Competition is the basis of the success or failure of firms. It also controls the appropriateness of a firm’s activities that can affect its performance. Firms compete because they are looking for a competitive position in the industry.
To gain a competitive advantage in the industry firms can choose
- differentiation strategy or
- cost leadership strategy.
Firms with a cost leadership approach can easily attract those customers who always prefer to purchase a product that is available at a lower price.
The question is HOW? How cost leadership allows businesses to gain a competitive advantage where the price is a decisive factor. i.e., price-sensitive market. So, what is a cost leadership strategy? Let’s find out in detail!
What is Cost Leadership?
Cost leadership, in the simplest of terms, means creating a competitive advantage by lowering the cost of operations. That said, reducing the operating costs to an extent where you can sell your products at lower prices than your competitors while keeping the profits regular or high.
This strategy is useful when you are competing in a price-driven market. However, it doesn’t necessarily mean that a company following cost leadership has lower prices than its competitors.
Well, reducing operations costs may look easier on paper. But, in reality, it is not that simple. So, how do firms implement a cost leadership strategy effectively? Well, there are several ways to do that, but here are two of the most common methods:
- Achieving the economies of scale with the help of large scale production.
- Bringing innovation in the production process.
How can a firm reduce production cost? Well, the best way to do this is to purchase raw materials at the lowest possible prices. Then, you need labor (ideally, low-cost) that will convert the raw material into a valuable product.
However, keep one thing in mind; the cost of a product is always different from the price of the product. Cost is the total expense incurred by a firm to bring the product to a sellable condition. Price is the amount a customer pays for the product. Unless a firm sells its product(s) at a break-even point, the price of the product is greater than its cost. That is why the cost leadership strategy is different from the price leadership strategy.
Difference Between Cost Leadership vs. Price Leadership
Price leadership and cost leadership are two different marketing strategies, but people often confuse them. For instance, price leadership means a firm is offering its products at lower or lowest prices. However, cost leadership means that a firm is having the advantage of lower operational cost. A company working with cost leadership doesn’t necessarily mean that it has lower product prices too.
Price leadership means a firm is operating at lower or lowest prices for its products. Now, it doesn’t mean that the firm’s production cost is also lower. That said, the firm may be selling its products at extremely lower profit margins. In fact, sometimes firms even sell their products at a loss or break-even point to get maximum market penetration.
For instance, online companies are a perfect example of price leadership strategy. They often operate at lower prices with lower profit margins to get maximum market share. These companies boost their profits by increasing the sale volume. So, they are price leaders rather than cost leaders.
Cost leadership means a company focuses on lowering the production or operation cost. The company may still be selling its product(s) at competitive market prices. i.e., the company has the same prices as its competitors. This means the company is earning huge profits even at a similar market price.
However, cost leadership mostly works in collaboration with price leadership strategy. Cost leadership is a common strategy for firms competing in price-driven markets. That said, a company may also achieve low operation costs and sell its product(s) at lower prices too.
Ways to Achieve Cost Leadership Strategy
Achieving the actual benefits of the cost leadership method is not an easy thing to do. But, it doesn’t mean that it is “impossible.” As mentioned above, a cost leadership strategy focuses on reducing the production or operation costs or creating a competitive advantage.
Now, large-scale production is an effective way to lower the operation cost. There are two basic types of costs:
- Fixed costs (salaries, property taxes, insurance, depreciation, building rents, etc.)
- Variable costs (utility cost, direct labor cost, material costs, etc.)
A firm can reduce its fixed costs easily if the production volume increases. The rent of the building, property tax, or the salaries of managers, supervisors, etc., will remain the same irrespective of the total units produced. Therefore, reducing fixed costs is one great way to reduce the overall production cost.
Apart from that, technological advancements can also help a firm to exploit the scale of production. There are several other cost leadership strategies that can help a firm to achieve the ultimate objective:
Economies of Scale
A highly efficient production process always reduces production costs. Companies can achieve economies of scale by lowering production costs. However, this only possible for large companies that follow a large-scale production method.
A large firm means a business has a strong purchasing power. When a business produces massive quantities of a product, it needs raw material in bulk quantities. Of course, when you purchase bulk quantities of raw material, you get more discounts from the sellers.
Bringing in better and more effective technological methods is also a great cost-cutting measure. A firm’s keenness to adapt to technological innovation can help it to maintain cost leadership advantage in the long run.
Efficient Operating Methods
Efficiency means utilizing the available resources in an optimal way. A company can achieve cost leadership by using its resources efficiently. That said, hiring an efficient and result-oriented workforce, reducing wastage, and automating the processes can reduce the production costs significantly.
Sourcing Raw Materials
Having better access to the raw material helps a cost leader to achieve its ultimate goal. Of course, a supplier also sells the raw material with a profit margin and may increase prices whenever needed. However, if a firm can get access to the raw material directly or reduce its reliance on a third party, it can reduce its operational costs.
A firm can do that by having direct access to the raw material. Or purchasing raw material from multiple suppliers can reduce dependency. This allows the firms to negotiate with the suppliers.
Advantages of Cost Leadership Strategy
Doubtlessly, cost leadership is “full of advantages,” and here are a few of them:
The first and the most mentionable benefit of cost leadership is an increase in profit margins. As the firm is able to reduce the production costs significantly, it allows the firm to maximize profits.
The cost leadership method not only helps companies to maximize their profits, but it is an effective method for market growth. A firm may temporarily or even permanently lowers its prices and ensure maximum market penetration.
Strengthen Business Sustainability
Market fluctuations are a common thing in the business world. However, a cost leader can minimize the effects of a dry market period. As the firm already produces a low-cost product, the intensity of losses will not hurt the firm that much. However, companies with higher production costs will suffer greater losses. Thus, cost leadership also gives sustainability to the firm.
Practical Examples of Cost Leadership
Well, as expected, there are some big names that follow cost leadership strategy, and here are some prime and successful examples of firms “bossing” the market with this method:
The juggernaut of the eCommerce world is the prime example of cost leadership. Here is how Amazon does it:
- Economies of Scale. Although the company has a huge storage facility, it does not work as a brick and mortar store. This reduces overall costs significantly. The warehousing facility and processing capability mean the company can reduce the costs significantly.
- Technology Advancement. Amazon maximizes operational efficiency with the help of advanced networking and computing technology.
- Process Automation. Amazon has successfully automated most of its operational processes, such as delivery scheduling, purchasing process, etc.
One of the leading fast-food chains all over the world, McDonald’s is another excellent example of cost leadership method. Let’s take a look at how McDonald’s is doing it:
- Training. McDonald’s have a special labor division that recruits new people and then train them. This way, the company does not have to hire highly paid experts and thus reduces its overall costs.
- Rapid Food Delivery. The company has optimized the cooking processes. This allows the employees to easily learn those methods, and the learning curve decreases as much as possible.
- Vertical Integration. McDonald’s also own facilities for the production of mixture ingredients used in their products. This ultimately reduces the overall cost.
One of the biggest retailers across the globe, Walmart is a name familiar to everyone. The American giant is also a follower of the cost leadership strategy. Walmart follows these practices of cost leadership strategy:
- Automation and Technology. The use of the latest technologies and process automation helped Walmart to reduce its costs.
- Minimal Human Resource Expenditures. Walmart spends the minimum budget on its human resources that includes low wages.
- Strong Business Relationship with Suppliers. Walmart works closely with leading suppliers in the market.
- Minimum Outsourcing Costs. The company minimized the outsourcing cost because of its fleet of 12000 trailers and 3000 trucks.