Cost Leadership Strategy

Strategic planning can take any organization to its pinnacle. Thus, companies need to consider various strategies to remain successful and keep their plus side against their competitors and continue to have a positive impact on revenue and profits. Strategies can range from competitive pricing to hiring skilled teams to reduce cost and all of them can be focused on one and only one goal “success and long-run stability” of the company. But today we will talk about “Cost-saving strategies”. The companies seeking cost advantage will have to focus on “an effective cost leadership strategy”.

What is Cost leadership?

  • Cost Leadership is a strategy to reduce the cost of operation and produce the lowest priced products or services, to out-do the closest competitors and gain market share. 
  • It requires the vigorous pursuit of cost minimization techniques such as efficient utilization of scale of production, good purchasing strategy, modern technology and produce quality products. 
  • Companies can develop a cost leadership strategy by analyzing existing operations, researching their competitors, identifying strategies to reduce costs and by keeping a track of progress.

Examples:

a. Home Renovation

  1. Many renovation companies have made a mark in the home renovation market by opting to specialize in one aspect of home renovation instead of operating as a full-service contractor.
  2. Full-service contractors cost a lot of money and are burdened with additional overheads such insurance and licensing components. 
  3. Specializing in certain aspects such as kitchen, bathroom, garages, roofing helps them work with wholesale distributors to achieve the best pricing on the standard package they sell to the clients. 
  4. They also offer less option on customization, which further helps them purchase similar raw materials for their work at a discount. 

b. Realtor Services

  1. Realtors are legally allowed to charge up to six percent in commissions on a transaction and this amount is generally split between agents. 
  2. This means transaction for $300,000 could the seller almost $18,000 in commissions.
  3. This has led to flat fee brokers to enter the realty market and use the cost leadership strategy to advertise fixed commissions on every sale. 
  4. As a Result, customers attracted by the idea of pocketing most of the sale amount and the included services offered by these brokers such as listing and other necessary legal disclosures have opted to move their business with them.

Difference between cost leadership and price leadership:

So often, people use the terms price leadership and cost leadership interchangeably, but these two are entirely different concepts.

  • Cost leadership focuses on establishing a competitive advantage by lowering the cost of operation in the industry. While price leadership means having the lowest price. 
  • A cost leader can also be a price leader in its industry. But it’s important to note that a price leader prioritizes market share by selling its products or services at the lowest prices many times leading to fall in its profitability. 
  • While cost leaders focus on a system which tries to increase efficiency and reduce production costs below the industry average which can allow the company to have a balanced growth. These would be considered cost leaders but not price leaders. 

What are the benefits?

  • By employing cost leadership strategy, a company will not only be able to gain profit but eventually increase its market size as some consumers shop only at stores that offer the lowest price. 
  • Companies with the lowest cost of operation have higher chances of survival during downtimes.
  • As their survival period is lengthened and overall stability is assured due to balanced growth might lead to reduced competition.
  • Companies operating with a cost leadership strategy can achieve higher profit margins by reducing production costs as compared to their competitors who are focusing on pricing strategies.
  • Surplus capital can be utilized to fund growth or investments such as research, technology upgrades and other business expansion

How does it Work?

Let us take the example of the airline industry and try to understand this concept. The airline industry is a highly competitive market and some companies have adopted the cost leadership strategy to dominate the market and achieve a better position among its rival. 

1. Southwest from the U.S.A. is credited as the originator of the low-cost airlines business model, but the phenomenon spread worldwide in the 1990s. 

2. In the airline business, the market is often segmented by trip duration and by trip purpose. 

3. The Airline that has business travelers as their primary target segment are known as full-service carriers while the low-cost carriers are focused on leisure travelers.

4. There are differences between the business models of these two carriers

Full-service carrierLow-cost carriers
They utilize the ‘hub and spoke’ system of connections to destinations around a single hub, generally larger cities. Airline require you to stop in their hub to connect between two citiesInstead of flying several flights into and out of major airports, low-cost carriers utilize the point-to-point system which employs flying between two cities directly, regardless of size
Lower seat densityHigher seat density 
Slower turnaround time of usually one hourFaster turn-around time usually half an hour
Utilization of mediators such as travel agents for booking ticketsOnline or direct booking 
Higher service levels including expensive dining, in-built entertainment systems etc.Usually lower service levels with options to buy refreshments
Operate out of primary airportsMost low-cost airlines operate out of secondary airports which are located further away from the city 

5. The low-cost carriers have adopted many modifications to gain a competitive advantage over the traditional airlines such as internet paperless booking, minimum cabin crew with lower wage scales, high utilization of airports, low turnaround time, one class of seating in order to fit more seats, low luggage, and customers paying for refreshments.

6. They utilize a business model with an emphasis on low fares, reducing overheads and cost cuts by using secondary airports with cheaper landing charges. 

7. With a reduction in costs, low-cost airlines are even able to operate a wider point to point journeys than the traditional airlines, helping them to earn higher profit margins. 

8. Consequently, the low-cost carriers were able to capture a higher market share in the aviation industry and traditional airlines to set up their own low-cost subsidiaries or lower their prices. 

9. The following table will help us understand the increasing world-wide market share of low-cost airlines from 2007-2019

YearMarket Share
200615.7%
200717.5%
200819.2%
200920.3%
201021.4%
201122.8%
201223.4%
201325%
201425.9%
201525.4%
201625.5%
201730%
201831%
201931%

Source: https://www.statista.com/statistics/586677/global-low-cost-carrier-market-capacity-share/

10. According to Statista, In the United States, the Low-cost carriers hold above 30 percent of the domestic market with Southwest ranked second among the leading airline in the U.S., with a market share of 17.6 in 2019, just behind American Airlines. 

11. Few examples of the biggest low-cost carriers in the United States is Southwest Airline with a market capitalization of $14.1 billion (May 2020) and the biggest carrier in terms of originating domestic passengers boarded. JetBlue Airways Corp. known for the most legroom in coach class, free TV and broadband internet service on the flight has a market capitalization of $2.2 billion (May 2020).

12. Another example is Allegiant Travel, which runs Allegiant Air and known for connecting small and mid-sized, has a market capitalization of $1.3 billion (May 2020)

Other Examples:

1. Wal-Mart Stores:

  • Offers products at attractive cheaper prices than its competitors because of their large scale purchasing power and efficient supply chain.
  • They sell a wide range of products and its focus is always on selling products at the lowest prices in the market. From grocery to entertainment, Walmart provides a variety of products. 
  • They consistently engage with their customers with discounts and shopping convenience. Their net revenue grew to $514.4 billion in 2019 and the brand employs millions of workers. 

2. McDonald Restaurant:

  • The brand’s cost leadership strategy allows them to keep production cost low, hire few managers, recruit and train fresh labor and offer affordable prices to its customers. 
  • Their operational excellence helps to maximize the efficiency of the product development process and create a competitive advantage. 
  • In 2019, the company generated close to $40.5 billion, about $19 billion dollars more than its closest rival Starbucks in the fast-food industry.

3. Ikea

  • It operates roughly 422 stores in more than 50 markets, with nearly 70 percent stores located in Europe. 
  • Its sales are estimated to be $46.2 Billion, with a business model focused on lowering prices by sourcing from low-wage countries and offer a basic level of service. 
  • Ikea reduces its cost of operations further by allowing customers to assemble their own furniture and take their own delivery. 

Disadvantages of Cost Leadership:

1. Financial cuts:

  • The reduced costs can affect critical areas of the business for examples ‘customer service’. Most customers want to feel valued not just when they buy from a business but also when they require after-sales service.
  • Companies may also reduce employee benefits such as insurance, training, incentives to reduce operational costs, which can affect employee confidence and eventually their productivity

2. Lack of Innovation:

  • Many companies employing the cost leadership strategy might find the cost related to the research and development team undesirable. 
  • This results in a reduction of funds which ultimately results in the lack of innovative new products, leading the management to promote the same products.
  • Consequently, the company might end up losing its customers and market share to businesses with innovative products. 

3. Applicability to other products:

  • The cost leadership strategy cannot be applied to every industry, particularly premium products where customers pay the premium because of brand recognition and high quality.
  • It might lead to adverse effects, as the brand loses its exclusive tag and is no longer desired by its target customers

4. Consumer Feedback:

  • Executives tend to ignore the market shifts in the products and the change in consumer preferences when they only prioritize low prices. 
  • Consumers are ever-changing, and it is the responsibility of a company to keep up with the changes by constantly engaging with their customer through surveys, feedback, discussions, etc. This requires a certain amount of capital to be set aside for its operations.

5. Increase in competition:

  • Several competitors might enter the market, applying the same techniques of operational efficiency and cost cuts to sell the same products and benefit from the higher profit margins.
  • Consequently, leading to a crowded market and a drop in market share. 

6. Capital Availability:

  • Businesses employing this strategy should be able to achieve a large volume of sales while applying operational scaling, before they run out of capital.
  • This can lead to depletion of capital reserves as there is not enough cash flowing into the business. The company might also be forced to take up additional debt just to be operational. 
  • In the worst scenario, such a situation can cause the business to file for bankruptcy. 

Summary:

  • Cost Leadership is a strategy to reduce the cost of operation and produce the lowest priced products or services, to out-do the closest competitors and gain market share. 
  • Examples include home renovation companies specializing in one aspect such as kitchen or bathroom remodeling who can save on raw material cost and work with wholesale distributors to achieve the best pricing on their packages and flat fee brokers which offers fixed commission fees and included services to clients.
  • Cost leadership focuses on establishing a competitive advantage by lowering the cost of operation in the industry. While price leadership means prioritizing the lowest price to gain market share, even at the cost of less profits. 
  • Benefits include an increase in market size, higher chance of survival during downturns, more capital available for upgrades and higher profit margins.
  • Few examples, include Wal-Mart Stores, McDonald’s Restaurant, and Ikea
  • Disadvantages of the strategy include Financial cuts to critical areas like customer service, lack of innovation, lack of applicability to premium products, change in preferences of the consumer, increased competition, and crunch in capital availability.

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