Observing that all its rivals were forced to do the same, XYZ felt secure in its strategy. A perfectly competitive firm has only one major decision to make—namely, what quantity to produce. Cost competitive advantages can easily disappear with the introduction of a new competitor or new technology. Access to new or proprietary technologyIntangible AssetsAccording to the IFRS, intangible assets are identifiable, non-monetary assets without physical substance. For example, if you want to be the low-cost producer in the market but you anticipate rising capital costs as a major problem, your company’s best bet is either to build early (if demand projections are bullish) or not to build new plants at all (if the market is mature). Otherwise, a strategy to be the cost leader will beat a performance-based differentiation strategy. XYZ couldn’t count on price hikes to cover its still slowly rising costs because its volume-conscious rivals were aggressively using price as a weapon to gain market share. As a result, steel companies must either refurbish their inefficient mills or close them down. To find a lasting competitive advantage, look for something that your competitors cannot easily replicate or imitate. Source: Compiled from data in the U.S. Federal Trade Commission, The United States Steel Industry and its International Rivals: Trends and Factors Determining International Competitiveness (Washington, D.C.: U.S. Government Printing Office, 1978) and in Robert W. Crandall, The U.S. Steel Industry in Recurrent Crisis (Washington, D.C.: The Brookings Institution, 1981). An increase in price, with no current catalog or competition, should be about the current rate of inflation between the time of the last competition and the commitment of the current order. After adjusting for greater sales volume, for example, operating costs in electric utilities rose an average of $4 billion each year between 1970 and 1981. 1. After all, your competitive advantage is, by definition, something your competitors do not have. Reprinted with the permission of the publisher. One analytical approach is to compare your own cost structure with that of your rivals to discover who has been most affected by operating cost and capital cost changes. Only if the Government is committed to limit the rise to a creep of not much above 2 per cent can there be reasonable predictability. When the cost disadvantage is in distribution, the company can push for more favorable terms, change to more economical distribution, or make up the difference by initiating cost savings earlier in the total value chain. To illustrate the strategic payoff of constructing a value chain, look again at Exhibit I. 3, 12–13; © 1970 by New York University Press. Either way, you lock into a low-cost position with fewer dollars of fixed asset investment. Competitive advantages can be found almost anywhere. When rising costs hit the operating-cost side of the value chain harder than the capital side, a company can still be successful in pursuing a strategy of being the low-cost producer if it can find ways to innovate around the components of operating costs most susceptible to inflation. Another strategic option is to try to shift more of the basis for differentiation to aspects of product performance that can be added by investments in technology and fixed assets. Because inflation affects each company in an industry differently, the first step is to diagnose your changing cost economics all the way from the raw materials stage to the final price paid by the ultimate consumer. Take the time to look at the differences between your competitor's goods and services and your own. In 1976, the price of gas fuels went up 35.2%, while that of crude petroleum increased only 8%. You will have to adjust if, while pushing capacity to the limit, you find operating costs beginning to creep up. For example, if it’s losing out because of a competitive disadvantage in the cost of purchased inputs, the company’s strategic options are to negotiate with suppliers for more favorable prices, integrate backward to gain control over material costs, use lower-priced substitute inputs, or make up the difference by initiating cost savings elsewhere in the total value chain. In such cases, cite the price of prior purchase and note if it was competitive or based on catalog price or other. Because every company within an industry has a slightly different cost structure for manufacturing inputs, varied inflation rates for these inputs can open up important cost differentials between competitors. Since 1975, U.S. oil companies have invested $15 billion to upgrade refineries so that they can use cheaper, more plentiful low-quality crude oil. If the source of rising unit costs in an industry comes mainly from the added costs of new investments in plant and equipment, a “hold share” growth objective can yield attractive profit margins. It is noted that generally where the difference in prices … whether a company's costs are competitive with close rivals depends on how the costs of its internally performed value chain activities compare with the costs of the internally performed value chain activities of close rivals which of the following is not an indicator of how well a company's current strategy is working Such a move may produce a durable competitive edge, especially if it catches competitors by surprise. ABC assigns job costs based on the actual use of resources, enabling firms to price their products appropriately, determine in which markets they can compete effectively, make better capital allocation decisions, and calculate the incremental costs associated with potential courses of action. That’s in an industry that started from a base of $20 billion in sales and $3 billion in net income. Making these kinds of investments “early” can mean major savings in capital costs; Standard Oil of California, which spent $1.3 billion to upgrade its Pascagoula, Mississippi refinery in 1981 and 1982, has estimated that the same improvement would have cost $2 billion in 1983. A relative cost shift can occur in any one of three main areas—suppliers, the company’s own segment, or forward channels. This activity appraisal can be applied on commercial transactions, business or proposed policy, or an impending project. Walmart has enormous economies of scale. You must try, insofar as you can, to shift the basis of your differentiation to operating cost variables—to advertising, service, inspection procedures, and manufacturing workmanship. Variations in fuel costs, along with differences in capital construction needs, have driven big wedges between the rates charged for electric power across the United States. Because it is committed to cost-containing retrenchment and won’t encounter capacity-induced cost increases, a company can simply sell under the price umbrella of rivals and enjoy a long “cash harvest” as competitors raise prices to compensate for the higher costs associated with capacity expansion or capacity replacement. Their risk of falling into the pricing trap is lower, and they are more secure in raising prices when short-run cost changes squeeze profits. Plainly, the chain’s makeup will vary from company to company as well as from business segment to business segment (product line, customer type, geographic area, or distribution channel). This involves constructing a value chain, a diagram that shows the value added at each step in the whole market process and exposes shifting cost components. 1. At IBM, top management decided that the economic impact of rising operating costs would outweigh that of escalating capital costs. Whether you expect your company’s costs to be affected more by operating cost changes or by capital cost changes also determines the success of your competitive strategy. Joseph A. Pechman (Cambridge, Mass. Copyright © 2020 Harvard Business School Publishing. To be sure, they can never get a guarantee of future tuition costs, or the prospective price tag on their retirement home, or charges for large medical needs. Furthermore, suppose that all the firms in this industry are identical and that a representative firm’s total cost is: TC = 100 + 5q + q2 This can be roughly … Once you find this advantage, focus your company's efforts on heightening it. When operating costs spiral upward faster than the costs of plant and equipment, a focus strategy can succeed if the company either concentrates on buyer groups that are less price sensitive or tries to build its product line around items that are least affected by cost changes. To add insult to injury, XYZ’s rivals no longer went along with industrywide price increases; even when such hikes became timely, the other companies raised their prices by a smaller percentage than XYZ or delayed them altogether. Then deflation began, market demand slackened, and a deep recession set in. 2. To catch up, they considered investment to modernize existing facilities or to build new cost-competitive plants. After all, something is compelling for consumers to do business with them. Both Sun Oil and IBM have benefited from committing investment capital on a timely basis to strategic moves designed to yield strong cost positions vis-à-vis their competitors. In an industry where new fixed assets or capacity additions are expensive, a company with relatively modern facilities and adequate capacity may well find it competitively advantageous to use a focus strategy and concentrate on selected groups of buyers. This hold share strategy can work under conditions of strong or weak market demand. Given the realistic probability that rising operating and capital costs will affect each competing company in a different way, it is important for each company to probe the nature and size of the differences in order to understand the potential shift in competitive advantage. Strategic actions to eliminate a cost … Access to natural resources that are restricted to competitors 2. After constructing a value chain, a company may discover it can reestablish cost competitiveness only if it goes outside in-house operations. No company can totally avoid the impact of increasing costs. To use it, a company must recast its own historical cost accounting data into the principal cost categories that eventually make up the value of its product. The total revenue for a firm in a perfectly competitive market is the product of price and quantity (TR = P * Q). Rising capital costs will hit your company hard if you rely on a differentiation strategy to win market share. Like all assets, intangible assets are those that are expected to generate economic returns for the company in the fu… 7. They may actually tend to outpace the price level on the average in the long run, but only with wide swings and great uncertainty. The value chain is revealing but not simple. Manufacturing companies in such energy-intensive industries as pulp and paper, chemicals, and primary metals feel the competitive impact of fuel cost differences. The goal is to be the very best in your field. For example, if a company seems likely to suffer from both high operating and high capital costs, it will have to increase prices at rates faster than inflation to hold its market, but it will soon invite customers to switch to substitutes. It's impossible to determine whether lowering costs or increasing revenue is more important across the board for all companies. To sustain the advantage, it must be able to recoup the cost suffered from temporary excess capacity when rivals finally add or replace plant and equipment at inflated costs. The company made a big commitment to capital spending. The future holds even more competitive pricing threats; a potential breakthrough in the development of solar thermal equipment and photovoltaic cells by General Electric, Westinghouse, United Technologies, and several Japanese companies portends important new sources of even lower-cost energy substitutes. Competitive advantage refers to the ability of a company to deliver products, services or benefits, either at a lower cost or an improved level than other players in the same industry. Much of this can be performed through deduction and a process of elimination. Essentially, the goal of this general analysis is to assess whether a price is reasonable, and this depends on the type of market where the supplier operates. It is possible that Berkshire Hathaway's competitive advantage is perfectly unique: Warren Buffet's mind. The size of any first-mover advantage depends on the speed of increases in capital requirements, the extent of the industry’s need to add capacity to meet new market demand, and the potential for lower-cost substitutes to capture a lucrative share of the market. In the North American pulp and paper industry, a $100 per ton production cost difference exists between higher-cost new facilities and less costly, fully depreciated mills.1. To understand why this is so, consider the basic definition of profit:Since a perfectly competitive firm But these risks are much less serious than those associated with general inflation. Some restaurants thrive because of their location. But no asset shows a good year-by-year correlation with prices; even corporate equities and real estate are not good anti-inflationary hedges by this test. Southland Corporation saw its costs for new 7–Eleven convenience food stores rise because of the explosion in the industry. To begin with, companies usually experience a different rate and pattern of cost change for each cost component. Cost-benefit Analysis dete… Inflation, of course, raises the construction costs of new facilities, the prices of new equipment, the cost of equity and debt capital, and the needed amount of working capital. [List the factors that affect cost analysis and cost realism analysis considerations.] The concept of value chains is discussed and analyzed in Michael E. Porter and John R. Wells, “Strategic Cost Analysis,” unpublished working paper, Harvard Business School, 1982. These two main types of competitive advantage determine whether your company succeeds by being a cost leader or by differentiating its … By 1976, Japanese companies were producing a ton for $35 less than their American competitors.3. Furthermore, let’s focus the analysis on the extremes, where inflation drives up either operating costs or capital costs. Suppose there is a perfectly competitive industry with a market demand curve that can be expressed as: P = 100 – (1/10)Q where P is the market price and Q is the market quantity. In neither case do companies have to worry so much about the timing of decisions to add or replace production facilities. An aluminum producer with plant facilities in the Pacific Northwest today can manufacture more aluminum with fewer dollars than a producer in the Midwest. But there simply can’t be great confidence that the price level will rise steadily at any substantial rate, such as 4 per cent. Intellectual property is a set of intangibles owned and legally protected by a company from outside use or implementation without consent. And we now expect to begin realizing the productivity gains…made possible by our sizable investments.”6 The investment move allows IBM to take the offensive with its pricing strategy. Exorbitant Drug Costs Cost of acquisition is the total of expenses incurred when a business acquires a new client or a new asset. Such differences in inflation rates for particular cost components play a big long-term role in shifting the cost competitiveness of different fuel sources and energy-intensive industrial companies. A company can show the makeup of costs all the way from the raw materials phase to the end price paid by the ultimate customer on a value chain (see Exhibit I).5 Strategic cost analysis cannot be restricted to one’s own internal costs because economywide inflation often affects suppliers and distribution channels. Evaluating how well the present strategy is working B. Scanning the environment to determine a company's best and most profitable customers C. Assessing whether the company's cost structure and customer value proposition are competitive D. Evaluating whether the company is competitively stronger or weaker than key … Capital costs can rise because of unforeseen difficulties with expanding operations. A perfectly competitive market is characterized by many buyers and sellers, undifferentiated products, no transaction costs, no barriers to entry and exit, and perfect information about the price of a good. In these cases, it might be best to focus business strategy toward these areas, highlighting and pressing your advantage. View Test Prep - Ch 4 quiz from MGT 590 at RMU. The offers that appear in this table are from partnerships from which Investopedia receives compensation. Competitive advantages can be found almost anywhere. In the final analytic step, a company turns to the impact of future cost increases on both the operating and the capital side of the production equation. Of course, some companies did manage in the 1970s to avoid inflation’s trap by investing “early” in new facilities and protecting their long-run competitive position. A narrow customer base helps limit the need for capacity expansion and shields the company from the cost of escalating capital requirements. December 1982, p. 56. According to Hauht, the price analysis strategy is effective when applied to products that can be contrasted to other, “similar” procurements. In my judgment, the impact of inflation on balance sheets is considerably more serious than that on income statements. 3. There are limits to how much more buyers will pay for a product that is fancier than its rivals’. A perfectly competitive firm can sell as large a quantity as it wishes, as long as it accepts the prevailing market price. In the first place, inflation deprives people of the opportunity to save in a form that gives them a predictable command over future consumption goods. Then, given the capacity you have, you try to produce at rates close to practical capacity in order to enhance the revenue productivity of your fixed investment. In a slack market, low-cost companies are in the position to use a price-cutting strategy to protect their sales volume and preserve capacity utilization. For the sake of simplicity, let’s consider three basic strategic postures relating to growth: building market share, defending the current market share, or giving up market share (taking a “shrink abandon” approach). XYZ was caught squarely in a competitive pricing trap. Also, try changing the market price of the product to create break-even, profit, and loss situations. Highly skilled labor 3. Increasing capital costs can push the incremental costs of fixed assets and capacity far above the historic cost of existing plant and equipment. XYZ’s profits eroded while the others’ remained buoyant. 5. A company that finds itself in a trap like XYZ’s can do something to get out of it. Companies in perfect competition are considered to be price takers, meaning that they have no scope to set prices—this is the reason why marginal profit is equal to marginal cost. Virginia Electric and Power Company, for example, will mothball a nuclear power plant, despite a $540 million initial investment, because the estimated final price tag has risen from $1.2 billion to $5.1 billion. It must also forecast future market volume accurately and target its market share objectives to coincide with a relatively lower-cost industry position. Companies in the middle (either more or less affected by two variables) have less clear-cut strategies. Brignall, and A.R. Nonetheless, if your business has relatively high and rising fixed costs per unit, successful cost leadership depends on the combination—and timing—of low capital investment and productive use of fixed assets. Avoiding pricing traps requires a strategic view of the present cost structure, of how the structure changes, and of the implications for gaining a sustainable competitive advantage. With the rise in the number of fast retail operations, other fast food chains, service stations, and retail companies began to compete for the same locations and thus drove up their prices. You may find it hard to hold onto your share of the market and, more important, you probably can’t invest your way out of the cost disadvantage in the short run (because the new capital requirements are unattractively high and leave no room for a return on investment at going market prices for the product). Despite the tediousness of this job, the value chain pays off by exposing the cost competitiveness of your position and the attendant strategic alternatives. Costs can rise because of unforeseen difficulties with expanding operations Economics for Policymaking, Selected Essays of Arthur M.,... 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