Cost Leadership Essay

Any organization in order to survive in a highly competitive market should be able to achieve sustainable growth and profitability. Companies that have managed to reduce costs and understand the cost technology can obtain sustainable advantage as a cost leader. In order for any company to become a cost leader is important that the cost technology is understood and the five constituent steps are implemented and followed by the management. The five steps towards obtaining a cost leader advantage are: (1) Distinguish between economies of scale, size and scope, (2) Increase average productivity of labour, (3) Normalize wage structure, (4) Control more of the production costs, (5) Demarcate between excess and reserve capacity. Implementing those steps can take several years (even decades) e.g Canon. A company has achieved economies of scale when the average cost (AC) declines as output increases meaning that the marginal cost of the last unit produced must be less than the average cost. In cases that capacity is constrain then AC cost curves are U shaped and cost reduces up to the Minimum efficient scale (MES). This is indicated in FIGURE 1. On the other hand when capacity does not prove to be constrain and each facility operates efficient then average costs curves can be L shaped. Even beyond MES average costs will not raise. FIGURE 2. So it is essential that companies build up their capacity, expand their plants or build new ones. A company has achieved economies of scope when savings are achieved as it increases the variety of products so the total cost of a company producing both products x and y is less than two companies producing products x and y or : TC(Qx,Qy) < TC(Qx,0) + TC(0,Qy). Is essential for a company to keep variable costs constant and at the same time try to achieve economies of scope. Keeping costs constant and having economies of scope can lead a company of becoming the cost leader. Steps 2,3,and 4 as mentioned above is very important for any company that wishes to reduce costs. Step 2 is focusing in increasing average productivity of the labour e.g. by keeping in the company the most productive personnel while encouraging the least productive to leave the company, while step 3 is focusing in wage normalization e.g. fixed monthly salaries and bonus payments only related to increasing productivity. Average variable costs (AVC) has an inverse relation to average productivity (AVC=w/APL) where w is the wage proxy. By increasing productivity and normalizing wages (w=1) a company will eventually reduce average variable costs. Step 4 is among the most important in order a company to become a cost leader. This step is focusing in controlling and reducing production costs. Reducing production costs is a complicated function and many parameters should be taken under consideration form the management of any company. Among others, management should consider the complete supply chain process, the degree of vertical integration and define their vertical boundaries, decide what products and services will produce in house or subcontract to a supplier, find ways to reduce transactional costs, hedge positions on raw materials, establish long term relations and long term contracts with suppliers. Contracts with sub-suppliers supplies should be written in detail and be as accurate as possible including clauses for as many as possible eventualities may occur. Also establishing strategic alliances and join ventures can reduce transaction cost and eventually production costs. Reducing production costs is also related on running the plants as efficient as possible. Reduce inventories to minimum, optimize production lines, improve or even ‘automate’ communications between departments, suppliers and distributors, automating production lines, and reduce fixed costs. Actually reduction of production costs can be done in every step of the production from purchasing raw materials to final shipment of goods. Detail analysis and planning of all production steps will provide management with the right information and solutions on how production can be optimized and costs can be reduced. Finally in step 5 companies can have the production determine the demand. In this step size is not a constraint, companies have already reserve capacity and operate at the MES point or even on the right side of the MES.. (FIGURE 3) By having reserve capacity and being able to have production determine the demand companies can influence the demand curve of their products towards being inelastic. Any company that has managed to become the cost leader in its industry will have the ability and should be prepared to allow production determine the demand and have reserve capacity. This will prevent lagging sales and reduce carrying inventory to minimum. Over the last years more and more companies are focusing on costs, how those can be controlled and what measures should be taken in order costs to be reduced. Being able to reduce costs and in combination with economies in scale (neo classical model) and economies of scope (game theory) a company can become the cost leader in its industry. It is very important that a company can be the cost leaser in a game and in many cases companies camouflage this advantage so it is not revealed to competitors. Being a cost leader a company can obtain sustainable advantage, will have the capacity to ‘play the game’ longer and be able to determine the demand curves of their products.