Creating Cost Leadership

Some of the major cost drivers that determine the behavior of costs in the value chain are:

Economies of Scale

Scale economies can arise from the use of more efficient methods of production at higher volumes. Scale economies also arise from the less than proportional increase in overhead cost as production volume increases. Another scale economy results from the capacity to spread the cost of R&D and promotion to over a greater sales volume and create cost leadership. But scale economies do not proceed indefinitely. At some point, diseconomies of scales are likely to arise as size gives rise to complexity and personnel difficulties.

Learning

Costs can fall through effects of learning. People learn how to assemble more quickly, pack more efficiently. The combined effect of economies of scale and learning as cumulative output increases has been termed the ‘experience curve’. This suggests that firms with greater market share will have a cost advantage through the experience curve effect assuming all companies are operating on the same curve.

But a move towards a new technology can lower the experience curve effect for companies that adopt such new technologies, allowing them to leap-frog more traditional firms and thereby gain a cost advantage even though their cumulative output may be lower.

Capacity Utilization

Since fixed costs must be paid whether a plant is manufacturing at full or zero capacity, under utilization incurs costs. The effect of underutilized capacity is to push up the cost per unit for production. Therefore, greater capacity utilization ensures lower per unit cost of production and creating cost leadership.

Linkages

These describe how costs of some activities are affected by the way other activities are performed. For instance, improving quality assurance activities can reduce after sales service costs and create cost leadership. Activities of suppliers and distributors are also linked to the activities of a firm and affect costs of a firm. For instance, introduction of JIT delivery system by a supplier reduces inventory costs of the firm. Distributors can influence a firm’s physical distribution costs through warehouse location decision. To exploit such linkages, the firm may need considerable bargaining power.

Interrelationships

Sharing costs with other business units is a potential cost driver. Sharing the costs of R&D, transportation, marketing and purchasing lowers costs and also helps in creating cost leadership.

Integration

Both integration and de-integration can affect costs. Owning the means of physical distribution rather than using outside contracts could lower costs and create cost leadership. Ownership may allow a producer to avoid suppliers or customers with sizable bargaining power. Ownership also increases control, which may allow greater efficiency of distribution.

Timing

Both first movers and late entrants have opportunities for lowering costs. For first movers, it is usually cheaper to establish a brand name in the minds of customers if there is no competition. They also have prime access to cheap or high quality raw materials and locations. Late entrants to a market have the opportunity to buy the latest technology and avoid high market development costs and thus creating cost leadership. They can also avoid costly mistakes made by the pioneer in building a market for the product.

Policy Decisions

Firms have a wide range of discretionary policy decisions that affect costs. Product width, levels of service, extent of diversification, channel decisions etc. have direct impact on costs and impact cost leadership. Care must be taken not to reduce costs on activities that have a major bearing on customer value.

Locations

The location of plant and warehouses affect costs through different wage, physical distribution and energy costs. Location near customers lowers outbound distributional costs, and location near suppliers reduces inbound distributional costs and create cost leadership.