1. Chapter 4
Cost Leadership

2. The Strategic Management Process
External
Analysis
Strategic
Choice
Strategy
Implementation
Competitive
Advantage
Mission
Objectives
Internal
Analysis
Business Level
Strategy
Corporate Level
Strategy
How to Position a
Business
in the Market?
Which Businesses
to Enter?

3. Business Level Strategies
Two Generic Business Level Strategies
Cost Leadership:
• generate economic value by having lower costs
than competitors
Example: Wal-Mart
Product Differentiation:
• generate economic value by offering a product
that customers prefer over competitors’ product
Example: Harley-Davidson

4. Why Cost Leadership Matters
Competitive Market
ATCind
ATCff P D
Above Normal
Economic
Returns Q

5. Ryanair
Ryanair adapted Southwest’s business model to become the lowest-cost, lowest-priced airline in Europe. Its share of the European market has grown as fast as it can gain access to landing spots and add new planes. Ryanair’s CEO found ways to squeeze costs out of Ryanair’s cost structure. They use only one plane to reduce maintenance costs, sell tickets directly to customers, and have eliminated seat assignments and free in-flight meals. They also use smaller airports just outside big cities. In addition, they eliminated blankets, pillows, free sodas and snacks, and even sick bags. They have focused on eliminating all costs associated with differentiation. The flip side is that Ryanair adds to its revenues by having customers spend as much money as possible while on their flights. They offer snacks, meals, and drinks for a fee. Instead of back of the seat LCD screens, they offer a handheld version for rent. They have even given away unsold seats so that they would at least have the revenue from these ancillary activities.

6. Understanding Cost Advantage
Managers need to understand who has
the cost advantage in their market
• it could be the focal firm
• develop a strategy to exploit the advantage
• it could be a competitor
• develop a strategy to either capture the
advantage or compete on some other basis

7. End Segment 1

8. Segment 2
Sources of cost advantage

9. Sources of Cost Advantage
Economies of Scale
• average cost per unit falls as quantity increases
-until the minimum efficient scale is reached
• are a cost advantage because competitors may
not be able to match the scale because of capital
requirements (barrier to entry)
• international expansion may allow a firm to have
enough sales to justify investing in additional
capacity to capture economies of scale

10. 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
• are a risk of international expansion
Example: Nucor Steel

11. The Experience Curve
The “Law of Experience”
The unit cost value added to a standard product declines by a constant % (typically 20-30%) each time cumulative output doubles.
1992
1994
Cost per unit of output (in real $)
1996
1998
2000
2002
2004
Cumulative Output 10

12. Examples of Experience Curves
Japanese clocks & watches,
UK refrigerators,
15K K 30K
1960 Yen
Price Index
75%
70% slope
100K 200K K ,000K
Accumulated unit production Accumulated units
(millions) (millions) 11

13. The Importance of Market Share
If all firms in an industry have the same experience curve, then:
Change in relative costs over time = f (relative market share)
This implies that market share is linked to profitability. This is confirmed by PIMS data:
ROS (%)
over 40
Market Share (%)
BUT: - Association does not imply causation
- Costs of acquiring market share offset the returns to market share 12

14. 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
• international expansion may propel a firm down the
experience curve because of higher volumes
Example: Fuel Injectors

15. Sources of Cost Advantage
Differential Low-Cost Access to Productive Inputs
• may result from:
• history—being in the right place at the right time
• being first into a market—esp. foreign markets
• natural endowment—owning a mineral deposit
• locking up a source—buying all of its output
Example: Quantity Carpet Buys

16. Sources of Cost Advantage
Technology Independent of Scale
• may allow small firms to become cost competitive
• advantage typically accrues to the ‘owner’ of the
technology—may or may not be the ones who actually
use the technology
• size of the advantage depends both on how valuable
and protectable the technology is
Example: Vegetable Inspection

17. 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

18. 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)

19. Value of a Cost Advantage
Entry
Buyers
• increases capital
requirements
for entrants
• lowers incentives
for buyers to
vertically
integrate
Rivalry
Substitutes
• competitors rationally
avoid price competition
Suppliers
• increases
importance of the
focal firm to the
supplier
• limits
attractiveness
of substitutes

20. Rareness of a Cost Advantage
The rareness of a source of cost advantage
depends heavily on the industry life cycle:
Generally…
Emerging
Mature
Economies of Scale
Not Rare
Rare
Diseconomies of Scale
Rare
Rare
Learning Curve Economies
Rare
Not Rare
Differential Input Access
Rare
Rare
Technology
Rare
Not Rare
Policy Choices
Rare
Rare

21. Imitability of Sources of Cost Advantage
Conditions largely determine if a source of cost
advantage will be costly to imitate
Low Cost Conditions
Unbalanced Industry Capacity and Demand
Non-Proprietary Technology
Highly Observable Technology
Transactional Exchange
(A cost advantage can be easily imitated)

22. Imitability of Sources of Cost Advantage
High Cost Conditions
Balanced Industry Capacity and Demand
Path Dependence (Historical Uniqueness)
Protected Technology
Highly Unobservable Technology (Causal Ambiguity)
Relational Exchange (Social Complexity)
(A cost advantage cannot be easily imitated)

23. Implementing a Cost Leadership Strategy
A strategy is only as good as its implementation
Strategy is implemented through organizational
structure and control:
• structure: 1) the division of management
responsibilities, and 2) the establishment of
reporting relationships
• control: policies intended to influence behavior—align
the interests of the individual with the interests of the
organization

24. End Segment 2

25. Segment 3
Organizing cost advantage

26. Organizational Structure
Three Organizational Structures
Simple
Functional
Multi-Divisional

27. Organizational Structure
Simple Structure
Owner / Manager
• Owner/Manager makes all major decisions directly and monitors all activities
• difficult to maintain this structure as the firm grows in size and complexity

28. Organizational Structure
Functional Structure (U-Form: Unitary)
• divides management responsibilities by function
• marketing
• procurement
• HR
• finance
• production
• logistics
• accounting
• R&D
• etc.
• CEO is the only executive with enterprise-wide
perspective
• CEO is responsible for strategy & coordination
of functions

29. Chief Executive Officer
Organizational Structure
Functional Structure
Chief Executive Officer
Finance
Accounting
Human
Resources
Marketing
Production
R&D

30. 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

31. Organizational Structure
Multi-Divisional Structure (M-Form)
Chief Executive Officer
Corporate
Human
Resources
Corporate R&D
Corporate Finance
Strategic Planning
Corporate Marketing
Division
Division
Division
Finance
Production
R&D
Accounting
Human
Resources
Marketing

32. 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

33. Organizational Controls
Policies intended to influence behavior by aligning
the interests of the individual with the interests of
the organization
Management Controls
Formal
Informal
• budgeting policies
• culture
• credit policies
• attitudes
• spending policies
• leadership styles
• travel policies
• purchasing policies

34. Organizational Controls
Compensation Policies
• stock options
• non-monetary awards
• vacations
• bonuses based on:
• parking places
• cost reduction
• office decor
• financial performance
Compensation Policies Should Reinforce
Formal and Informal Management Controls

35. 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

36. Competitive Advantage
Summary
Business Level Strategy
Cost Leadership
Product Differentiation
Cost Advantages
Competitive Advantage
Depends on Meeting
VRIO Criteria
Economies of Scale
Diseconomies of Scale
Emphasis on
Organization
(Implementation)
Learning Curve Economies
Differential Input Access
Technology
Structure &
Control
Policy Choices