Don’t Confuse Cost Proximity with Cost Advantage

Having a cost structure which approximates, or achieves parity, with rivals is not a cost advantage. A firm obtains a cost advantage when its cumulative cost of performing its value activities is lower than that of rivals. Furthermore, the cost advantage obtained must be sustainable. That is, how the firm obtains its cost advantage must be resistant to replication by competitors. A transient cost advantage is no advantage at all.

Firms obtain a cost advantage by either controlling its cost drivers better than rivals, or by reconfiguring its value chain in ways that are fundamentally different from the value chains of competitors.

A cost advantage provider usually emphasizes tight cost control monitoring and control, overhead minimization, the pursuit of economies of scale, and use of the learning curve to lower costs. Firms that are able learn how to execute value chain activities in a way superior to the competition can often obtain unit cost advantages of 20 percent or more in some industries.

Value chain configuration to achieve the lowest total costs always involves differences. Cost advantage providers’ value chains are configured with different activities and processes than those of rivals, involve special supply chain or distributor linkages, and emphasize different amounts of vertical integration. It is the configuration of the value chain that gives rise to the cost advantage, not the firm’s ability to source lower cost inputs or willingness to operate with razor-thin margins by matching competitor’s prices.

Firms often fall into the trap of confusing cost advantage with low manufacturing costs. While this is important, it should be recognized that often a great portion of a firm’s costs reside in activities other than production – for example, in sales and marketing, service, product development, etc. When the focus is on manufacturing costs, these other costs get overlooked and the firm fails to see opportunities for value chain reconfiguration that could reduce these other costs.

Pursuing a cost advantage strategy is not easy. Cost advantage providers need a relenting focus on their value chains and the drivers of costs. And, they must avoid falling into the trap of slashing costs to support margins in favour of price matching with competitors.

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