1. Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-1 Chapter 4

2. Cost Leadership 2 Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-2 MissionObjectives External Analysis Internal Analysis Strategic Choice Strategy Implementation Competitive Advantage The Strategic Management Process Business Level Strategy Corporate Level Strategy How to Position a Business in the Market? Which Businesses to Enter?

3. Cost Leadership 3 Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-3 Business level strategy 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.

4. Cost Leadership 4 Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-4 Business Level Strategies Two Generic Business Level Strategies Cost Leadership: cost leadership strategy is intended to generate competitive advantage by achieving costs that are lower than all competitors Product Differentiation: generate economic value by offering a product that customers prefer over competitors’ product

5. Cost Leadership 5 Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-5 Understanding Cost Advantage Managers need to understand who has the cost advantage in their market it could be the focal firm it could be a competitor develop a strategy to exploit the advantage develop a strategy to either capture the advantage or compete on some other basis

6. Cost Leadership 6 Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-6 SOURCES OF COST ADVANTAGES 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.

7. Cost Leadership 7 Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-7 Sources of Cost Advantage Economies of Scale average cost per unit falls as quantity increases -until the minimum efficient scale is reached fixed overhead costs may be spread over larger volumes of production—lowering per unit cost of production exist because of specialized machines and the specialization of employees

8. Cost Leadership 8 Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-8 Sources of Cost Advantage Diseconomies of Scale are an advantage for those who do not have diseconomies of scale occur when firms become too large and bureaucratic Transportation costs Human factors—overly bureaucratic, de- motivated NUCORNucor 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

9. Cost Leadership 9 Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-9 Sources of Cost Advantage Learning Curve Economies a firm gets more efficient at a process with experience the more complicated/technical the process, the greater the experience advantage Example: Fuel Injectors One of the Big Three U.S. auto makers 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.

10. Cost Leadership 10 Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-10 Sources of Cost Advantage 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

11. Cost Leadership 11 Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-11 Sources of Cost Advantage 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 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.

12. Cost Leadership 12 Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-12 Sources of Cost Advantage Technology Independent of Scale Example: Vegetable Inspection 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. arise when a technology allows a firm to produce something at lower cost than competitors who do not possess the technology size of the advantage depends both on how valuable and protectable the technology is

13. Cost Leadership 13 Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-13 Sources of Cost Advantage Policy Choices firms get to choose how they will serve the market we’ll offer level of quality that is inexpensive to produce firms can make policy choices that give people incentives to reduce cost at every opportunity Example: Southwest Airlines

14. Cost Leadership 14 Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-14 Cost Leadership & Competitive Advantage A source of cost advantage will lead to competitive advantage if that source is: Valuable Rare Costly to Imitate Organized (Implemented Appropriately)

15. Cost Leadership 15 Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-15 Value of a Cost Advantage 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 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 attenuating rivalry if a firm chooses to offer lower prices, then it can expect increased rivalry Threat of Substitutes a cost leader’s market offering is more attractive if the price to consumers is less than the price of substitutes

16. Cost Leadership 16 Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-16 Value of a Cost Advantage 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 Threat of Buyers cost leaders can reduce the threat of buyers. lowers incentives for buyers to vertically integrate because they will often not have costs as low as an incumbent cost leader.

17. Cost Leadership 17 Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-17 Rareness of a Cost Advantage The rareness of a source of cost advantage depends heavily on the industry life cycle: Economies of Scale Diseconomies of Scale Learning Curve Economies Technology Policy Choices Differential Input Access Not RareRare Emerging Mature Rare Not Rare Rare Not Rare Rare Generally…

18. Cost Leadership 18 Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-18 Rareness of a 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

19. Cost Leadership 19 Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-19 Rareness of a Cost Advantage 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 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

20. Cost Leadership 20 Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-20 Rareness of a Cost Advantage 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 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

21. Cost Leadership 21 Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-21 Rareness of a Cost Advantage 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

22. Cost Leadership 22 Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-22 Rareness of a Cost Advantage 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

23. Cost Leadership 23 Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-23 Imitability of Sources of Cost Advantage Conditions largely determine if a source of cost advantage will be costly to imitate Low Cost Conditions 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)

24. Cost Leadership 24 Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-24 Imitability of Sources of Cost Advantage Conditions largely determine if a source of cost advantage will be costly to imitate Low Cost Conditions Transactional Exchange cost advantages such as differential low cost access to inputs and policy choices that are based on transactional exchanges 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.

25. Cost Leadership 25 Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-25 Imitability of Sources of Cost Advantage High Cost Conditions 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

26. Cost Leadership 26 Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-26 Imitability of Sources of Cost Advantage High Cost Conditions Highly Unobservable Technology 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 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.

27. Cost Leadership 27 Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-27 Implementing a Cost Leadership Strategy A strategy is only as good as its implementation Strategy is implemented through organizational structure and control: structure: 1) refers to how management responsibilities are divided and the reporting relationships among various managers. control: refers to the policies a firm adopts to give people incentives to behave in certain ways. Align the interests of the individual with the interests of the organization

28. Cost Leadership 28 Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-28 Organizational Structure Three Organizational Structures Simple Functional Multi-Divisional

29. Cost Leadership 29 Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-29 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. Simple Structure Organizational Structure

30. Cost Leadership 30 Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-30 Organizational Structure Functional Structure (U-Form: Unitary) divides management responsibilities by function marketing finance accounting procurement production R&D HR logistics etc. CEO is the only executive with enterprise-wide perspective CEO is responsible for strategy & coordination of functions

31. Cost Leadership 31 Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-31 ProductionFinanceR&D Accounting Marketing Human Resources Chief Executive Officer Functional Structure Organizational Structure

32. Cost Leadership 32 Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-32 Organizational Structure Multi-Divisional Structure (M-Form) functions are replicated in each division as appropriate this structure makes sense when the firm is involved in more than one business or has grown large enough to justify geographic divisions CEO has strategic responsibility with the help of vice presidents, etc.—information is filtered through layers CEO balances coordination & competition among divisions

33. Cost Leadership 33 Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-33 Organizational Structure Multi-Divisional Structure (M-Form) Strategic Planning Corporate Finance Corporate R&D Corporate Marketing Production Finance R&D Accounting Human Resources Division Marketing Chief Executive Officer Corporate Human Resources

34. Cost Leadership 34 Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-34 Organizational Structure The Functional Structure and Cost Leadership specialization within functions facilitates cost reduction CEO can use this structure to: ensure best cost reduction practices are shared among divisions allow and encourage decision-making by those who are in the best positions to do so—those close to decisions ensure that functions are coordinating efforts in pursuit of a common strategy

35. Cost Leadership 35 Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-35 Organizational Controls Policies intended to influence behavior by aligning the interests of the individual with the interests of the organization Management Controls FormalInformal culture budgeting policies credit policies spending policies travel policies purchasing policies attitudes leadership styles

36. Cost Leadership 36 Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-36 Organizational Controls Compensation Policies stock options bonuses based on: cost reduction financial performance non-monetary awards vacations parking places Compensation Policies Should Reinforce Formal and Informal Management Controls office decor

37. Cost Leadership 37 Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-37 Organizational Controls Organizational Controls and Cost Leadership management controls and compensation policies can be focused on cost reduction supply contracts that stipulate cost reductions over time tight credit policies austere travel policies (e.g., no first class) bonuses tied to cost reduction targets Example: Wal-Mart & Southwest Airlines

38. Cost Leadership 38 Cost Leadership Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall. 4-38 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. Copyright ©2012 Pearson Education, Inc. publishing as Prentice Hall