1. Cost Advantage
Chapter 3

2. Objectives To study the framework for analysing the behaviour of cost
To study the determinants of cost position
To study the ways firm can gain sustainable cost advantage or minimise their cost disadvantage

3. Framework for analysing the behaviour of cost
The behaviour of a firm’s cost can be understood by studying its value chain
Each value activity has its own cost structure and the cost’s behaviour is determined by interrelationship and linkages with other activities inside/outside the firm

4. Value chain for cost analysis
Operating costs and assets (fixed and working capital) are to be assigned to each value activity
Amount of assets and efficiency of its utilisation will determine the activity’s cost
Value chain is split into individual activities in order to study its impact on cost. Three factor are to be taken into consideration
Size and growth of cost represented by activity
Cost behaviour of activity
Competitor differences in performing the activity

5. Assigning costs and assets
Operating Costs are to be assigned to the activities that incur them
Assets are to be assigned to activities that employ, control and utilise them the most

6. Study of the determinants of cost position
A firms cost position results from the cost behaviour of its value activities
Cost behaviour depends on a number of structural factors that influence cost – which are known as “Cost drivers”
A firms cost position depends upon its cost drivers

7. Cost Drivers There are ten major cost drivers Economies of scale
Learning
Pattern of capacity utilisation
Linkages
Interrelationships
Integration
Timing
Discretionary policies
Location
Institutional factors

8. Economies of scale
It states that an activity operating at full capacity is more efficient at larger scale
It arises from the ability to perform activities differently and more efficiently at larger volume
Measure of scale is also very important in order to manage costs
For some value activities, global scale of operations is important, for others national scale is fine and for some other value activities even regional scale is good

9. Learning and Spillovers
Learning is the accumulation of many small improvements rather than a major breakthrough
The cost of a value activity can decline over time due to learning that increases its efficiency
Learning can spill over from one firm in an industry to another through mechanisms such as suppliers, consultants, ex-employees and reverse engineering of products
Sustainable cost advantage is always due to proprietary learning, so if spillover happens it needs to be seen whether it creates cost advantage for a single firm or reduces cost for the entire industry
Learning and scale of operations is also correlated since high scale make learning accumulate rapidly.

10. Pattern of Capacity Utilisation
If high fixed cost is linked to a value activity, its cost is affected by capacity utilisation, since high fixed cost is a penalty in case of underutilisation
Capacity utilisation can also be a function of seasonal, cyclical and other demand or supply fluctuations unrelated to competitive position, so pattern of capacity utilisation for an entire cycle is the cost driver
Changes in level of capacity utilisation will involve cost of expanding or contracting and thus affect cost behaviour.

11. Linkages
Linkages indicate relationships between two value activities in terms of how the performance of one affect the cost and performance of the other
Linkages are of two types
1. Linkages within the value chain
2. Vertical linkages with value chain of suppliers and channels

12. Interrelationships
Interrelationships with other firms help reduce costs
Sharing a value activity with a sister concern is a form of interrelationship
It can be of two types: Tangible and Intangible
Tangible interrelationships occur in case of sharing of physical resources
Intangible interrelationships occur in case of sharing knowhow between separate but similar value activities
Sharing can also increase scale of operations and affect learning as well

13. Integration
The level of vertical integration in a value activity may influence its costs
One needs to study whether integrating all functions within the organisation lowers the cost in comparision to dis-integrating them (outsourcing them).

14. Timing Being a first mover has its own pros and cons
Similarly being a late mover advantage has it own advantages and disadvantages

15. Discretionary policies independent of other drivers
It refers to the policy choices a firm makes and the resulting impact on its cost position
Some policy choices that affect cost behaviour are product performance, level of service, delivery time, channels employed, raw material used etc.

16. Location Geographical location of a value activity can affect its cost
Cost of location is affected by cost of labour, management, raw material, energy and other factors like taxes and wage rates

17. Institutional factors
It includes government regulations, tax holidays, tariffs, government subsidy etc that influence cost

18. Diagnosing Cost drivers
Cost drivers determine asset utilisation and operating costs of an value activity
It is also possible that cost behaviour of a value activity is a function of two or more cost drivers
Thus cost drivers often interact with each other to determine the cost of an value activity

19. Interaction among cost drivers
They are of two forms:
Reinforcing : Where cost drivers support each other
Good locations may require early timing in sectors like retailing
Scale economies are partially determined by discretionary policies of the firm
2. Counteracting : where cost drivers counteract with each other, offsetting each others effects
Economies of scale can be affected by institutional policies like unionisation

20. Cost of Purchased Inputs
It consists of two parts
Purchased operating inputs
Purchased assets
The cost of purchased inputs is a function of three factors
Their unit cost
Their rate of utilisation
Their indirect effects on other activities through linkages

21. Cost dynamics
A firm must consider how the absolute and relative cost of value activities will change over time independent of its strategy. This is known as cost dynamics

22. Sources of Cost dynamics
Industry growth
Differential scale sensitivity
Different learning rates
Differential technological change
Relative inflation of costs
Aging
Market adjustments

23. Cost advantage
A firm has a cost advantage if its cumulative cost of performing all value activities is lower than competitor’s costs
And its strategic value lies in the sustainability of the cost advantage
A firm’s cost position is a function of
The composition of its value chain versus competitors
Its relative position in terms of cost drivers vis-à-vis the cost drivers of each activity of the competitors.

24. Gaining Cost advantage
There are two major ways of gaining cost advantage
Control cost drivers
Reconfigure the value chain

25. Control cost drivers Control scale a. Gain appropriate type of scale
b. Set policies to reinforce scale economies
c. Exploit the types of scale economies where the firm is favoured
d. Emphasize value activities driven by types of scale where the firm has an advantage

26. Control learning
Keep learning proprietary by back ward integration to protect knowhow, control information dissemination, retain key employees, non disclosure provisions in employee contracts
Learning from rivals

27. Controlling effect of capacity utilisation
By leveling fluctuations through value chain
Reducing throughout fluctuations by using
tapered integration

28. Control linkages
Work with suppliers and channels to exploit vertical linkages
Exploit cost linkages within the value chain

29. Controlling Interrelationships
Share appropriate activities
Transfer know how in managing similar activities

30. Controlling integration
Examine systematically possibilities for integration and de-integration

31. Controlling timing Exploit first mover and late mover advantage
Time the firm’s purchases in the business cycle

32. Controlling discretionary policies
Modify expensive policies that do not contribute to differentiation
Invest in technology to skew cost drivers in the firm’s favour
Avoid frills

33. Reconfiguring the value chain can reduce cost
By using different production process
Through differences in automation
By using direct sales instead of indirect sales
By using a new raw material
By using a new distribution channel
By using new promotion medium

34. Pitfalls of cost leadership
Focus on cost of manufacturing activities
Overlooking indirect or small activities
Undermining differentiation
Thinking incrementally