Low-Cost Leadership

Low-cost leadership has paved the road to success for many companies. Discount retailers in the United States such as E.J. Korvette and later Kmart grabbed significant chunks of the retail market away from traditional department stores and specialty stores when they first appeared in the 1950s and 1960s. Their success was a function of their ability to deliver goods at lower prices; and they developed that ability by keeping their cost structures much lower than those of traditional competitors. These early discounters were displaced, in turn, by Wal-Mart and Target, which were even more effective in operating a low-cost strategy. Wal-Mart’s success, in part, stems from its innovations in supply chain management.

In this strategy, the product or service is usually the same as the product or service offered by rivals. It may be a commodity, such as rolled steel or electrical wire, or it may be something readily available through other vendors. Items sold by Wal-Mart, for example, can be obtained at many other locations, some just down the street—Duracell batteries, Minolta binoculars, Canon cameras, Kodak photographic film, Wrangler jeans, Hanes underwear, Gillette razor blades, Bic pens. So why do so many people in North America head to Wal-Mart to buy these items, often driving past rival vendor locations? Because they believe they will get the same items for less money. And they usually do.

The key to success using the low-cost strategy is to deliver the customer’s expected level of value at a cost that assures an adequate level of profitability. Consider figure 6-1, which is adapted from a model first advanced by Adam Brandenburger and Harborne Stuart. ¹ The vertical distance between the willingness of customers to pay (top line) and the cost of providing the product itself (bottom line) represents the range of pricing within which every company must operate. It also represents the value added by the company, as perceived by customers. For commoditylike or undifferentiated products, the spread between these lines is narrow. And the top line—what customers are willing to pay—is generally fixed, particularly when competition is strong. So, to establish greater profitability, the vendor must push the cost-of-providing line lower. It will generally attempt to do this through operational efficiency, pressuring suppliers for low prices, and other means. This is the game that Wal-Mart has been playing and winning for many years. It has squeezed more costs out of its supply chain than any other major retailer.

FIGURE 6-1

Expected value

Using process innovation that automates data from the checkout register back to product suppliers—to the suppliers’ suppliers—Wal-Mart’s supply chain technology managed to break the “three-day barrier,” a feat that many in the retail trade had thought impossible. Using information technology, Wal-Mart is often able to move replenishment items from suppliers to its shore shelves (not to its own warehouses) in less than three days. Thus, when a customer buys a toaster oven at the Wal-Mart store in Lynn, Massachusetts, the purchase triggers a signal that “pulls” a replacement item to that store’s shelf. Rapid turnaround makes it possible for the company to maintain lower levels of inventory than competitors while meeting customer demand—and saving millions in working capital. Lower store inventories also make it possible to offer greater product diversity in the same floor space. Rapid supplier response also puts Wal-Mart stores in a better position to respond to unanticipated demand and changing customer requirements. The fact that the entire system is automated reduces the labor costs that burden so many retailers.

It’s easy to assume that the low-cost leadership strategy applies solely to physical products: jeans, paint, tons of steel, and so forth. There are, however, many examples of low-cost strategy in the service sector. Consider The Vanguard Group, a leading investment management company. Started in 1974 by John Bogle, the company provides a broad array of mutual funds and a very high level of client service. There is nothing particularly fancy about Vanguard or its funds. While some of its actively managed funds have been top performers over the long term, many are index funds that purposely aim to replicate the return of the market, not “beat” it. In most years, these passive index funds actually outperform the average managed funds in the same category. Index funds require very little human tending and operate without benefit of highly paid securities analysts and portfolio managers. The index fund is an innovation whose roots are found in financial academic research and its practical application by pioneering portfolio managers such as Charles Ellis in the 1970s. Bogle recognized the value of index funds and successfully popularized it among individual investors.

What also sets Vanguard apart from other fund families is its nocommission policy and the fact that it has the lowest average expense ratio among fund families. In 2003, for example, Vanguard’s average expense ratio was a tiny 0.25 percent of assets—less than one-fifth of the mutual fund industry’s average expense ratio of 1.38 percent. That has the effect of giving Vanguard clients a 1.13 percent greater annual return on their money (all else being equal). By keeping management and transaction costs low, Vanguard actually invests and reinvests more of a client’s money. And that produces better returns over time, all other factors being equal. Vanguard’s success with this strategy has earned it accolades among individual investors and made it one of the largest fund families in the United States.

Making the Low-Cost Strategy Work

As mentioned above, the key to retaining low-cost leadership is keeping the costs of providing goods or services lower than those of competitors. This is a constant challenge, since rivals will be working hard to drive their costs lower than yours. But it can be achieved through several means, and innovation—bother process and product (or service) innovation—can play a role in several. Consider these four:

CONTINUOUS IMPROVEMENT IN OPERATING EFFICIENCY. The Japanese developed the philosophy of kaizen, or continuous process improvement, to gain their well-known lead in manufacturing. Kaizen encourages all members of the organization, from the executive suite to the loading dock, to seek out ways to incrementally improve what they are doing. It has a lot in common with incremental innovation, as described in chapter 1. A 1 percent improvement here and a 2 percent improvement there quickly add up over time, giving the firm a notable cost advantage. The concept of process reengineering aims for a similar result, but kaizen aims for incremental improvements to the existing work, whereas process engineering aims for breakthrough change—either through wholesale restructuring or the total elimination of existing activities. Process reengineering is a form of reinvention. Both kaizen and process engineering have had profound impacts of operating efficiency in both manufacturing and services.

EXPLOITATION OF THE EXPERIENCE CURVE. Production managers know that people learn to do the same job more quickly and with fewer errors the more frequently they do the job. Thus, a heart operation that once took eight hours can be completed successfully in four hours as a surgical team gains more and more experience with the procedure. And before long, the procedure may take the team only two or three hours. The same pattern is observed in manufacturing settings in which managers and employees focus on learning.

The experience curve concept holds that the cost of doing a repetitive task decreases by some percentage each time the cumulative volume of production doubles. Thus, a company that gets onto the experience curve sooner than an imitator can theoretically maintain a cost advantage. Consider the two cost curves in figure 6-2. Both companies A and B begin at the same cost level and learn at the same rate. They compete primarily on price. But A got into the business first and, consequently, is further down the cost curve than rival B, maintaining its cost advantage at every point in time. At time T, for instance, that advantage is C. Company B must either learn at a much faster rate, accept a permanent cost disadvantage (and smaller profit margin), or exit the market.

AN UNBEATABLE SUPPLY CHAIN. Wal-Mart is not the only master player of the supply chain strategy. Everyone is familiar with the Dell business model. It sells its PCs directly to consumers, skipping the middleman. It also builds those PCs to order, thus eliminating the costly finished goods inventory problem that plagues rivals that operate with traditional business models. It has no finished products sitting on the shelf and becoming technologically obsolete with each passing day.

FIGURE 6-2

The experience curve

What people often overlook about Dell is the innovativeness of its efficient and effective supply chain. That chain includes component suppliers, assemblers, and the logistical services of UPS. All are digitally linked so that order information can be immediately translated into production and delivery schedules. The ability of this supply chain to deliver a customized PC to a customer’s doorstep in a week or so makes it possible to eliminate middlemen and inventory costs, giving the company cost leadership in its field.

PRODUCT INNOVATION. Huge cost reductions are often achieved through product innovation. For example, back in the 1970s, Black & Decker, a manufacturer of consumer power tools, found itself going head-to-head with low-cost Asian competitors. It had a serious cost disadvantage that could not be cured simply by being more thrifty and efficient. Something more dramatic was required. B&D responded with product innovation—it redesigned its entire family of consumer power tools and the process for making them. At the heart of this product line makeover was a new electric motor that could be inexpensively altered to provide power for any number of different hand tools. That eliminated dozens of different motor types as well as the need to make and store hundreds of different components. The core product platform’s simplicity and “manufacturability” made it possible to produce the new family of tools with 85 percent lower labor costs. Inventory and other related costs tumbled by similar percentages. The Société Micromécanique et Horlogère (SMH) accomplished similar results with its development of Swatch watch, which was based on the company’s development of a reliable, plastic, quartz timekeeper that could be mass-produced for a tiny fraction of the cost of traditional watch works. This design breakthrough made it possible for the Swiss company to compete and prosper in a market dominated by low-cost Asian competitors.

In these and other cases, product innovation or redesign proved to be an effective tool for achieving cost leadership.

Is a low-cost strategy feasible for your company? If it is, what would have to happen to make it work?

Differentiation

Every successful strategy is about differentiation, even the low-cost leadership strategy. “We can fly you to Barcelona for less than our competitors.” “At Auto City Sales, we will not be undersold.” But for most companies, differentiation is expressed in some qualitative way that customers value. For example, when Thomas Edison first began to market his system of electric incandescent lighting, his principal rivals were local gas companies. Both methods of illumination were effective, but Edison’s approach had clear differences that most customers favored. Unlike gas lamps, Edison’s innovative electric lighting didn’t noticeably heat up people’s living rooms on hot summer nights. It was more convenient, requiring just a flick of the switch to turn it on and off. And it eliminated a serious fire hazard in many applications, such as in small, closed spaces. Edison played on these qualitative differences as he attacked and eliminated the gas companies’ dominance of urban lighting in the late 1800s and early 1900s.

Companies today likewise adopt differentiation strategies. Consider the auto industry. Volvo touts the crashworthiness of its vehicles to set itself apart. Toyota plays on its reputation for quality and high resale value; more recently it has differentiated its Prius model with high-mileage hybrid engine technology. The MINI Cooper practically screams “I’m fun to drive” to potential buyers. Porsche has also differentiated itself by concentrating on the development of high-performance sports cars—while GM may offer a vehicle for every household budget, and Toyota may claim a high level of quality and reliability, neither have much appeal for the small number of drivers who look for speed, agility, and a sense that they could handle the raceway circuit at LeMans. That is what Porsche aims to deliver through its strategy of differentiation.

Customer Relationship

Everyone knows that you can buy a camera or wide-angle lens for less at Wal-Mart, Best Buy, or one of the other discount stores. But many people still patronize small, independently owned photography shops when they purchase cameras, accessories, and film. Likewise, Fantastic Sams, a national franchise, provides great hairstyling services at low prices, yet many—if not most—women will pay more to go to the stylist who has been handling their hair for the past many years. Many women, in fact, can claim a longer-term relationship with their male hairstylists than with their husbands! In the words of one, “A husband is replaceable—a good hairdresser isn’t.”

What’s going on here? Why do so many customers pay more to patronize local camera shops, hairdressers, corner bookstores, neighborhood meat markets and bakeries, and many other vendors of goods and services when they could get a cheaper deal elsewhere? The reason is that they value the personal relationship experienced in doing business with these shops, their owners, and their employees. The relationship itself can take many forms: doing business with a familiar face; the fact that the vendor knows the customers and their needs; or the vendor’s willingness to explain the product, how to use it, and the pros and cons of different purchase choices. It’s difficult to find these qualities online, in a direct-mail catalog, or at most big-box stores. Those vendors provide a transaction, but not a relationship.

The Network Effect

When the first telephones were sold in the late nineteenth century, they weren’t particularly useful. A person could only call one of the few other owners of the new gadget. But the telephone’s utility grew as more and more homes, stores, and offices joined the telephone network. This is called the network effect—a phenomenon in which the value of a product increases as more products are sold and the network of users increases.

As a deliberate strategy, the network effect is fairly new. Perhaps its most obvious practitioner and beneficiary is eBay, the online auction company. eBay began as a hobby business of its founder, Pierre Omidyar, who developed software and an online system that allowed individuals to list new and used items of all types for auction. His wasn’t the first online auction site, but it was the first to become widely popular, and that popularity sent the network effect into high gear. Buyers flocked to eBay over other sites because it had the most sellers, and sellers listed their items on eBay because it attracted the most buyers. This virtuous circle quickly established Omidyar’s site as the dominant online auction site, and it continues to support eBay’s remarkable growth.

There is no evidence that Omidyar and his colleagues set out with an implicit network effect strategy. It simply happened. However, early success encouraged them to use their rising tide of revenue to keep the ball rolling, which they did through heavy investments in site development, customer service, brand recognition, and a number of strategic acquisitions.

Success with a network strategy depends heavily on a company’s ability to get out in front and become the dominant provider. Doing so leaves very little space available for challengers, which is why some call this a winner-take-all strategy. eBay quickly dominated its industry. Microsoft did the same with its Windows operating system, though most experienced computer users agree that the user-friendly Macintosh operating system developed by Apple is superior to Windows. But Apple kept its operating system proprietary, while Microsoft allowed its operating system to be installed on all PC manufacturers’ machines. Thus, since most PCs operated with Windows, most new software was developed for Windows machines. And because most software was Windows-based, more people bought PCs equipped with the Windows operating system. To date, this virtuous circle appears to be unbroken.

This chapter has presented four general strategies. Each has been a winning ticket for any number of companies. Chances are that one or another—or some variation—would be appropriate for your company. But which one? Look for the answer in your company’s mission, its goals, and what you have managed to learn through external and internal analysis, as shown in figure 6-3. Think of the mission as setting the boundaries within which you may seek a new strategy. Your goals set the bar of achievement that the strategy must be capable of attaining.

You should understand, however, that any strategic choice involves trade-offs. If you choose to focus on a narrow set of customers, as in the USAA example, you’ll have to give up the idea of serving the broad general market. As Michael Porter has warned, “Companies that try to be all things to all customers . . . risk confusion in the trenches as employees attempt to make day-to-day operating decisions without a clear framework.”⁵ Thus, if you want to be the low-cost retailer in your field, don’t try to set up a special boutique chain of stores to cater to high-end customers. You’ll confuse the market and yourself.

FIGURE 6-3

Which strategy is best?

Above all, make sure that your choice of strategy is aligned with the primary customer market you plan to address. This may be the most critical factor in strategy creation. Keep your chosen customer market in your sights at all times, and make sure that your colleagues do the same. Alignment between strategy and customers is absolutely essential. And innovation in product, service, process, or customer delivery can help you win the game.

Summing Up

• As a strategy, low-cost leadership is most appropriate in industries in which competitors essentially offer a commoditylike product or service.
• Continuous improvement in operating efficiency, process reengineering, exploitation of the experience curve, supply chain power, and product innovation are among the methods used to achieve low-cost leadership.
• A differentiation strategy sets the product or service apart from those of rivals in a qualitative way.
• Commodity products—those with standard features, quality, and price—can be differentiated from those of rivals by means of faster, more reliable delivery and/or superior customer support.
• Strong customer relationships can be used to retain customers who would otherwise gravitate toward lower-cost providers.
• To be effective, a customer relationship strategy must provide something that customers value—for example, something that simplifies their lives or work, ongoing benefits, personalized service, or customized solutions.
• The network effect is a phenomenon in which the value of a product increases as more products are sold. Companies that pursue this strategy (or benefit from it) succeed to the extent that they can get out in front and become the dominant provider of some enabling product or service, such as eBay’s online auction site or Microsoft’s Windows operating system.
• Whichever strategy type you consider, always look for alignment between the strategy and your target customer market.