The importance of management in securing cost leadership through production cost relationships

Managerial Economics

Whether it is important for a company to achieve cost leadership is dependent on the generic strategy that the company has chosen to pursue. The two basic forms of generic strategy are differentiated and cost leadership. Companies pursuing a differentiated strategy do not need to pursue cost leadership. They seek to maximize profits by building brand power to the point where they can charge premium prices for their goods. Thus, the strategy is fundamentally different from cost leadership, and is perfectly valid. Many firms have successfully pursued a differentiated strategy, and indeed, the differentiated strategy is a hallmark of firms in monopolistic competition. Each seeks to achieve a measure of differentiation that will attract customers. There are many different ways to achieve this differentiation, and cost leadership is just one among them.

For firms that wish to pursue cost leadership as a means of winning market share in a state of monopolistic competition, attaining cost leadership is critical. In most industries, it can reasonably be expected that multiple firms will pursue a cost leadership strategy, and the bulk of the success will go to the firm that is able to achieve this strategy successfully. The cost leader must be just that -- the firm that offers the lowest cost product or service to the customer. In order for that to happen, the cost leader must adopt this strategy in all aspects of the business.

The cost that a firm can profitably charge for a good or service is directly related to the cost of producing that good or service and bringing it to market. Thus, for a firm to succeed with a cost leadership strategy, it must be able to get that product or service to market for less than what it costs competitors to do the same. This is the essential nature of the production-cost relationship; that the cost a firm can charge is dependent on the production cost. The only constraint is that the good or service should have a baseline level of customer satisfaction. This can be lower than the satisfaction level for other competing firms, as long it is sufficiently high to allow the firm to continue to attract business.

Firms can lower their production costs in a number of different ways. These include utilizing cheaper inputs, using less labor, lowering overhead costs and minimizing the costs associated with distribution and financing. Wal-Mart is a leader in minimizing distribution costs with its cross-docking techniques and sophisticated inventory tracking systems. Costco is a leader in reducing its financing costs because it is able to turn goods over so fast that it sells most goods before it needs to pay its suppliers for them. This leaves the firm with almost no inventory on hand. Both of these retailers are cost leaders because they have taken approaches such as this to minimize the costs associated with all aspects of bringing goods to market.

Thus, management can bring a firm to cost leadership status through a better understanding of the production-cost relationship. This relationship for a cost leader is going to be very strong, especially in an environment characterized by intense competition among multiple players seeking a cost leadership strategy. As such, the closer the firm pays to minimizing all elements of the production cost, the more likely that firm is to be able to assume the role of the cost leader in its industry.

It is also worth considering another reason why effective management of the production-cost relationship is essential for cost leaders -- economies of scale. Firms that compete with a cost leadership strategy typically earn very low margins on their goods or services. As such, they need to be able to generate high transaction volumes in order to cover fixed costs. It is accepted that a firm that is able to clearly stake out a position as the cost leader in an industry will enjoy high volumes, assuming that the industry itself has the demand to support this.