Value Chain -Cost Advantage

 

Last month I introduced the concept of the value chain. I emphasized that a successful value chain can provide a competitive advantage by creating either cost advantage or a differentiation advantage.

Today’s post focuses on the importance of creating a cost advantage.

At the outset let me say that creating a cost advantage is not merely about charging lower prices than the competition. Any price reduction is likely to be matched by others in the industry, and unless a business has a real lower cost position then lowering prices has merely created a benefit for the consumers but lower profits for the industry. Consequently, it makes little sense to lower prices unless the competition is unable to match the reduction or will be unable to match the lower price for a long period. However assessing the competitors’ value chain is definitely not a trivial matter, and I will address it in a future post.

A firm’s cost position derives from the activities that the firm performs to provide value for its customers. Provide these activities more efficiently and you have a cost advantage. For most businesses that I’m familiar with, few have a cost advantage. They all have similar activities; they purchase the same raw materials from the same suppliers at the same price and have similar staff paid at the same rate. We do not see a real cost advantage.

However, a cost advantage may be secured through making different choices. A business may choose who it wants to sell to, how it wants to market its products or services, what products or services it wants to provide and which it does not.

For example, my own firm provides advisory services as opposed to compliance services. We service business owners that need assistance with their business. We do not provide tax services or bookkeeping although we collaborate on behalf of our clients with those that do. Similarly, Wal Mart targets customers who have a hard time making their paycheck last. This is not the clientele that patronizes high end department stores.

Choices don’t need to focus only on customers. Choices may be made as to the process in creating a product or to what extent to automate a process. A choice may be made between direct and indirect sales and the advertising media used. These choices create an individual value chain with specific costs.

Other choices may involve which product features to include or do without. A choice concerning the level of service one wants to provide will impact on the level of costs. It could be a decision concerning delivery or the level of wages to pay.

A cost advantage is also obtained by performing activities more efficiently than others. However, anyone with a cost advantage will soon have imitators, so a sustainable cost advantage can only be maintained if it cannot be imitated by others.

Some of the strengths possessed by incumbents that may deter new entrants from attempting to dislodge an existing low cost provider include:

  • Economies of scale- The incumbent has a scale advantage that is not easily replicable.
  • Learning- The incumbent possesses proprietary knowledge or rights not widely available, and/or a strong business intelligence capability.
  • Integration- The incumbent has high vertical integration and thus lower costs than a competitor that must use outside vendors, manufacturers and salespeople.
  • Discretionary policies- It may be a choice of location of the manufacturing facilities.

 

To determine whether one has a real cost advantage that can be sustained a proper analysis of the drivers and their impact on costs is necessary. The analysis will determine one’s cost position and that of its competitors.