Cost Advantage Chapter 3

Objectives To study the framework for analysing the behaviour of cost To study the determinants of cost position To study the ways firm can gain sustainable cost advantage or minimise their cost disadvantage

Framework for analysing the behaviour of cost The behaviour of a firm’s cost can be understood by studying its value chain Each value activity has its own cost structure and the cost’s behaviour is determined by interrelationship and linkages with other activities inside/outside the firm

Value chain for cost analysis Operating costs and assets (fixed and working capital) are to be assigned to each value activity Amount of assets and efficiency of its utilisation will determine the activity’s cost Value chain is split into individual activities in order to study its impact on cost. Three factor are to be taken into consideration Size and growth of cost represented by activity Cost behaviour of activity Competitor differences in performing the activity

Assigning costs and assets Operating Costs are to be assigned to the activities that incur them Assets are to be assigned to activities that employ, control and utilise them the most

Study of the determinants of cost position A firms cost position results from the cost behaviour of its value activities Cost behaviour depends on a number of structural factors that influence cost – which are known as “Cost drivers” A firms cost position depends upon its cost drivers

Cost Drivers There are ten major cost drivers Economies of scale Learning Pattern of capacity utilisation Linkages Interrelationships Integration Timing Discretionary policies Location Institutional factors

Economies of scale It states that an activity operating at full capacity is more efficient at larger scale It arises from the ability to perform activities differently and more efficiently at larger volume Measure of scale is also very important in order to manage costs For some value activities, global scale of operations is important, for others national scale is fine and for some other value activities even regional scale is good

Learning and Spillovers Learning is the accumulation of many small improvements rather than a major breakthrough The cost of a value activity can decline over time due to learning that increases its efficiency Learning can spill over from one firm in an industry to another through mechanisms such as suppliers, consultants, ex-employees and reverse engineering of products Sustainable cost advantage is always due to proprietary learning, so if spillover happens it needs to be seen whether it creates cost advantage for a single firm or reduces cost for the entire industry Learning and scale of operations is also correlated since high scale make learning accumulate rapidly.

Pattern of Capacity Utilisation If high fixed cost is linked to a value activity, its cost is affected by capacity utilisation, since high fixed cost is a penalty in case of underutilisation Capacity utilisation can also be a function of seasonal, cyclical and other demand or supply fluctuations unrelated to competitive position, so pattern of capacity utilisation for an entire cycle is the cost driver Changes in level of capacity utilisation will involve cost of expanding or contracting and thus affect cost behaviour.

Linkages Linkages indicate relationships between two value activities in terms of how the performance of one affect the cost and performance of the other Linkages are of two types 1. Linkages within the value chain 2. Vertical linkages with value chain of suppliers and channels

Interrelationships Interrelationships with other firms help reduce costs Sharing a value activity with a sister concern is a form of interrelationship It can be of two types: Tangible and Intangible Tangible interrelationships occur in case of sharing of physical resources Intangible interrelationships occur in case of sharing knowhow between separate but similar value activities Sharing can also increase scale of operations and affect learning as well

Integration The level of vertical integration in a value activity may influence its costs One needs to study whether integrating all functions within the organisation lowers the cost in comparision to dis-integrating them (outsourcing them).

Timing Being a first mover has its own pros and cons Similarly being a late mover advantage has it own advantages and disadvantages

Discretionary policies independent of other drivers It refers to the policy choices a firm makes and the resulting impact on its cost position Some policy choices that affect cost behaviour are product performance, level of service, delivery time, channels employed, raw material used etc.

Location Geographical location of a value activity can affect its cost Cost of location is affected by cost of labour, management, raw material, energy and other factors like taxes and wage rates

Institutional factors It includes government regulations, tax holidays, tariffs, government subsidy etc that influence cost

Diagnosing Cost drivers Cost drivers determine asset utilisation and operating costs of an value activity It is also possible that cost behaviour of a value activity is a function of two or more cost drivers Thus cost drivers often interact with each other to determine the cost of an value activity

Interaction among cost drivers They are of two forms: Reinforcing : Where cost drivers support each other Good locations may require early timing in sectors like retailing Scale economies are partially determined by discretionary policies of the firm 2. Counteracting : where cost drivers counteract with each other, offsetting each others effects Economies of scale can be affected by institutional policies like unionisation

Cost of Purchased Inputs It consists of two parts Purchased operating inputs Purchased assets The cost of purchased inputs is a function of three factors Their unit cost Their rate of utilisation Their indirect effects on other activities through linkages

Cost dynamics A firm must consider how the absolute and relative cost of value activities will change over time independent of its strategy. This is known as cost dynamics

Sources of Cost dynamics Industry growth Differential scale sensitivity Different learning rates Differential technological change Relative inflation of costs Aging Market adjustments

Cost advantage A firm has a cost advantage if its cumulative cost of performing all value activities is lower than competitor’s costs And its strategic value lies in the sustainability of the cost advantage A firm’s cost position is a function of The composition of its value chain versus competitors Its relative position in terms of cost drivers vis-à-vis the cost drivers of each activity of the competitors.

Gaining Cost advantage There are two major ways of gaining cost advantage Control cost drivers Reconfigure the value chain

Control cost drivers Control scale a. Gain appropriate type of scale b. Set policies to reinforce scale economies c. Exploit the types of scale economies where the firm is favoured d. Emphasize value activities driven by types of scale where the firm has an advantage

Control learning Keep learning proprietary by back ward integration to protect knowhow, control information dissemination, retain key employees, non disclosure provisions in employee contracts Learning from rivals

Controlling effect of capacity utilisation By leveling fluctuations through value chain Reducing throughout fluctuations by using tapered integration

Control linkages Work with suppliers and channels to exploit vertical linkages Exploit cost linkages within the value chain

Controlling Interrelationships Share appropriate activities Transfer know how in managing similar activities

Controlling integration Examine systematically possibilities for integration and de-integration

Controlling timing Exploit first mover and late mover advantage Time the firm’s purchases in the business cycle

Controlling discretionary policies Modify expensive policies that do not contribute to differentiation Invest in technology to skew cost drivers in the firm’s favour Avoid frills

Reconfiguring the value chain can reduce cost By using different production process Through differences in automation By using direct sales instead of indirect sales By using a new raw material By using a new distribution channel By using new promotion medium

Pitfalls of cost leadership Focus on cost of manufacturing activities Overlooking indirect or small activities Undermining differentiation Thinking incrementally