Cost leadership

Cost leadership isn’t about slashing your pricing; it’s about eliminating waste, encouraging constant innovation and boosting your margins.

A couple of weeks ago I talked about Michael Porter’s competitive strategies. You might remember that there were three:

1. Niche markets.
2. Cost leadership.
3. Differentiation.

I am constantly coming up with situations where people just don’t understand the cost leadership strategy. People tend to think of it as price competitiveness, which immediately introduces the concept of price wars. Cost leadership can assist people to be price competitive, but it has nothing to do with price competition. It has everything to do with being able to produce a product of similar quality to that of a competitor at a lower cost.

The other day a guy told me how he had finally bought out a competitor that had been a constant pain in the side to his business. When he bought it with the intention of integrating it into his own business he discovered that the competitor was more profitable than his company.

The reason was that it was able to produce the same or similar products more cheaply. It was able to charge the same prices as its competitors, but the margins were better because of the fact that the products cost less to produce.

So, this guy pays a premium for the competitor with the intention of integrating the business into his own.

I suggested to this businessman that perhaps if he had understood the concept of cost leadership and had focused his production around that concept, he might have been more competitive with a greater market share with the result that he may not have had to buy one of his competitors. It suddenly dawned on him that cost leadership was a powerful managerial tool that enables you to get on top of your competitor. Not only do you become more profitable but you are not at a competitive disadvantage.

Another aspect of cost leadership is its compounding effect. It is just like compound interest. Every time you produce something at a cost lower than that of your competitor, it is money in the bank and gradually the financial benefits accumulate – so that years of cost leadership end up with giving you a serious bank account, which enhances your competitive ability.

However, you have to be aware of the pitfalls. Enter the bean counter who calculates the benefits of cost cutting to meet short-term goals. The moment short-term cost cutters come on the scene, a number of bad things happen. The first and most serious is that good people leave and generally go to the opposition. The next thing is that attempts are made to lengthen the productive life of equipment. Once again, this has short-term benefits but damages the longer-term competitiveness of the business. Maintenance and product quality issues start to come into play and more time is spent in addressing these issues than on simply getting the product out the door.

Cost leadership involves the development of systemic processes that eliminate waste, involve the passion of the worker in the enterprise and concentrates on constant improvement. Over time, each little improvement compounds and all of the little improvements in process aggregate to massive competitive advantages.

Cost leadership is built around understanding the value chain and constantly identifying elements within that chain where improvements can be achieved. GE and Motorola went heavily into Six Sigma. The Japanese put more emphasis on staff feedback (it is said by Toyota in Japan that at their Nagoya factory, they receive 500,000 improvement suggestions a year from their employees and act on most of them).

Toyota is a fantastic story of cost leadership. We are constantly hearing about how the Chinese can produce manufactured goods cheaper than most people. Well, the Chinese car manufacturer Denway Motors, which made the ranks of Forbes 2000 in 2004, has now fallen out of that esteemed company. One of the main reasons is that it can’t compete with Toyota because Toyota can produce good cars at a cost lower than its Chinese competitor.

So, there you go, just think about cost leadership and give yourself a mark as to how you are going. It you aren’t travelling well, you might have to spend a lot of money to acquire your competitor. Then, guess what! You might find that the combined entity still has the same cost structure as your old uncompetitive model.

Louis Coutts left law and became a successful entrepreneur. His blog examines the mistakes, follies and strokes of genius that create bigger, better businesses. Click here to find out more.

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