COST STRATEGY TO GAIN COMPETITIVE ADVANTAGE
WHAT IS COST STRATEGY ? HOW TO GAIN COMPETITIVE
ADVANTAGE THROUGH COST STRATEGY ?
Cost analysis occupies an important place
in business strategy. In order to gain and sustain competitive advantage, a
firm should not only monitor its cost performance but also should endeavour to
control it. Several strategic decisions like fixation of competitive prices,
provision of after-sale services, quality of the products etc. depend upon
relative cost level of the business firm. The role of cost in different market
conditions is to be examined. The Experience Curve analysis is also important
to derive the cost strategy of a firm. Michael Porter in his book Competitive
Advantage suggested three generic competitive strategies aiming
to develop a dependable position in the long-run and out-perform the
competitors. These three strategies are:
1.
Cost Leadership,
2.
Differentiation,
3. Focus.
All the three strategies can either be used
individually or in combination to each other. Figure-1 shows a matrix of
the three generic competitive strategies and their interrelationship given by
Porter.
Figure-1 : Three Generic Competitive
Strategies
ROLE OF COST IN BUSINESS GROWTH
You have noted that costs play an important
role in the survival and growth of a business firm. For survival, a business
firm must make some profit so that it can sustain its operations on a long-term
basis and fulfil its other obligations. Before a business starts operating, it
has to incur certain initial costs for acquiring assets, such as land,
building, plant and equipment. These assets have to be installed and
commissioned. Then the raw materials are paid for and fed into the machines so that
the finished goods can be produced. These are then sold in the market to
generate revenue. A part of this revenue is used for repaying instalments
towards loans and other borrowings. The shareholders also expect certain
returns in the form of dividends on the equity held by them. Hopefully, after
meeting such expenses, the firm is left with some revenue to buy the raw
materials and other needed utilities so that it can run the next operating
cycle of the business process. The survival and growth of the business firm, to
a large extent, depends on what the firm pays for its fixed costs and what
contribution it generates after meeting all the expenses.
Apportioning of the fixed costs incurred by
the firm in starting a business depends on the volume of its operations. A
lower volume of products puts a heavy burden on each unit produced. A larger
volume of operations reduces the cost per unit. The total variable cost,
which varies with the volume produced, may also reduce, as a consequence of the
ExperienceCurve Effect.
CHANGING ROLE OF COST IN DIFFERENT MARKET
CONDITIONS
Cost is an important aspect of running any
business operation. It is a major level for running the business activities,
and has its influence on the progress of an organization. Acceleration,
stagnation or deceleration in progress are affected by it.
Cost in Sellers’ Market
While the markets are operating as sellers’
markets, the cost may not be considered so critical in determining the profits
of a running organization. Under sellers’ market conditions, price is fixed on
cost plus basis. So whatever is the internal cost, the desired profit margin is
added to it by the business firm, and the price is derived accordingly.
Thus, Price of a Product = Internal Cost +
Desired Profit Margin.
Here, the price of the product is the
derived variable, and the cost is an independent variable. The customer in the
market is forced to pay the price so derived by the sellers. If the cost moves
up, due to certain unavoidable factors like scarcity of raw material, labour
problems or additional taxation, the manufacturer/seller merely takes the
boosted cost figures, adds his/her desirable profit margin and sells the goods
at the enhanced price. In the sellers’ market conditions (say due to shortage
in emergency conditions or man-made), the customer has no choice but to buy
goods at the new prices. Under these conditions, the seller is not much worried
about the costs or their upward movements, as he can pass on these additional
burdens to the customers.
Cost in Buyers’ Markets
On the other hand, as the number of
suppliers grow due to conspicuous profits in sellers’ markets, the competition
from the internal (or external) sources may increase. A surplus supply of goods
in the market may be created, if the demand does not move at the corresponding
rate. In such conditions the buyers get a choice to pick and choose from. The
markets are thus governed by the buyers and the way their preferences change.
Under these competitive conditions, the manufacturer or supplier is no more
free to choose whatever price s/he wishes. The equilibrium equation changes to:
Profit Margin = Permissible Price –
Internal Cost
Or
Tolerable Cost = Permissible Price –
Acceptable Profit
Under the new conditions, the price of a
product is decided outside the organization in the market place and, not
according to the wishes of the manufacturer or supplier. The price becomes an
independent variable decided by the competition in the market place. Each
competitor, in general, may choose a different level of acceptable profit for
himself or fix the price matching with the market requirements. As the
competitors become more and more active there will be a downward push on these
permissible profits, unless the firm activates itself for effective cost
reduction. Thus, unlike in the sellers’ market conditions, now the cost or
profit margin becomes the derived variable. If the firm can’t do much about the
cost of manufacture or supply, then the profit margin also gets fixed by the
market forces, and the firm has to decide whether it can survive at the
prescribed level.
The other alternative for the organization
is to fix a minimum acceptable profit (or contribution), and then determine its
tolerable level of cost. The next step is to do a careful introspection and see
what are the different variables getting into the cost of goods, and find ways
and means to reduce the cost so as to improve its profitability. One way of
doing this is to make use of the Experience Curve, and the other way is to carefully
consider its break-even point and operate well above this level.
ROLE OF COST IN BUSINESS GROWTH
You have noted that costs play an important
role in the survival and growth of a business firm. For survival, a business
firm must make some profit so that it can sustain its operations on a long-term
basis and fulfil its other obligations.
Before a business starts operating, it has
to incur certain initial costs for acquiring assets, such as land, building,
plant and equipment. These assets have to be installed and commissioned. Then
the raw materials are paid for and fed into the machines so that the finished
goods can be produced. These are then sold in the market to generate revenue. A
part of this revenue is used for repaying instalments towards loans and other
borrowings. The shareholders also expect certain returns in the form of dividends on the equity held by them.
Hopefully, after meeting such expenses, the
firm is left with some revenue to buy the raw materials and other needed
utilities so that it can run the next operating cycle of the business process.
The survival and growth of the business firm, to a large extent, depends on
what the firm pays for its fixed costs and what contribution it generates after
meeting all the expenses.
Apportioning of the fixed costs incurred by
the firm in starting a business depends on the volume of its operations. A
lower volume of products puts a heavy burden on each unit produced. A larger
volume of operations reduces the cost per unit. The total variable cost,
which varies with the volume produced, may also reduce, as a consequence of the Experience Curve Effect.
Porter has defined business level strategy
as competitive strategy and classified it into three basic strategies :
1.
Cost Leadership,
2.
Differentiation,
3.
Focus
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