Monday, November 8, 2010

Revisiting Basics: Cost Leadership

By Dr. Glenn Rowe

You have a great idea! It is a process innovation that could dramatically reduce the cost of a desired product/service on a per unit basis. But, you find there will probably be a price war when you enter the market. What strategy should you pursue?

You decide to pursue cost leadership because you can do it less expensively than your competitors. You have some differentiation but your focus will be on keeping the per-unit cost below that of your competitors. That low cost will allow you to be competitive on price.

There are several sources of cost leadership. Some are scale related such as volume per specialized machine or plant and equipment. It could be technological hardware such as robotics or policy choices as to what you will produce and sell. All of these are easy for competitors to overcome. A second group of sources of cost leadership may be learning curve economies – these are harder, but still possible, to imitate. A third group consists of access to low cost production factors such as labour, capital, land, and/or raw material while the fourth group consists of management processes, relationships between managers and employees, and/or culture. These last two groups are hardest for competitors to imitate.

How do you assess if you have the resources to support cost leadership?

To assess this you should conduct a thorough analysis of your firm’s value chain. Here are five key questions to start.

1) Can you efficiently control and inventory raw materials?

2) Do you have the operational elements to reduce production costs and to increase the efficiency of layout and work-flow design required to add value to the raw materials going into your product/service.

3) Will your outbound logistics ensure timely/efficient delivery of your service/product?

4) Do you have marketing and sales consistent with cost leadership?

5) Is your customer service appropriate for cost leadership and is it cost effective?

All of these areas need to be supported by an effective procurement system, a supportive HRM system, efficient and appropriate technology and a senior management team that can effectively integrate all activities across the value chain and effectively manage your firm’s cash flow.

The next step is examining the structure, control systems and reward systems needed to support cost leadership. Structurally, consider setting up a reporting structure with only a few layers, create simple reporting relationships, have a small headquarters staff and focus on a narrow range of business functions outsourcing other functions as efficiently as possible. Your control systems should include a cost leadership philosophy, tight cost controls, quantitative cost controls, and close supervision of the costs of labour, raw material, inventory, etc. Compensation needs to be structured to reward for cost reduction and there need to be incentives for all employees to be involved in cost reduction. Compensation may be the hardest thing to do when pursuing cost leadership. As with a differentiation strategy your leadership and preferences should always be top of mind.

For you, is it being a strategic leader, a managerial leader or a visionary leader that will support cost leadership? Ask yourself what type of culture you want to develop. A company like Westjet has created a culture focused on participation and pitching in that supports their cost leadership strategy. Are you the leader to do this? Another key question is: what are the preferences of your stakeholders and investors? How do you best sell your cost leadership strategy to them?

Answering these questions will ensure the effective pursuit of a cost leadership strategy.
*Dr. Glenn Rowe is the Director of the Executive MBA Program at the Richard Ivey School of Business, Canada. He is an Associate Professor of Strategic Management and holds the Paul MacPherson Chair in Strategic Leadership.

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