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Stewart Anderson

Six Sigma

Cost Reduction ≠ Cost Advantage

Cost leaders are linked with the supply chain

Published: Wednesday, March 23, 2011 - 16:29

An excellent article by Donald Wheeler on the economic cost of quality, “What Is the Zone of Economic Production?” gave me pause to consider the strategic implications of reducing the costs associated with poor quality. As Wheeler pointed out in his article, there is an economic zone of production in which firms should strive to operate. His insights highlighted the key reason why firms should strive to improve quality and reduce the incidence of scrap and rework: Poor quality consumes resources and increases costs.

Although there can be no dispute about a firm reducing or eliminating the costs associated with poor quality, the question arises whether cost reduction per se can be used by a firm to create a competitive advantage. To answer this question, I draw the distinction between cost reduction and cost advantage.

Competitive advantage is obtained when a firm achieves the highest rates of profitability in its industry. It is industry structure that ultimately determines the profitability of a firm because the forces that shape industry structure are the chief determinants of profitability. These forces include the intensity of competitive rivalry, bargaining power of buyers and sellers, the availability of product substitutes and complements, and the threat of entry and exit. Within a given industry, firms must seek to establish a position that maximizes the profit they can extract within the industry. Profitability is a true measure of competitiveness because lower rates of profitability indicate that a firm is competing some of its profit away to the forces that shape industry structure.

Three paths to competitive advantage

There are essentially three generic strategic pathways a firm can pursue to achieve a competitive advantage: cost advantage (sometimes called “cost leadership”), benefit advantage (sometimes called “benefit leadership”), and focus, which is the application of either a cost-advantage or benefit-advantage strategy within a narrower competitive scope.

Both cost advantage and benefit advantage grow out of a firm’s desire to create value for its customers. Cost advantage is the provision of equivalent benefits to buyers for a lower price than competitors. Benefit advantage is the provision of unique benefits that command a price premium relative to that charged by competitors.

Under a cost-advantage strategy, a firm can build a competitive advantage if it can become the low-cost provider in its industry. Under a cost-advantage strategy, a firm establishes a significantly lower cost structure than competitors and uses that advantage to provide equivalent benefits to customers as competitors, but at lower prices. Because the cost-advantage firm has a lower cost structure, it can price lower, yet achieve margins that equal or exceed those of competitors. If competitors wish to match the low price set by the cost-advantage leader, they must accept lower margins on every sale due to their higher cost structures.

To become the low-cost producer in its industry, a firm must configure its value chain in such a way that dramatically lower costs result. This is different than merely reducing costs through tactical cost-reduction initiatives. In addition, a firm that uniquely configures its value chain to become the lowest-cost producer in its industry renders itself relatively immune to imitation by competitors. Thus, the cost-advantage producer carries out different activities, or carries them out in different way, that cannot be readily imitated by competitors. Therefore, even if a competitor were to pursue radical cost-reduction activities, it could never replicate the low cost structure of the cost-advantage leader.

When viewed through a strategic lens, it is doubtful if cost reductions resulting from quality improvement alone could enable a cost-advantage strategy. This is so for two reasons. First, the cost savings that would result from reductions in scrap, rework, and warranty claims are unlikely to be sufficient in magnitude to approximate the cost structure of a cost-advantage leader. Second, the initiatives that would be undertaken to improve quality could be easily imitated, meaning they would confer no enduring cost advantage.

Another way of looking at this is to look at the demand curve of a typical firm. The demand curve illustrates the law of demand: that the quantity of product demanded by customers in the marketplace is inversely proportional to price.


Figure 1: Demand curve

 

Configuring the value chain to create a cost advantage

In figure 1, Firm A sells its product at price P1, which results in quantity Q1 being demanded by the marketplace. By pursuing a cost-advantage strategy, Firm A then attains a cost leadership position in the industry and as a result is able to translate some of that cost advantage into a lower price and offer price P2 to the marketplace. This lower price results in a higher demand (Q2) for the product from the marketplace.

While a competitive firm can certainly match Firm A’s lower price P2, doing so will harm its profitability because its cost structure is, by definition, higher than the industry cost leader, Firm A. Thus, through its cost advantage, Firm A is able to increase its market position at the expense of competitors and generate higher rates of profitability in the process.

There are two things to note about this example. First, if no firm achieves a position as the industry cost-advantage leader, and there are no other important sources of differentiation between competitors, then the only thing that firms can compete on is price. Second, if all competitors pursue essentially the same pathways to achieving lower costs—but not achieving a cost advantage—then no single firm is likely to emerge as the industry cost leader.

A firm competing with Firm A may be able to move down the demand curve by lowering costs and then passing some of that cost reduction through to customers in the form of lower price. However, it is unlikely that cost-reduction initiatives alone could ever result in such a firm achieving the price point and margin of the cost-advantage leader. As noted above, the cost-advantage leader finds the source of its advantage in the configuration of its value chain, not in the ability to perform activities at the lowest total cost. This differentiated value chain cannot be easily replicated by competitors, and as such provides a barrier to imitation.

Taking costs out of value chains is not the same as configuring value chains to create a cost advantage over rivals. For example, Wal-Mart achieves its cost advantage over rivals through its unique capabilities in supply-chain logistics and inventory management. Competitors cannot easily replicate these capabilities, and no matter how hard they try they cannot achieve the low costs attained by Wal-Mart.

The danger of firms competing through cost reduction is that no single firm becomes a cost-advantage leader, resulting in the homogenization of strategic positions. When the strategic positions of firms competing in an industry converge, with all firms doing the same things in the same way, the only differentiator that is left to attract customers is price. When this situation occurs, the firm that is willing to offer the lowest price, and accept a lower margin as a result, is the one that is likely to capture the business.

The often-overlooked value in quality improvement is not so much in the costs that can be saved, but rather in the additional revenue that can be generated. If a firm can raise quality levels above the prevailing industry norm, and if that improved quality is perceived as valuable by customers, then the firm may capture additional customers and business that it might otherwise have foregone. It should be noted that such quality improvements will attract infra-marginal customers: i.e., customers whom the firm would not otherwise have captured if all else remained the same. Thus, firms that undertake quality improvements can acquire market share at the expense of competitors, with one caveat: Quality improvements can usually be imitated and copied by competitors, leading once again to homogeneity of strategic positions among competing firms.

To summarize, a distinction needs to be made between operating economically and competing economically through low costs. The former can be achieved by addressing the sources of unwanted costs in a business system, while the latter can only be achieved by pursuing a cost-advantage strategy that allows a firm to become the cost leader in its industry.

Discuss

About The Author

Stewart Anderson’s picture

Stewart Anderson

Stewart Anderson is a partner with Anderson Lyall Consulting Group, a Toronto-based consulting and advisory firm that helps firms develop their competitive advantage. Anderson’s background and expertise includes competitive strategy and value chain engineering. He has advised companies in the manufacturing, service, and contract manufacturing industries. Anderson is completing his bachelor of arts in economics and he is a certified trainer in lean manufacturing principles and techniques.