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4 Cost Leadership INTRODUCTION Chapter 4 marks the beginning of Section 2 of the textbook. This section covers business level strategies. This is the beginning of the “Strategic Choices” element of the strategic management process. As such, you should clearly signal to students that you have taken them through external and internal analysis. Students are now ready to begin learning about how to use external and internal analysis to make important strategic decisions. Business level strategy refers to the strategic choices managers make about how to position a specific business and/or product line to gain competitive advantage in a single market or industry. Recall the business level strategy decisions in the Stanley Black & Decker example from Chapter 1. Stanley Black & Decker must make strategic decisions about how to position small appliances and power tools. Of course, managers’ decisions concerning the positioning of businesses will be influenced by the results of their external and internal analyses. Cost leadership and product differentiation are the two business level strategies covered in this text. These two strategies are sometimes referred to as generic business level strategies because they represent heuristically two extremes that a firm could choose to pursue. However, as with most of the concepts covered in this course, some firms are better able to gain competitive advantage by pursuing these generic strategies than other firms. Teaching Points • Explain the logic of strategic choices following internal and external analysis in the strategic management process. • Remind students of what business level strategy is. • Explain that low cost leadership and product differentiation are two ways of positioning a business to achieve competitive advantage. • Offer a brief outline of your discussion of cost leadership: Benefits of cost leadership Sources of cost advantages Cost leadership and competitive advantage Cost leadership and organizational structure Summary of cost leadership Slide 4-2 Use this slide to show how strategic choices can be categorized as business level strategy issues and corporate level strategy issues. Explain that business level strategic choices are concerned with the positioning of specific businesses. Corporate level strategic choices deal with decisions about which businesses to enter and how to enter them. Slide 4-3 This slide shows the two generic business level strategy choices of cost leadership and differentiation. Explain that this chapter covers cost leadership and the next chapter will cover product differentiation. The following Discussion and Activity is a fun way to engage students’ attention in thinking about how and why firms choose to position their products in various ways in the market. Discussion & Activity: The Plastic Bag Activity This activity requires some advance preparation on your part. Go to a grocery store and find that store’s offering of plastic garbage bags. You will usually find a range of several bags including a high end, heavy duty bag with pull strings, a lighter weight bag with pull strings, a bag with a tapered opening that can be tied by pulling the tapered corners together, a bag that comes with twist-ties, and a very plain bag with no closure apparatus whatsoever. Choose several of the bags to represent a good cross section, but focus on the extremes—make sure you get the cheapest one. It will be helpful if you can get more than one bag that is at the obvious low end of the market. This may cost a few dollars, but it’s an investment; you’ll be able to refer to these bags several times throughout the semester. Make sure to note the price per package, the number of bags in each package, and the per bag price of each type of bag. Take these bags to class, but before you show the bags, ask students if they can name brands of garbage bags. They will most likely be able to name Glad and Hefty. Now show the boxes and each type of bag to the students. Explain the package sizes and prices. Ask students if they have had any experience with the expensive versus cheap garbage bags. You will usually get at least one impressive, perhaps gross, story about garbage bags. Ask the students why anyone would ever buy the inexpensive (cheap) bags. Ask them why anyone would ever pay the super premium you seem to be paying for the high priced bags. These questions and the ensuing discussion will help the students realize that not all consumers are alike and different consumers have different needs and motivations for buying bags. Now ask the students what they think the basis of competition is for the producers of each type of bag. Make sure the point is made that some producers are competing on quality and others are competing on price. Ask the students which companies have to be concerned about the costs of production. The point should be made that costs matter for everyone but they matter more for those who are competing on price. Point out that the students didn’t know the brand names of the cheap bags. Even though they didn’t know the names of the cheap bags, the cheap bag producers are making enough money to stay in business. Explain that the high-end bag producers and the low-end bag producers are positioning themselves in the market in fundamentally different ways. This is business level strategy. Some are trying to compete on differentiation and some are trying to compete on cost leadership. Point out that both strategies can work in a single market. Both strategies can generate economic value. Note: It may well be the case that the manufacturers of high-end bags also produce the low-end bags under different names. Ask students why we as consumers don’t know this for sure. THE BENEFITS OF COST LEADERSHIP Define Cost Leadership As the name implies, a cost leadership strategy is intended to generate competitive advantage by achieving costs that are lower than all competitors. Our definition of competitive advantage is: the ability to create more economic value than competitors. A firm with lower costs than competitors creates more value because of the greater difference between the firm’s costs and the price the firm is able to charge (i.e., higher profit margins). Important Points: In a market where competitive pressures (e.g., a commodity-type product) do not allow one firm to charge higher prices than other firms, the firm with a cost advantage will be able to generate more value than competitors. Slide 4-4 Use this slide to illustrate that a cost leadership position vis-à-vis competitors will allow the focal firm to have average total costs (ATCff) that are less than the industry average total costs (ATCind). Thus, an above normal return is possible. Also, point out that the focal firm does not have to charge a lower price—it can enjoy a wider margin than competitors. Finally, use this graphic to illustrate why competitors would not want to engage in a price war with the cost leader. If other firms have higher cost (such as the industry average total cost), they can never win a price war with the cost leader. Cost leadership is not necessarily synonymous with low price. It is true, by definition, that the cost leader in a market can charge the lowest price and still have a positive profit. However, a firm pursuing a cost leadership strategy would want to have the advantage of the lowest costs without being forced to charge the lowest price. Firms in a market have a strong incentive not to compete on price with the low cost leader. This is akin to the old boxing adage that: One’s success in the ring has a lot to do with choosing one’s opponent. Firms have a strong incentive to compete on cost (not price) because of the advantages explained above. Therefore, firms enjoying cost advantages typically face strong competitive pressures on their cost positions. The durability of cost advantages will be discussed later in the Cost Leadership and Competitive Advantage section. ► Example: Wal-Mart’s Cost Advantages Wal-Mart has always been focused on achieving the lowest possible costs. As the firm began to expand and grow there were two main sources of cost advantage: 1) a growth pattern of rural locations surrounding distribution centers, and 2) information technology. Wal-Mart’s careful selection of rural locations created cost advantages because of relatively cheap land and very efficient distribution through its distribution centers. Stores were typically located along interstate highways and/or heavily traveled crossroads. There was usually very low demand for the land purchased for these locations because other retailers were uninterested in rural locations. However, these stores had incredible drawing power. People flocked to the stores in search of low prices and a wide product offering. Distribution was also relatively inexpensive because Wal-Mart’s trucks could easily get to these locations from interstate highways. One large distribution center could efficiently handle all the stores within a day’s drive. These location advantages were coupled with Wal-Mart’s information technology, which was always state-of-the-art. Highly efficient inventory management, facilitated by IT systems, allowed Wal-Mart to achieve costs significantly lower than its competitors. Wal-Mart knew which items were selling and which were not. It knew how much of which products were needed and where they were needed. And, it could distribute these products quickly and efficiently. Wal-Mart has heavily advertised low prices. People tend to associate Wal-Mart with low prices. However, careful shoppers in some markets have realized that competitors sometimes offer lower prices, especially on food items. Thus, it would appear that Wal-Mart is in the enviable position of having low costs but not having to charge the lowest prices on all products all the time. This pricing advantage can be very frustrating for competitors. Wal-Mart has a policy of beating competitors’ prices whenever a customer points out that a competitor has a lower price. If a competitor attempts to compete vigorously on price, Wal-Mart will simply lower its price and it can better afford to do so. One store manager from a competing food retailer stated his frustration this way: “People just assume that Wal-Mart has the lowest prices on everything, but they don’t. I have sent professional shoppers to compare prices and we have better prices on many items. But, if I advertise lower prices on any specific item, Wal-Mart will beat my price and I’m worse off.” Wal-Mart is able to offer low prices and still make a profit because of its low costs. One remarkable aspect of Wal-Mart’s success is that it has operated in a business that is highly competitive. Wal-Mart appears to have achieved competitive advantage with its cost leadership strategy. Teaching Points • Refer to the Ryanair example from the opening case in the chapter and the Wal-Mart example above to help explain the three Important Points above. • Emphasize that firms can achieve competitive advantage in very competitive markets through cost leadership. • Ask students about their experiences at Wal-Mart. • Do they think Wal-Mart always has the lowest prices? • Ask students how they would respond to Wal-Mart if they were the manager of a competing store. SOURCES OF COST ADVANTAGES Identify Six Reasons Firms Can Differ in Their Costs Managers facing a strategic decision about how to position a business within an industry need to understand several fundamental cost issues. A sound understanding of these issues will help managers determine whether their focal firm is likely to generate competitive advantage by competing on cost. Alternatively, managers may recognize that other firms have a clear cost advantage and therefore their focal firm should choose to compete on some other basis—such as product differentiation. Important Point: Sources of cost advantage should be analyzed very objectively. Finding out that the focal firm is not likely to have a cost advantage may be just as valuable as finding out that the focal firm is likely to have a cost advantage. Slide 4-5 Use this slide to make the Important Point above. Explain that the development of an appropriate strategy depends on knowing who has the cost advantage. Six Sources of Cost Advantage The textbook offers detailed coverage of six sources of cost advantage. Therefore, we suggest that you simply offer a brief explanation of each one of these sources and move on to a discussion of how managers can determine if these sources of cost advantage are likely to lead to competitive advantage. Identify Four Reasons Economies Of Scale Can Exist and Four Reasons Diseconomies Of Scale Can Exist Economies of Scale • exist if the average per unit cost of production falls with an increase in the quantity produced • exist because of the ‘fixed’ nature of some costs • suppose the investment cost of a machine is $50,000—whether the machine produces 1,000 pieces or 10,000 pieces the investment cost is the same, the per unit cost falls from $50 to $5 • fixed overhead costs may be spread over larger volumes of production—lowering per unit cost of production • imply that there is some minimum efficient scale—firms that operate at the minimum per unit cost will have an advantage over firms that have not reached the minimum efficient scale • exist because of specialized machines and the specialization of employees • may be achieved through international expansion that increases sales to the point that minimum efficient scale may be reached Slide 4-6 Use this slide to make the points above. Emphasize the fact that economies of scale are most effective as a cost advantage and barrier to entry, when the necessary increments of capacity would push industry capacity beyond industry demand. Diseconomies of Scale • arise as production moves beyond the minimum efficient scale—average per unit cost increases as quantity produced increases • the firm (or business) has become too large • physical diminishing returns to scale—machines able to handle larger volumes may be prone to more defective pieces and/or may be so expensive as to result in higher average per unit costs • transportation costs—trying to cover a vast geographic area from a very large plant may contribute to diseconomies of scale • human factors—overly bureaucratic, de-motivated • may result from international expansion if bureaucracy increases and/or if the necessary scale of production exceeds the minimum efficient scale Slide 4-7 Make sure students understand that diseconomies of scale are an advantage to those firms who do not suffer from them. Nucor Steel had several cost advantages, one of which was the fact that the large integrated mills were experiencing diseconomies of scale in the parts of the market that Nucor served (light structural steel, rebar, etc.). Explain the Relationship between Cost Advantages Due to Learning Curve Economies and a Firm’s Market Share, as well as the Limitations of this Logic Learning Curve Economies • result from people learning a production process so that they get better at the process • result from cumulative experience • do not suffer from diseconomies—costs continue to fall with increasing cumulative experience • typically increase as market share increases—however, market share may be expensive to acquire, potentially offsetting learning curve economies • may be accelerated through international expansion because of larger volumes Slide 4-8 Emphasize that learning curve economies are greater in processes that are more complicated—where learning matters more. One of the Big Three U.S. automakers licensed technology from Robert Bosch, a German company, to produce fuel injectors. The basic terms of the agreement were that Bosch would share new technology within six months of any such new technology being put into production. As a result of this agreement, the U.S. company was always behind Bosch in both quality and price because Bosch was essentially guaranteed a learning curve advantage. Eventually the U.S. company exited the fuel injector business and purchased its fuel injectors from Bosch and/or Nippondenso, a Japanese manufacturer. Differential Low-Cost Access to Productive Inputs • result when firms are able to access inputs at less cost than competitors • are one of the main motivations behind international expansion—low cost labor and raw materials have often been the target of international expansion • usually result from some historical artifact—being the first firm to discover the value of a raw material and being able to lock up the source • are very difficult to achieve if the input is found in competitive markets where the value of the input is known and is subject to any form of bidding Slide 4-9 This is an excellent place to emphasize the importance of the international context. Firms often look to foreign markets for low-cost access to inputs, especially labor. Point out that the standard of living improves in the foreign markets and eventually another country usually develops a low cost advantage. One practice in the carpet business that is indicative of a differential low-cast access to inputs-advantage occurs when a retail flooring chain buys all the output of a mill in a particular style of carpet. The retail chain gets a low price on the carpet and no competitor can sell that particular carpet. Technological Advantages Independent of Scale • arise when a technology allows a firm to produce something at lower cost than competitors who do not possess the technology • fresh vegetable packing operations have traditionally relied on manual inspection of the produce—new technology allows much faster, more reliable, lower cost inspection by passing ultra-violet light through the produce and using pneumatic devices to discard bad produce from the production line • can sometimes be acquired by firms from developing economies by partnering with international partners from developed economies Slide 4-10 Point out that new technology can sometimes cancel scale advantages. Use the vegetable inspection example from above. This technology is in use in the potato packing business. Instead of paying several laborers to inspect potatoes as they pass over a conveyor, processing companies can invest in this technology that greatly reduces cost. While there is certainly economic value in the technology for potato processors, most of the value is being captured by the firm that invented and produces the inspection machinery. Policy Choices • may create cost advantages in two ways: firms may decide to produce low cost, highly standardized products and compete on price, and/or, firms may develop a cost conscious culture in which managers and other employees are given incentives to constantly look for ways to reduce per unit costs (increase efficiency) Slide 4-11 Emphasize the fact that firms are free to make a wide range of policy choices. However, over time firms tend to have less and less freedom in making policy choices because of organizational rigidity. Firms can experience a cost advantage from policy choices either because they were lucky in making good policy choices in the first place or they can remain flexible so that they can make policy choices on an ongoing basis. Southwest Airlines adopted human resource policies that have contributed to their cost advantage (cross functional work practices, hiring practices, incentive systems, etc.) Other large airlines cannot effectively make these policy choices at this point in time because of unions, traditional, psychological contracts, etc. Thus, Southwest’s policy choices are a source of cost advantage.
Teaching Points • Point out that it is important for students to know these sources of cost advantage well, even though you may have covered them quickly—tell students you assume they have read the book carefully. • Emphasize that a good strategic choice is dependent on knowing which firms in a market are likely to have a cost advantage—whether the focal firm or competitors. • Emphasize that international expansion may be used to develop some of these sources of cost advantage. Conversely, international competitors may also possess and/or develop these sources of cost advantage. • Ask students to identify Wal-Mart’s cost advantages. Point out that many of Wal-Mart’s cost advantages were policy choices in the beginning. Now, Wal-Mart enjoys scale advantages. As suggested in the opening case of the chapter, Ryanair is also a good example of a cost leader. COST LEADERSHIP AND COMPETITIVE ADVANTAGE The textbook takes a novel approach in explaining how a cost leadership position may generate competitive advantage. The VRIO model is applied to the cost advantage a firm may have. Recall from Chapter 3 that a resource, in this case the source of a cost advantage, may lead to competitive advantage if it meets the VRIO criteria. The ‘Value’ question is addressed by using the environmental threats model to explain how a cost advantage may generate value for a firm. Thus, the environmental threats model is nested within the VRIO model—very clever indeed. Important Point: Students need to be clear about how the VRIO and the environmental threats models are being used here to analyze the competitive advantage implications of a cost advantage. The logics of these models from earlier chapters are being applied to help determine if a firm is likely to have a sustainable competitive advantage due to a cost advantage. Identify How Cost Leadership Helps Neutralize Each of the Major Threats in an Industry The Value of Cost Leadership Important Point: As you begin this discussion, make sure students understand that this analysis would be used after it has been determined that the focal firm has a cost leadership position stemming from a source of cost advantage as described above. Also, students should understand that if competing firms are found to have cost advantages, the same logic could be applied to them in explaining why the focal firm probably would not be able to generate a competitive advantage based on cost leadership. Environmental Threats Model. The value of a cost advantage can be explained, at least in part, by showing how the cost advantage may help to neutralize threats in the external environment. If a cost advantage helps to neutralize one or more of the threats, then the cost advantage would be considered ‘valuable’ within the VRIO model. Slide 4-12 Make sure students understand that the logic of the VRIO model can be applied to a source of cost advantage. Explain that a source of cost advantage could lead to temporary competitive advantage if it’s valuable and rare, or sustainable advantage if it’s valuable, rare, and costly to imitate. Threat of Entry • a cost advantage presents a barrier to entry because would-be entrants face the investment cost of matching an incumbent’s cost position • incumbents typically face lower opportunity costs because they have made a series of investments over time that are now sunk costs, whereas entrants face relatively higher opportunity costs with a large one-time investment to enter a new business • the threat of entry by international competitors should be taken into account Threat of Rivalry • a cost advantage can be used to manage the threat of rivalry • a recognized cost leader can establish a price in a competitive market and other firms will not rationally go below that price, thus reducing rivalry • an unrecognized cost leader can choose to either: meet the competitive price and enjoy wider margins than competitors without alarming competitors with lower prices, or offer a lower price to gain market share from competitors—this is rational only if the increased market share offsets the lower margins • if a firm chooses to offer lower prices, then it can expect increased rivalry • a lower price strategy gives competitors incentive to focus on lowering costs which may put the focal firm’s cost advantage in jeopardy • thus, the focal firm should carefully analyze the likely responses of competitors Threat of Substitutes • a cost leader’s market offering is more attractive if the price to consumers is less than the price of substitutes • cost leaders are in a position to respond with lower prices, if necessary, to keep their offerings more attractive vis-à-vis substitutes Threat of Suppliers • cost leaders in a market typically have large market share—meaning they will be important customers to the suppliers in the industry • the threat of suppliers will be reduced because of the suppliers’ desire to keep the cost leader as a customer—nobody wants to lose their best customers • cost leaders will be better able to absorb price increases than higher cost competitors, thus the threat of suppliers is greater for higher cost competitors than for the cost leader Threat of Buyers • cost leaders in a market typically have large market share—meaning they will probably be among the largest, most powerful suppliers in an industry • buyers will naturally be more dependent on such supplier firms • a cost leadership position will create a disincentive for buyers to vertically integrate backwards for all the reasons listed in the Threat of Entry section • cost leaders can more easily absorb demands for lower prices or increased service and/or quality from powerful buyers compared to higher cost competitors Slide 4-13 Use this slide to help you make the points listed above. The overall point is that a cost advantage may insulate a firm, to an extent, from industry forces. Teaching Points • Emphasize that a single source of cost advantage may be valuable for multiple reasons (i.e., it neutralizes more than one threat). • Emphasize the importance of signaling a cost advantage. Note that the ability of a cost advantage to neutralize threats often depends on other firms knowing about the cost advantage. • Point out that firms have strong incentives to compete vigorously on cost because of the many sources of value associated with a cost leadership position. Identify the Bases of Cost Leadership that are More Likely to be Rare and Costly to Imitate Rarity of Sources of Cost Advantage The source of a cost advantage will confer competitive advantage only if the source is rare. Remember that we said the starting point in this competitive advantage analysis of a cost advantage is at the point where it has been determined that the focal firm has a cost advantage. Well, by definition, if a firm has a cost advantage it must be relatively rare. The real question then becomes, “How long is it likely to remain rare?” Of course, answering this question is really a matter of assessing the costs of imitation, which will be addressed in the next sub-section. However, it is useful to understand why a source of cost advantage is rare at a given point in time. In most cases, the rareness of a source of cost advantage at a given point in time is dependent on the interaction of two things: 1) the life cycle stage of the industry, and 2) the imitability of the source of the cost advantage. Some sources of cost advantage will be rare in the emerging stages of an industry and then become less rare as the industry matures—some will remain rare. Yet other sources may be rather common in the emerging stage of an industry and become more rare as the industry matures—some will remain common. The Sources of Cost Advantage Economies of Scale: • are less likely to be rare in emerging industries because multiple firms are discovering where the minimum efficient scale is • may become more rare as the industry matures if the minimum efficient scale is discovered to be quite large and if industry demand roughly equals industry capacity—such that an incremental plant at minimum efficient scale would vastly exceed industry demand—this is even more likely as an industry declines Diseconomies of Scale: • are likely to be rare in emerging and mature industries because most firms will not exceed the minimum efficient scale • may become less rare in a declining industry if demand falls sharply leaving most firms with excess capacity—this is not a likely scenario (Remember diseconomies of scale refer to other firms, not the focal firm) Learning Curve Economies: • are likely to be rare in an emerging industry because the first-mover is moving along the learning curve ahead of competitors • are likely to become less rare as the industry matures as competitors also move along the learning curve—as the learning curve flattens the advantage of more cumulative experience lessens Differential Low-Cost Access to Inputs: • may be rare in emerging industries if the inputs themselves are rare, such as mineral deposits or input factor markets that are of limited size, otherwise there is not likely to be differential low-cost access • may arise (and be rare by definition) as the industry matures if a firm is able to tie-up sources of supply by acquiring suppliers or forming exclusivity agreements with suppliers Technology Advantages: • are likely to be rare in emerging industries as the new technologies are developed • usually become less rare over time as duplication occurs or as competitors are able to buy the same technology—some technology can remain rare if the firm is able to protect its proprietary nature, especially software technology as opposed to hardware technology Policy Choices: • valuable policies may be rare in emerging industries as many different firms establish various policies—some firms will adopt policies that prove to be valuable and others will adopt policies that prove to have little, if any, value • some valuable policy choices will remain rare if those policies are 1) difficult to observe and/or understand, or 2) if the adoption of those policies is costly for competitors because of path dependency—other airlines face a large cost disadvantage in attempting to adopt some of Southwest Airlines’ human resource policies Slide 4-14 Make sure students understand that there is no hard and fast rule about the rareness of a cost advantage. These are general patterns—there will be exceptions. For example, it could be that a firm estimates the minimum efficient scale correctly very early in the life cycle of the industry, in which case that firm’s cost advantage would be rare in the emerging stage. Teaching Points • Remind students that external analysis is necessary to help them understand who has a cost advantage and whether or not the advantage is rare. • Emphasize that few firms in a market must hold a cost advantage if it is to be a source of competitive advantage. In other words, a firm must have a cost advantage compared to most, if not all, other firms in a market. • Point out that the rareness of a cost advantage will likely be a fleeting thing—subject to changes as the industry moves through the industry lifecycle. • Some firms will want to make their cost advantage known to competitors to signal a barrier to entry. Other firms will want to keep their cost advantage secret in an effort to preserve its rareness. This can make external analysis difficult. • A firm would want to compete on cost only if it had a cost advantage vis-à-vis its relevant competitors and only if that advantage is rare—and costly to imitate as explained below. Imitability of Sources of Cost Advantage The resource-based view logic introduced in Chapter 3 holds that a firm’s cost advantage will generate competitive advantage only if competitors face a cost disadvantage in attempting to imitate the cost advantage. Understanding the imitability of a source of cost advantage is important from at least two perspectives. First, if the focal firm is found to have a cost advantage, managers would want to know if that advantage is costly for competitors to imitate. Second, if a competitor is found to have a cost advantage, managers of the focal firm would want to know if the focal firm faces a cost disadvantage in imitating the source of cost advantage. Important Point: Any of the sources of cost advantage described in this chapter may be costly to imitate depending on the conditions that gave rise to the advantage in the first place, and on the conditions faced by would-be imitators. Conversely, circumstances could make any of the sources of cost advantage less costly to imitate. Several conditions that give rise to low costs and high costs of imitation are presented below. Keep in mind that each of these conditions could affect more than one of the sources of cost advantage. Low Cost Imitation Conditions Unbalanced Industry Capacity and Demand • when an industry has excess demand, economies of scale advantages are imitated at relatively low cost because competitors have an incentive to expand capacity • when an industry has excess demand, learning curve advantages are less costly to imitate because there is room in the market for several firms to be moving down the learning curve simultaneously (this is observed in the memory chip industry) • when an industry has excess capacity, diseconomies of scale advantages will disappear more rapidly because firms operating beyond the minimum efficient scale will quickly realize their diseconomies and correct them Non-Proprietary Technology • technology cost advantages based on technology that is not owned and tightly controlled by the focal firm will be less costly to imitate, especially if vendors can sell the technology to the focal firm’s competitors Highly Observable Technology • technology advantages based on technology that is highly observable can be imitated at lower cost, even when the technology is proprietary because competitors can more easily see a way around the protection (patents) Transactional Exchange • cost advantages such as differential low cost access to inputs and policy choices that are based on transactional exchanges (purely arm’s length transactions) are easily imitated • Example: The bonus policy of an appliance manufacturer that has a cost advantage because it uses a bonus system with production line employees to reduce defective parts can easily be imitated. Slide 4-15 This slide lists the conditions under which imitation is not likely to be costly. Be sure to explain the notion of transactional exchange (arm’s length, unsophisticated transactions where personal relationships do not matter much). Explain that these conditions can affect one or more of the sources of cost advantage. High Cost Imitation Conditions Balanced Industry Capacity and Demand • economies of scale advantages are more costly to imitate in balanced industries because would-be imitators face a lower net benefit if they add industry capacity (excess capacity will lead to lower overall prices for output, lowering the net benefit of entry)—economies of scale present a barrier to entry • diseconomies of scale may be more difficult to recognize for firms that have expanded beyond the minimum efficient scale, making the advantage for the focal firm more durable Path Dependence (Historical Uniqueness) • cost advantages that developed through a set of unique historical circumstances may be very costly, if not impossible, to imitate • Example: A grain elevator built decades ago along the Columbia River in Washington State provides a cost advantage for its owners. The elevator occupies the only location for miles along the river in which an elevator could be built without incurring tremendous earth-moving expenses. Protected Technology • a technology protected by patent, copyright, trademark, etc. will present a higher cost of imitation than unprotected technologies—although such protection does not guarantee that imitation will not occur Highly Unobservable Technology (Causal Ambiguity) • a cost advantage based on a relatively unobservable technology will present a high cost of imitation to competitors because they will not know what to imitate Relational Exchange (Social Complexity) • cost advantages that stem from socially embedded exchanges are more costly to imitate because competitors face the cost (or impossibility) of recreating socially complex relationships • Example: Suppose the appliance manufacturer in the example above had a corporate culture based on years of experience and life long employees that encouraged low defect rates. Such an advantage would be much more difficult to imitate than an advantage based simply on paying people for lower defect rates. Slide 4-16 Use this slide to explain the conditions that lead to high costs of imitation. Make the point that the focal firm would want there to be high costs of imitation if it currently has a cost advantage. Emphasize that with some effort managers can know, or least make an educated guess, about the costs of imitation of a source of cost advantage. Re-emphasize that only those sources that are difficult to imitate will lead to sustainable competitive advantage. ► Example: Low Cost Advantage of U.S. Catfish Gets Challenged Although catfish was a regional favorite in parts of the Southern U.S., it was generally considered an undesirable ‘trash’ fish by many consumers in the U.S. until the 1980s. Based on the knowledge that catfish are hardy creatures, enterprising farmers began digging ponds on their land to raise catfish in a controlled environment. These farmers soon discovered that catfish could be produced at a considerable cost advantage compared to other species of fish. Consumers had to be convinced that farm-raised catfish was good tasting and healthy. In time, the marketing efforts of catfish producers and processors paid off. By 2000, the catfish market had grown to over $600 million in the U.S. Catfish was widely available in grocery stores and restaurants. It was widely viewed as a low cost alternative to farm-raised trout and salmon. The successful development of the catfish market in the U.S. was a direct result of the cost leadership strategy pursued by producers. Catfish are very efficient at converting low cost feed into body mass, making their cultivation a natural ‘cost leadership’ strategy. The feed used to grow catfish is primarily a by-product of other food manufacturing operations, thus making the feed relatively inexpensive. Furthermore, the cost of the land used in catfish production is typically very low. Labor costs in the rural South further enhanced the cost advantage of raising catfish. In 1994, the U.S. began to normalize trade relations with Vietnam. By 1998, trade barriers that had made the export of catfish to the U.S. unprofitable for Vietnamese producers had been removed. Imports of Vietnamese catfish into the U.S. exploded between 1998 and 2001 from 0.6 million pounds to 17 million pounds. Early on, this imported catfish was sold primarily in ethnic markets to Vietnamese immigrants. However, the low price of Vietnamese catfish soon caught the attention of large U.S. grocers. Vietnamese catfish producers had several important cost advantages over U.S. producers. In fact, the very cost advantages that U.S. catfish producers had over the producers of other farm-raised fish were now advantages enjoyed by Vietnamese producers. Feed was less costly in Vietnam. Labor was a fraction of the U.S. cost. For many Vietnamese farmers there were no land costs associated with catfish production because the farmers simply used nets that floated under their houseboats—they were already living on the Mekong River. U.S. catfish producers quickly became suspicious that Vietnamese producers were ‘dumping’ (selling below cost) catfish in the U.S. market. This was very difficult to prove because it was impossible to get actual production costs because of the industry structure (1000’s of very small producers) and Vietnamese government policy. Production costs in India and Bangladesh were used to impute production costs to Vietnam. Based on these imputed costs, it was determined that the Vietnamese were guilty of dumping. Penalties ranging from about 32% to 65% were imposed on various Vietnamese importers. Vietnamese producers were also prohibited from calling their product catfish. They were forced to use the traditional names of Basa and Tra. (Aguiar, Anh, & Davies, 2005, The Agifish Case: International Trade Dispute and Market Opportunities for Catfish in the Mekong Delta. 15th World Food and Agribusiness Symposium and Forum, Chicago, IL). There is no question that Vietnamese producers have a significant cost advantage over U.S. producers. Capital requirements and labor costs in Vietnam are a small fraction of U.S. costs. Most of these cost differences stem from cultural and lifestyle differences. The standard of living demanded by Vietnamese producers and laborers is vastly different from that demanded by U.S. producers and laborers. The catfish market is a good example of how cost leadership positions may change with new market entrants. In this case, we observe that economies of scale and learning curve cost advantages may become obsolete in the face of competitors who face a different set of constraints. Whereas large U.S. producers benefited from economies of scale and learning curve advantages, extremely small Vietnamese producers quickly learned to produce at much lower costs in a market environment that was fundamentally different from that faced by U.S. producers. Teaching Points • Make sure students understand that analyzing the imitability of cost advantages is important whether the focal firm has a cost advantage or a competing firm has an advantage. • Emphasize that circumstances surrounding a cost advantage may make that advantage costly to imitate or rather easy to imitate—the point being that one cannot conclude that the type of cost advantage is automatically either costly to imitate or easy to imitate. • Encourage students to consider how circumstances may change over time. For example, a very balanced industry may become unbalanced if demand changes rapidly, thus changing the costs of imitation. • Refer to the catfish market example to call attention to the fact that international competition may entail circumstances that can make sources of cost advantage more or less costly to imitate. Also, point out that what U.S. producers saw as dumping was probably a matter of Vietnamese producers being willing to accept much smaller returns than U.S. producers. Implementing Cost Leadership through Organizational Structure and Control Managers intending to pursue a cost leadership strategy must consider several important organizational issues. Recall the experiences of General Lee at Gettysburg during the Civil War. Great strategy without sound implementation is not great strategy at all. The eventual success of a cost leadership strategy depends on the appropriate implementation of that strategy within an organization. Organizational structure refers to how management responsibilities are divided and the reporting relationships among various managers. Organization control refers to the policies a firm adopts to give people incentives to behave in certain ways. These policies are intended to align the interests of employees with the interests of the organization. Structure and control issues must be addressed if a strategy is to be successfully implemented. Slide 4-17 Emphasize the importance of implementation—yet again. Make sure students understand the concepts of organizational structure and control. Organizational Structure. Students will understand the functional structure best if they understand the organizational structure alternatives. Three basic organizational structures are: simple, functional, and multi-divisional. An organization in which one person, or perhaps a small partnership, performs all business functions is using a simple organizational structure. A small family-owned (mom and pop) grocery store is a good example. One or two people handle all the necessary business functions. One or two people can handle the purchasing, merchandising, bookkeeping, financing, marketing, etc. Slide 4-18 Use this slide to introduce students to the three organizational structures. Explain that you are introducing all three at this point so that they have some context throughout the remainder of the course. Slide 4-19 This slide explains the simple structure. Point out that the simple structure is appropriate for very small and simple businesses. Make sure that students understand that most start up firms skip this structure and begin with a functional structure. The functional structure simply means that the organization is structured around the business functions that must take place for the firm to succeed. Suppose the family-owned grocery store has expanded to several stores. Now it makes sense to have one person responsible for purchasing, one person responsible for all the accounting, one person responsible for all the marketing, etc. A manager is assigned responsibility for each business function. This manager reports to the CEO who has overall responsibility for the company. Slides 4-20 and 4-21 Use these slides to explain the functional structure. Discuss implications of the specialization within functions (efficiency). Emphasize the role of the CEO in setting strategy and coordinating the efforts of the various functions. The multi-divisional structure is a replication of the functional structure across two or more divisions. Each division has a manager of each of the functions who report to a division manager who then reports to the CEO of the company. Suppose the family-owned grocery business has grown to the point that it makes sense for the company to have its own warehousing and transportation business. The multi-division structure would be adopted by appointing a division manager for the grocery business and a division manager for the transportation business. Within each division there would be an accounting manager, a purchasing manager, a finance manager, a marketing manager, etc. Slides 4-22 and 4-23 These slides explain the M-Form structure. Explain that moving to an M-Form in the face of a growing, more complex organization is a way to coordinate the management functions of many individuals. Point out that even though the organization may be using the M-Form, at the business level the functional structure is still being used. Explain How Firms Use a Functional Organizational Structure to Implement Business-Level Strategies Like Cost Leadership The functional structure and cost leadership. It should be noted that functional structure is used to implement strategy at the business level in organizations of significant size, whether the overall organization is using a functional or multi-divisional structure. If the organization is using the functional structure (meaning there are no divisions), then the CEO is the only person who has an enterprise-wide perspective. If the organization is using the multi-divisional structure, then within each division the division manager is the only executive with a division- or business-level perspective. This arrangement implies two notable characteristics of the functional structure. First, the CEO or division manager is the only executive tasked with responsibility for the whole enterprise or business. The functional structure is sometimes referred to as the U-form structure, which stands for “unitary” because of the singularity of the CEO’s perspective. Second, the functional heads are able to specialize in their respective functions. The specialization within functions is a large part of what makes this structure attractive to firms pursuing cost leadership strategies. Important Point: The CEO or division manager is responsible for setting strategy and ensuring that the efforts of each functional manager are appropriately aligned to carry out the strategy. Thus, the CEO must balance the benefits of specialization within functions and the benefits of coordination across functions in the pursuit of a cost leadership strategy. The functional structure can be fine-tuned to help achieve low costs by: having the CEO manage the coordination of the functions so that cost reducing activities can be shared across functions allowing decisions to be made by those best able to reduce the cost of a product and/or process—not requiring that all decisions be cleared by the CEO—few layers of reporting relationships allowing functional managers to streamline their respective functions keeping each function narrowly focused—realizing gains from specialization Slide 4-24 Point out that with a cost leadership strategy, the firm needs to be organized so that efficiency and cost reduction are facilitated. By delegating functional authority, the CEO is able to focus on strategic issues and the coordination of the functions. Describe the Formal and Informal Management Controls and Compensation Policies Firms Use to Implement Cost Leadership Strategies Organizational control. Organizational controls can take the form of management controls and compensation policies. Management controls refer to policies governing the way things are done in the organization. These policies may be very formal or they can be very informal. Formal management controls are things like budgeting processes where the cost of a product may be projected and closely tracked to determine if the product is being produced at the budgeted cost. Such a control focuses attention on constantly striving to lower the cost of the product. Another formal management control would be a policy stipulating who can approve expenditures of various amounts. A firm’s credit policies and executive travel policies are also formal management controls. Informal management controls include things like cultural norms and attitudes. The cost conscious behavior of employees who turn off lights when leaving a room and minimize production waste by frequently calibrating machines is indicative of informal management controls. Informal management controls play an important role in re-enforcing more formal management controls aimed at cost reduction. Important Point: Most successful cost leaders have strong cultural norms that focus the attention of employees on achieving low costs. Southwest Airlines and Wal-Mart are two good examples of firms whose cultures encourage employees to constantly pursue low costs. In both of these examples, this attitude toward cost reduction is traceable to the founder of the firm. Herb Kelleher and Sam Walton understood that low cost was critical to the success of their companies—and they made sure that a culture developed in their respective companies that focused on cost reduction. Slide 4-25 Emphasize that organizational controls are policies that are intended to influence, perhaps even constrain, behavior in an organization. The overall idea is to get people to do things in a way that is simultaneously in their own self-interest and in the interests of the organization. Point out that management controls can be formal or informal. Informal controls can be just as powerful as formal controls, sometimes more powerful. Compensation policies. Compensation policies provide a level of organizational control by giving employees incentive to behave in certain ways. Bonuses based on cost reduction are often used to encourage employees to cut costs. These bonuses may be based on individual performance or on group performance. Basing bonuses on group performance gives people the incentive to help others in their group achieve cost reduction goals. Such compensation policies tend to reinforce both formal and informal management control policies. Important Point: Managers must be careful not to provide cost reduction incentives that go so far as to reduce quality or service in a detrimental way. For example, piece rate compensation schemes based solely on quantity may give employees the incentive to reduce quality. Compensation policies should be carefully scrutinized to avoid giving employees undesired incentives. Slide 4-26 Use this slide to explain compensation policies. Pay special attention to the non-monetary rewards, which can have powerful motivating effects. Special parking places, corner offices, types of chairs, etc. can all be important status symbols within organizations. Emphasize the point that compensation policies must be carefully considered so that they do not end up giving incentives that are counterproductive. Also, point out that compensation policies should reinforce other management controls. Slide 4-27 Use this slide to drive home the point that organizational controls can be used to encourage behavior that supports a cost leadership strategy. Emphasize this point by discussing the cases of Wal-Mart and Southwest Airlines with respect to their strong cultures that are traceable to their founders’ vision. Also, point out that these strong cultures are well coordinated with more formal management controls and compensation policies. SUMMARY OF COST LEADERSHIP The main things that you want students to go away from this class session with are: 1) an understanding of the concept of business level strategy • the positioning of a single business, even if the firm is involved in more than one business 2) an understanding of the benefits of a cost leadership strategy • in a competitive market, a cost advantage may be the only way to achieve above normal economic returns • a cost leadership position will allow a firm to enjoy greater margins • a cost leadership position may be a valuable barrier to competitive threats by other firms 3) the six sources of cost advantage • economies of scale • diseconomies of scale • learning curve advantages • differential low cost access to inputs • technology advantages independent of scale • policy choices 4) an understanding of how a cost leadership position allows a firm to respond to the five industry forces 5) an appreciation of the fact that a cost leadership position will lead to competitive advantage only if the cost advantage is rare and costly to imitate 6) an understanding that a cost leadership strategy must be implemented appropriately within the organization 7) a basic understanding of organizational structure and control Slide 4-28 This slide allows you to build a model for the class session. Pause after each mouse click to briefly explain your coverage of that point. Teaching Points • Encourage students to commit the six cost advantages to memory. • Remind students that a cost advantage will be a sustainable competitive advantage only if it meets the VRIO criteria. • Emphasize that you have focused a lot of attention on implementation issues in this discussion. • Remind students that it is important that they understand the concepts of organizational structure and control. • Successful cost leaders implement their business level strategies such that the whole organization is focused on cost consciousness. Drive this point home by referring again to Wal-Mart and Southwest Airlines. It seems that everything they do is part of a systematic effort to reduce cost. Instructor Manual for Strategic Management and Competitive Advantage Concepts and Cases Jay B. Berney, William S. Hesterly 9781292060088, 9781292258041
