More significant, however, is how the phenomenon of rising costs can, over time, produce strategically relevant shifts in a company’s cost structure and cost competitiveness. When Southland first bought sites in the 1960s, few other companies were competing for the kind of location it needed. The costs are planned in the early phase of a new product by understanding the market thoroughly. 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. 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. A unique geographic location 4. A buyers’ market emerged. 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. Many electric utility executives have begun to push the use of this approach. And most managers have learned to adjust to the effect inflation has on current operating costs. To illustrate the strategic payoff of constructing a value chain, look again at Exhibit I. The fixed costs, like administration, are spread over more units of production.Sometimes the company can … If the inflationary combination results in a company expecting higher relative capital costs but lower operating costs and if its industry has good growth prospects and a mature technology, then there is a potential first-mover advantage from adding new capacity early. (a) (1) The contracting officer shall obtain certified cost or pricing data only if the contracting officer concludes that none of the exceptions in 15.403-1(b) applies. 5. In turn, average costs rise sharply as new capital investments are made and cause a squeeze on profit margins and a need to raise selling prices. An aluminum producer with plant facilities in the Pacific Northwest today can manufacture more aluminum with fewer dollars than a producer in the Midwest. And most managers, particularly those in capital-intensive industries, have not paid enough attention to the way increasing capital requirements affect […]. A build-share growth strategy by one company can coexist with a hold-share strategy by another. 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). Conduct customer surveys to see why consumers chose your company. Furthermore, let’s focus the analysis on the extremes, where inflation drives up either operating costs or capital costs. Exhibit II Value chains for U.S. and Japanese steel companies: a comparison between 1956 and 1976 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). If that is impossible and you must continue to base the strategy on the better performance of your product, then you must make certain that the costs to buy the new plant and equipment necessary to make your product the better performer can be offset by performance gains that will preserve your buyers’ preference for your product and forestall their natural motivation to switch to a lower-cost substitute. Take the case of energy fuels. This is where a value chain comes in. 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. That’s in an industry that started from a base of $20 billion in sales and $3 billion in net income. 7. For example, if both your operating and your capital costs are higher than those of competitors, you’re about to be caught in the pricing trap. The company made a big commitment to capital spending. Though small at first, the cost disparities that emerge can over time create big shifts in cost competitiveness and competitive advantage. Also, try changing the market price of the product to create break-even, profit, and loss situations. During years of chronic inflation, the managers of XYZ Corporation developed the habit of raising prices to cover rising costs and defend profit margins. No company can totally avoid the impact of increasing costs. If you increase the number of units sold at a given price, then total revenue will increase. Petroleum refining provides an interesting example of how to defend against long-term price increases in a key resource input. The shifts in the several cost components are dramatic. It intends to satisfy the growing needs and requirements of a consumer about price, features, and quality of a product.. Target costing is estimated as the expected selling price of a product minus the desired profit from selling the product. 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). The LCOE can also be regarded as the minimum constant price at which electricity must be sold in order to break even over the lifetime of the project. Determining whether a company's overall prices and costs are competitive requires an entire value chain analysis, which typically demands: -Looking at the costs of a company's competitively relevant suppliers and forward channel allies (distributors/dealers). 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. These two main types of competitive advantage determine whether your company succeeds by being a cost leader or by differentiating its … Like the weather, inflation is a lot easier to talk about than to do something about…. 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. However, if the contracting officer has reason to believe exceptional circumstances exist and has sufficient data available to determine a fair and reasonable price, … 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. 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. Southland Corporation saw its costs for new 7–Eleven convenience food stores rise because of the explosion in the industry. 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. Sustained inflation leaves an imprint on current operating costs as well as on the cost of fixed assets and new capacity. A company that finds itself in a trap like XYZ’s can do something to get out of it. If all competitors feel the same inflationary impact on operating costs but the fixed asset-capacity cost increases that they suffer from differ greatly, then an “invest and grow” strategy to build market share can work to the advantage of a company, provided it invests early in new capacity. 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. The $44 billion increase over 11 years spawned round after round of rate increases, pushing rates in 1982 some 200% to 300% higher than in 1970. In the electric utility industry, where fuel costs account for 40 to 60% of operating expenses, each power company has experienced a different net inflationary impact, depending on the particular mix of coal, fuel oil, natural gas, nuclear power, and hydroelectric generation. To catch up, they considered investment to modernize existing facilities or to build new cost-competitive plants. 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. (XYZ is a name I am using to designate a composite of several companies.) Like all assets, intangible assets are those that are expected to generate economic returns for the company in the fu… At some point, the buyers may be attracted to a more generic product at a lower price. 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. At the other end of the spectrum, where your company is less affected by both relative operating and capital cost increases, you are in an excellent position to use your low-cost stance to win a higher market share by offering a lower price. Companies that don’t build new plants can gain a competitive advantage if they are able to use a higher percentage of existing capacity to produce the extra volume needed to maintain market share. 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. 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. By 1976, Japanese companies were producing a ton for $35 less than their American competitors.3. Ashland Oil figures it will reduce raw materials costs by 20% to 25% through a $240 million upgrading of its refineries. Such focus directs corporate attention to the best use of existing capacity and has a tight strategic fit with the economic need to enhance the revenue productivity of expensive capital assets. But there simply can’t be great confidence that the price level will rise steadily at any substantial rate, such as 4 per cent. Although it makes sense to start with a value chain for a whole business, searching for variations by segment can reveal important differences in each product’s cost competitiveness and the company’s unwitting cross-subsidy of unprofitable products. Strategic actions to eliminate a cost … The major causes of the shift in cost competitiveness involved differing inflation rates in the prices for production inputs, but technological changes and higher Japanese labor productivity also worked against the United States. This activity appraisal can be applied on commercial transactions, business or proposed policy, or an impending project. 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. In 1981, however, the price of crude shot up 44.4%, while the rise in gas prices was only 23.5%. 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. By narrowing the product line, the company can allocate expensive production capacity to its most attractive items and market segments. Walmart has enormous economies of scale. Only a detailed analysis will reveal the trade-offs between higher and lower capital costs and lower and higher operating costs and what to do about them. All rights reserved. Therefore, in a perfectly competitive market, the main problem for a profit-maximizing firm is not to determine the price of its product but to adjust its output to the market price so that profit is maximized. There are some constraints on this strategy. A company's cost competitiveness is largely a function of how efficiently it manages its internally performed value chain activities and the costs in the value chains of its suppliers and forward channel allies. The Brookings Institution, 1981), p. 173. A marketing strategy is a business's general scheme for developing a customer base for the product or service the business provides. (1) Cost analysis is the review and evaluation of any separate cost elements and profit or fee in an offeror’s or contractor’s proposal, as needed to determine a fair and reasonable price or to determine cost realism, and the application of judgment to determine how well the proposed costs represent what the cost of the … < Previous Question 1 Next > Two useful tools for determining whether a company's customer value proposition. Exhibit II shows a simplified value chain comparison of the shifting costs and competitive advantage between U.S. and Japanese steel producers from 1956 to 1976. Sometimes the competitive advantage is only accessible through a certain target market, with a specific product or service or with a specific location. 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 But few have factored it into their competitive strategies. When over-all prices are rising rapidly, their exact course is bound to be unpredictable. To build value for the long term, you needed to develop distinct competencies that your competitors would not be able to imitate, and then find a way to apply them as an advantage in the markets in which you … The easier it is to replicate, the faster competition catches up. In business school, we learned that companies need to develop sustainable competitive advantages. Companies also consider the huge research and development (R&D) costs incurred to bring a drug to market, a consideration that often leads to high prices for new drugs. Long-term contracting for coal-fired generating capacity from neighboring utilities is now more economical. Observing that all its rivals were forced to do the same, XYZ felt secure in its strategy. Two useful tools for determining whether a company's prices and costs are competitive are: a. competitive strength analysis and SWOT analysis. The key cost drivers are the timing of capacity additions and investment and capacity use. 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. 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. Each seller and buyer takes the price as determined. In my judgment, the impact of inflation on balance sheets is considerably more serious than that on income statements. Exhibit II Value chains for U.S. and Japanese steel companies: a comparison between 1956 and 1976. Most companies that are making a profit have a competitive advantage of some kind. Customers became so price sensitive that they cut their use of electricity and average loads from a rapid annual 6% to 8% growth rate down to a mature industry rate of 1% to 3%. Many U.S. steel companies have seen their variable operating costs rise more quickly than those of Asian producers, and the capital costs of modernizing large, integrated mills seem prohibitive. 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. From my research and work with companies facing sharply rising capital requirements, I’ve seen the value of doing strategic cost analysis to identify ways to defend against, and sometimes escape, a competitive pricing trap. When two or more acceptable offers are received and the lowest price is selected, the price of the lowest offeror can be assumed to be fair and reasonable. Most companies are either founded on a competitive advantage or can apply certain criteria toward finding their competitive advantage. John R. Opel, IBM’s CEO, once said, “We want to be the lowest-cost producer of everything we make. 6. 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. The following graph shows the cost curves for a firm in a perfectly competitive market. Furthermore, suppose that all the firms in this industry are identical and that a representative firm’s total cost is: TC = 100 + 5q + q2 A target cost is the maximum amount of cost that can … In such cases, cite the price of prior purchase and note if it was competitive or based on catalog price or other. Copyright © 2020 Harvard Business School Publishing. Because inflation affects each company in an industry differently, the first step is to diagnose your changing cost If the price of the product increases for every unit sold, then total revenue also increa… 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. 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. It is possible that Berkshire Hathaway's competitive advantage is perfectly unique: Warren Buffet's mind. Then deflation began, market demand slackened, and a deep recession set in. Cost-benefit Analysis dete… The company’s managers believed that competitors held a cost advantage. The capital costs for a new steel mill in the United States have escalated to about nine times the cost of the embedded technology.4 While production costs for new plants have dropped $60 per ton (because the amount of labor and energy necessary to produce a ton has dropped), the capital costs for a new mill are $130 per ton higher and push unit costs up a net $70, or 10% above the market price per ton of steel. 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. After all, something is compelling for consumers to do business with them. 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. The most common methods or criteria used to determine whether a price is fair and reasonable are: Price competition. 3, 12–13; © 1970 by New York University Press. 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. For example, the Canadian surplus of cheap hydroelectric power and New England’s 30% electricity surplus threaten the once sound economics of New Hampshire’s Seabrook nuclear project (whose original estimated price tag of $1 billion for units 1 and 2 has ballooned to $5.2 billion). 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. prices. Competitive advantages can be found almost anywhere. It could be that you are able to offer a comparable service at a lower price, in which case it is time to review your processes to determine where you reap cost savings. The increased demand for ad space results in a competitive marketplace, which can lead to aggressive bids and bigger campaign budgets that inflate the cost of advertising … To begin with, companies usually experience a different rate and pattern of cost change for each cost component. 1. The total revenue for a firm in a perfectly competitive market is the product of price and quantity (TR = P * Q). A differentiation strategy based on the intangibles of image, buyer confidence, and brand recognition has a stronger chance of being successful when the costs of creating or maintaining the intangibles are not greatly affected by the forces of rising operating costs. While there is nothing inherently wrong in making a series of short-run pricing changes to cover chronically rising costs, the fatal mistake is to fail to recognize why and how strategy must deal with almost certainly uneven cost changes among rival companies. To remain competitive, all the companies must offer quality products at cutthroat prices. Cost competitive advantages can easily disappear with the introduction of a new competitor or new technology. Next, you assess the long-run shifts in the cost position of your competitors relative to your own. They may actually tend to outpace the price level on the average in the long run, but only with wide swings and great uncertainty. 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 will have to consider the option to harvest or divest unless the industry’s growth prospects are bullish despite inflation, or unless the industry has an immature technology and “breakthroughs” can take away some sources of rising costs. 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. 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. 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. 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. 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. The opportunity for safe saving is lost in a period of sizable and unpredictable price increases. Use the sliders to adjust the firm's productive capacity, fixed costs and variable costs, and see how the cost curves change in response. Much of this can be performed through deduction and a process of elimination. Brand equity refers to the value a company gains from a product with a recognizable and admired name when compared to a generic equivalent. XYZ’s predicament is shared by companies in many capital-intensive industries. 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 … Unchecked inflation can radically change the whole cost structure of an entire industry. Dog eat dog refers to intense competition in a market where products or services have become commoditized. Exorbitant Drug Costs Take the time to look at the differences between your competitor's goods and services and your own. The major lesson in strategy formulation that emerges from this analysis is that a company must closely gear its strategy to the long-term changes in the industry’s cost economics. The investment is expected to pay a good return through the use of lower-cost crude oil and improved refining technology to increase the yields of higher-margin products. Finally, you factor the implication of future inflation into your own costs and those of the competition. Cost realism analysis Cost examination Price realism analysis Cost analysis 6) If an offeror is expected to be exempted from submitting cost or pricing data, you should: [Determine whether to use price analysis or cost analysis to evaluate the … This hold share strategy can work under conditions of strong or weak market demand. It is likely, of course, that a substantial portion of any cost disadvantage a company has lies within its own in-house cost structure. Less vulnerable are companies that (1) differentiate in parts of the value chain less affected by costs, (2) cater to price-insensitive buyers, or (3) enhance the value of their differentiation features enough to outrun the effects of higher unit costs. While the first step is grounded in … In these cases, it might be best to focus business strategy toward these areas, highlighting and pressing your advantage. When demand is expected to remain slack, the best position to defend is a hold-share strategy, in which long-term cost competitiveness is protected by keeping new investments in fixed assets to a minimum. If the tables are turned and inflation hits operating costs unevenly while capital costs remain equal, a company can protect cost competitiveness if it: (1) innovates around troublesome operating cost components as new investments are made in plant and equipment, (2) translates the resulting cost advantage into a gain in market share, or (3) offsets any increases in operating costs that do arise with new efficiencies associated with added sales volume and higher market share. Nearly every electric utility that is constructing nuclear power stations to meet future generating needs is being squeezed by escalating capital costs and a market place replete with generating capacity. During the 1970s, the annual cost increases for British Steel’s key components rose as little as 8% to as much as 24%, and the year-to-year patterns from component to component fluctuated markedly.2, This kind of cost differential helped reverse the international advantage U.S. steel producers once had. This kind of analysis provides the backdrop for formulating an effective strategy and defense to help you avoid (or escape from) the competitive pricing trap, whether you want to become the low-cost producer in the industry, focus your sales efforts on a particular segment of the market, or differentiate your product from your competitors’. and costs are competitive are .f. In the next phase of strategic cost analysis, the company has to assess how rising cost pressures will affect its growth objectives and market share potential. Given price, then total revenue will increase set of intangibles owned and legally protected by a 's... 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