issue we shall be looking at in Module 6. Each of these
potential sources of cost advantage may impact on pieces of the value
chain. The successful cost leaders will squeeze as much cost advantage
from the overall value chain as possible without sacrificing elements
that are valued by consumers, though some trade-off may have to be
made between standardisation and differentiation. Cost leadership is
most likely to be successful where there are some factors that cannot
be easily replicated. For example, overseas location in a low-wage
country may succeed in keeping costs down, but in itself it will not be
sufficient for overall cost leadership if there is nothing to stop
competitors setting up facilities in these locations as well. Cost
leadership is more likely to be sustainable where a standardised product
combines with economies of scale, learning and experience curve
effects, and the firm can achieve a high market share. Crucially it
depends on firms being able to extract a cost advantage over
competitors and then being able to attract and retain buyers on the basis
of price. These conditions are likely to hold:
1. in the early stages of the product life cycle if the firm can steal an
advantage over competitors. This may be, for example, through getting
down the cost curve or the learning curve more quickly, either by
exploiting first-mover advantages or second-in advantages of learning
from competitors’ mistakes.
2. in the later stages of the product life cycle if the product is a standardised
commodity-type product with a high price elasticity of demand and
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buyers do not face significant switching costs from one seller to

another.
The dangers are of course that the firm’s strategy is based on a single trick: a
low cost operation which other firms may learn to imitate or beat, either
through improved organisation or technological innovation. Since the strategy
is essentially a supply-side strategy (based on cost) it is inward-looking
compared to a differentiation strategy (which is based on the firm’s perception
of the demand side and consumer needs). Consequently this may encourage
insensitivity on the part of the firm in relation to significant trends such as shifts
in distribution and consumption patterns. And of course if there is room for
only one cost leader then it is a strategy that only one firm can achieve. The
worst scenario for firms in a sector is that they try to chase each other down
the demand curve in a price war with each trying to achieve supremacy as the
cost leader.
Table 2.1 Cost leadership and credible threats
Other firm
Low price High
price
Cost leader
Low price 120/30 140/50
High price 80/100 100/80

Bearing in mind the reservations we expressed concerning the game theory

ideas in Section 1.4, they can nevertheless be useful to show how a firm
may increase its chances of a sustainable cost-leadership strategy. This may
work if it can make a credible threat that it will maintain this strategy
irrespective of the actions of its rivals. In Table 2.1, the cost leader’s pay-
offs are the first entry and its rival’s pay-off is the second entry in each
case. The best result for the other firm would be if it priced low and
received a pay-off of 100 and the cost leader was pushed into setting a
higher price (bottom left in Table 2.1). However, if the cost leader priced

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low, the other firm would be best leaving this segment of the market to
the cost leader and pricing high (50 pay-off for the other firm versus 30 if
it tried to match the cost leader’s low price).
However, look at the pay-offs for the cost leader. If the other firm priced
low, the cost leader would be better off matching this strategy (pay-off 120
versus 80 if it raised price). But if the other firm priced high, the cost leader
would still be better off setting a low price (pay-off 140 versus 100). The
crucial thing here is that the cost leader’s best strategy is to keep price low
whatever the other firm does. As we saw in Module 1, this can be termed a
dominant strategy for the cost leader, that is it represents the best choice for
the firm no matter what the competing firm does.
The important consideration for the other firm is that no matter what it
does, its rival (the cost leader) will keep prices low. So that means that the
bottom row of pay-offs (associated with the high price option for the cost
leader) is irrelevant in its calculation. This leaves the top row in which the
other firm can choose to match the cost leader’s low price (pay-off of 30),
or go upmarket (and achieve a pay-off of 50). Clearly the other firm would
be better off going upmarket and pricing accordingly, leaving the cost
leader with the larger share of the pay-offs.
However, it is critical here that not only does the cost leader know that
its dominant strategy is to price low, the other firm must be fully aware
that this is the cost leader’s dominant strategy. If the other firm
(mistakenly) suspected that it could somehow squeeze the cost leader out
of this strategy and undercut it, then a costly price war could ensue with
both firms finishing worse off than would have been the case had the
other firm read the situation correctly. Ways that the cost leader may be
able to persuade the other firm that it would be a tactical mistake for it to
try to achieve cost leadership would be through credible commitments that
show it is irrevocably committed to this low-price strategy, irrespective of
what the other firm does. For example, it could close down its R&D team
except for those researchers working on process improvements, it could
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standardise its production around one or two basic lines, it could move all
its production to a cheap low-cost location, and so on.
As we saw in Module 1, the ironic thing is that strategies that
demonstrably tie the firm’s hands and lock it into its preferred strategy
may help to reduce the chances of retaliation from competitors. These
rivals will perceive they have little or no chance of shifting the firm from
its strategy, and so they will have to plan around it. Just as an army may
credibly threaten its enemy that it intends to stand and fight by burning its
bridges (and destroying its escape route) behind it, so a firm may credibly
demonstrate its commitment to a cost strategy by eliminating the
alternatives to it. The important thing, of course, is not only to burn the
bridges but to make sure that the enemy can see them burning as well.
Similarly, if you have no choice but to fight your low-cost corner, it is
important that your rivals know this as well in case they indulge in a futile
price war.
Porter (1985, p. 118) summarises the major steps to be taken in undertaking
a strategic cost analysis of the value chain as follows:
1. Identify the value chain, and separate out and assign costs and assets
attributable to it.
2. Identify the relevant cost drivers and how they interact with each other.
3. Identify competitor value chains, costs, and sources of cost advantage. (This
should help test whether cost leadership is a viable strategy, or at least
whether there are further cost gains that the firm could seek out.)
4. Develop a strategy to reduce costs through cost drivers or by reconfiguring
value chain.
5. Guard against eroding differentiation.
6. Test for sustainability. (Can competitors replicate what you have done?)
A difficulty in carrying out the third step of the process is that rivals are
unlikely to open their books to you to help you work out their cost structure.
Further, even if you can observe that your competitors appear to be pushing
down their costs and prices, it may be difficult to identify the sources of these
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cost gains. Many cost drivers, some of which are illustrated in Figure 2.7, tend
to be achieved over time and may be mutually reinforcing (X-efficiency in the
diagram below refers to the elimination of inefficient high-cost practices in the
firm). If cost per unit for a competitor falls, is it because of internal or external
economies, innovative improvements, learning curve gains or simply the
elimination of waste?
In practice, the firm may be able to find indirect methods of assessing its
competitors’ cost levels, e.g. market share, the size of its sales team, information
on the costs of publicly available inputs, and so on. At best, the firm may only
be able to get rough guides as to its competitors’ cost positions and how various
cost drivers contribute to the relative positioning of it and its rivals.

* External
* Economies economies
of scale £
£ * Innovation

AC ACx
1

AC
Q Q

* X- eff iciency * Learning

£ £
curve

ACx
AC/unit
AC

Q Q

Figure 2.7 Various sources of cost advantage over time

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Exhibit 2.2: Cost leadership as a niche: Dell and PCs

It is usual to think of cost leadership as dependent on achieving high market share and
exploiting cost drivers such as economies of scale and the experience curve more fully than
competitors. However, the computer manufacturer Dell achieved the position of cost leader
in the PC industry with a carefully fashioned direct sales strategy that occupied only a niche in
the overall PC market. While most PC manufacturers sold indirectly through intermediaries
such as retail stores, Dell sold directly to the customer using telephone and Internet
technology. There were a number of elements that helped create and reinforce Dell’s cost
leadership.
• Direct selling eliminates the retailer’s mark-up.
• Dell’s build-to-order allows customisation to user needs.
• Eliminating the weeks of delay a PC might be sitting in store means that Dell’s sales can
immediately incorporate the latest changes in components’ prices. These can fall several times
during the year.
• Direct selling gives immediate, direct and high-quality feedback on demand trends.
• The absence of ‘lumpy’ bulk orders from retailers and accurate feedback on demand
trends allows better forecasting and production scheduling, quicker turnover of inventory, and
lower costs of holding stocks. Dell has most of its components warehoused within 15 minutes
of a Dell factory.
Although Dell achieved cost leadership (estimates suggested that it cost some PC
manufacturers up to twice as much as Dell to build and sell each PC) and had been one of the
fastest-growing PC manufacturers, it was not able to translate this into a dominant market
share. This raises two main questions. First, why was Dell not able to translate this cost (and
price) advantage into a higher market share, which in turn should have reinforced its cost
advantage? The answer is that consumers were willing to pay a premium for products they
could see and try out in retail outlets first. Dell’s strategy eventually hit natural limits on the
demand side. A second question is, how was Dell able to sustain such an effective cost-
leadership strategy in its chosen niche when other manufacturers could have tried to replicate
its cost-leadership strategy? In fact, Dell was not the only direct PC seller. A problem was also
that it was difficult for any company to be active in selling both directly and through retailers.
If a manufacturer that used high-street retailers also became involved in direct selling, such a
strategy could compete with its own sales through shops. This could pose problems for its
established marketing strategy as well as its relations with retailers.

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