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Ritu heads an organization that’s been a market leader in food processing and products for several years in Pune. Ritu’s aim is to achieve the same status in the neighboring cities of Mumbai and Nagpur. Initially, Ritu comes up with a strategy of introducing new products, such as gourmet chocolates and new flavors of cup noodles and ice cream to appeal to newer customers. The first two sales quarters show that Ritu’s strategy has failed.
On the advice of her marketing manager, Ritu decides to discontinue the new products and focus on reducing the costs of the products that were popular in Pune across the production lines of the organization.
In other words, Ritu follows a cost leadership strategy, which makes her products more feasible for customers with less purchasing power. Ritu’s brand starts raking in profits across all three cities in subsequent quarters.
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Meaning Of Cost Leadership Strategy
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Difference Between Cost Leadership And Price Leadership
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Focused Cost Leadership
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How To Execute A Cost Leadership Strategy
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Cost Leadership Strategy Advantages And Disadvantages
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Becoming A Competent Cost Leader
Meaning Of Cost Leadership Strategy
Cost leadership is a form of business strategy, believed to have been designed by American academic Michael Porter, that establishes a competitive advantage for an organization by helping it achieve the lowest cost of operation in its industry. As part of a cost leadership strategy or low-cost leadership, an organization usually becomes the cheapest manufacturer or provider of a particular product that has more than one supplier.
A cost leadership strategy is lucrative in terms of gaining market share and drawing consumers, but it isn’t easy to implement. This is because it requires the management to constantly work on minimizing costs at every level. An example of an organization that has successfully engaged in low-cost leadership for a long time is the American retail chain Walmart.
Difference Between Cost Leadership And Price Leadership
Before proceeding to observe how exactly a cost leadership strategy functions, along with cost leadership strategy advantages and disadvantages, it’s vital to differentiate cost leadership and price leadership, two terms often used interchangeably.
Price leadership means that an organization offers the lowest-priced products or services, as opposed to overall cost leadership, where an organization is the lowest cost producer in an industry. Price is the final amount that a consumer pays for a product or a service, while cost is the expense an organization incurs on producing a product or service. In this sense, the two are different concepts.
Because of the close relationship between price and cost, which is generally directly proportional—higher costs mean higher prices—organizations that secure price leadership frequently establish low-cost leadership as well. Whenever an organization is aiming for cost leadership, it’s in their interest to look at reducing prices as that’s likely to pull in more buyers and increase profit margins.
However, there remain exceptional cases where organizations are so desperate to achieve price leadership that they end up reducing prices by big enough margins for their profits to take a hit.
Focused Cost Leadership
Focused cost leadership is a component of overall cost leadership where the cost leadership strategy is based on reducing prices to target a narrow market. This doesn’t mean that an organization following focused cost leadership charges the lowest prices in the industry. It means that focused cost leadership allows an organization to charge low prices relative to other organizations competing within the target market. The target market may be defined by any number of metrics, such as demographics, purchasing power or geographical location.
For example, Reebok sneakers aren’t the cheapest sneakers around. But when it comes to customers looking to purchase sneakers from the biggest and most reputable brands, Reebok would be a cheaper option than Adidas, Nike, Puma or New Balance. So, Reebok is able to achieve focused cost leadership within a narrow target market of consumers looking for sneakers from elite brands.
How To Execute A Cost Leadership Strategy
To nail overall cost leadership, organizations can take a variety of approaches. The most common and crucial ones are explained below:
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A Larger Production Scale
Scaling refers to the process by which an organization reduces costs by increasing the volume of materials produced. Scaling production can help secure larger orders of raw materials and supplies, which can, in turn, reduce the costs of the products. This also gives an organization greater sway over suppliers since the organization’s orders form a larger part of the supplier’s business operations. Organizations that scale well tend to gain more negotiating power, greater durability against competitors and enhanced flexibility in pricing.
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Sourcing Raw Materials
Purchasing raw materials for manufacturing can be expensive as suppliers will naturally mark up their prices to make a profit. To solve this, organizations can look to source their own raw materials and reduce their dependence on third-party suppliers. Moreover, if an organization can source its own raw materials such that they exceed the organization’s needs, the surplus can also be sold to other organizations to bolster revenues.
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Increasing Efficiency
Perhaps the most frequent way to assume cost leadership is to boost the efficiency of production at an organization. The simplest way to do so is to reduce the number of employees and ensure that each employee is performing at their optimal level. But, a less harsh route is also available. Revamping the working hours and using better equipment, wherever applicable, can also have a major impact on manufacturing times, which is bound to positively affect efficiency.
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Getting Hold Of Advanced Technology
In the history of low-cost leadership, the entry of advanced technology has been a game-changer more often than any other factor. Creating or investing in the latest technology can allow organizations to reduce their costs across departments and move beyond the reach of their competitors. By patenting a technology, organizations can prevent competitors from accessing the same technology. Later on, an organization can sell its patented technology to generate additional revenue. Sometimes, it may not be possible for an organization to build new technology from scratch. In such scenarios, using already existing technologies may also go a long way in realizing an organization’s aim of cost leadership.
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Limiting Products And Services
If an organization is in the business of offering a series of products and services, a useful way of cutting costs may be to eliminate some of the offerings and focus on the most profitable products and services. During periods of growth, organizations can branch out into sectors they don’t need to, manufacturing goods that their customers don’t want from them. Limiting these tendencies or getting rid of them in leaner times can be a smart low-cost leadership strategy.
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Monitoring The Market
As with any industry that’s competitive, an organization has to watch the space it is in before it can meaningfully craft a plan of action. The same holds true for a cost leadership strategy. Monitoring the market, which means tracking the actions of competitors and identifying trends or ways of cutting costs, is not immediately rewarding. In the long run, though, it often proves to be the most effective.
Cost Leadership Strategy Advantages And Disadvantages
Below is a list of cost leadership strategy advantages and disadvantages that all organizations must be aware of before proceeding with their cost-cutting endeavors.
Advantages Of A Cost Leadership Strategy
- Cost leaders can charge the lowest amount for a product while retaining profits
- Cost leaders can compel other organizations to sell their products at a substantial loss simply to remain competitive
- Cost leaders tend to perform better during recessions than competitors as they’re already experienced in standing out to customers with a limited budget
- Low operational costs allow cost leaders more wiggle room for achieving sales goals
- Cost leaders enjoy the privilege of greater flexibility when it comes to supply and pricing
Disadvantages Of A Cost Leadership Strategy
- Low costs can often overshadow the quality of products or services provided by an organization
- Cost leaders may find it difficult to break into high-end markets
- Brand appeal of cost leaders rarely undergoes a surge simply on account of low costs
- A cost leader may provoke another more resourceful competitor to reduce costs and/or prices, creating a repetitive cycle where the lowest cost-setter wins
Becoming A Competent Cost Leader
Cost leadership is among the most challenging of business strategies for any organization, especially if there are multiple competitors in the industry. Harappa’s Creating Solutions course is designed to help navigate these challenges and show you how to master the concept of overall cost leadership. Through this course, you’ll be able to interact with a world-class faculty, analyze costing problems, explore perspectives relating to costs and familiarize yourself with cost leadership strategy advantages and disadvantages in the short and long terms. Advanced frameworks and techniques such as the Multiple Whys and the Synthesis Technique will enable you to attain greater practical clarity in terms of implementing cost leadership successfully and sustainably.
So, what are you waiting for? Sign up for Harappa’s Creating Solutions course right away and help your organization become a competent cost leader.
Explore Harappa Diaries to learn more about topics such as Types Of Leadership Theories, Steps Of Strategy Formulation, Role of Cause And Effect Relationship in Problem Solving and Steps for writing a Problem Statement to classify problems and solve them efficiently.
