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. 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. 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. 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. 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%. An airline company might have locked in a low-price fuel contract before prices rose, allowing it to price customers away from other airlines. Ashland Oil figures it will reduce raw materials costs by 20% to 25% through a $240 million upgrading of its refineries. The opportunity for safe saving is lost in a period of sizable and unpredictable price increases. The Brookings Institution, 1981), p. 173. 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 following graph shows the cost curves for a firm in a perfectly competitive market. The company made a big commitment to capital spending. Joseph A. Pechman (Cambridge, Mass. 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. But there simply can’t be great confidence that the price level will rise steadily at any substantial rate, such as 4 per cent. XYZ’s predicament is shared by companies in many capital-intensive industries. When over-all prices are rising rapidly, their exact course is bound to be unpredictable. Observing that all its rivals were forced to do the same, XYZ felt secure in its strategy. 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. Some restaurants thrive because of their location. Brand equity refers to the value a company gains from a product with a recognizable and admired name when compared to a generic equivalent. Many electric utility executives have begun to push the use of this approach. Furthermore, let’s focus the analysis on the extremes, where inflation drives up either operating costs or capital costs. 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. 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. Long-term contracting for coal-fired generating capacity from neighboring utilities is now more economical. It is likely, of course, that a substantial portion of any cost disadvantage a company has lies within its own in-house cost structure. 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. Access to natural resources that are restricted to competitors 2. 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. Each seller and buyer takes the price as determined. Price patterns across fuel types have varied widely from fuel source to fuel source and from year to year. 6. 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). Next, you assess the long-run shifts in the cost position of your competitors relative to your own. 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. (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. Walmart has enormous economies of scale. XYZ was caught squarely in a competitive pricing trap. 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. (XYZ is a name I am using to designate a composite of several companies.) Because inflation affects each company in an industry differently, the first step is to diagnose your changing cost That’s in an industry that started from a base of $20 billion in sales and $3 billion in net income. Like all assets, intangible assets are those that are expected to generate economic returns for the company in the fu… 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. In these cases, it might be best to focus business strategy toward these areas, highlighting and pressing your advantage. Eventually it will enjoy lower fixed costs than competitors that add capacity later, when investment costs are higher. Once a secure geographic monopoly—and essentially a commodity business—the electric utility industry is now in the throes of price warfare in the wholesale and bulk power market segments, with low-cost producers in a position to take business away from higher-cost suppliers. The shifts in the several cost components are dramatic. Performing a price analysis typically inv… A relative cost shift can occur in any one of three main areas—suppliers, the company’s own segment, or forward channels. In such cases, cite the price of prior purchase and note if it was competitive or based on catalog price or other. 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. 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. As a result, steel companies must either refurbish their inefficient mills or close them down. The levelized cost of energy (LCOE) is a measure of a power source that allows comparison of different methods of electricity generation on a consistent basis. In business school, we learned that companies need to develop sustainable competitive advantages. 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. A marketing strategy is a business's general scheme for developing a customer base for the product or service the business provides. 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. Either way, you lock into a low-cost position with fewer dollars of fixed asset investment. [List the factors that affect cost analysis and cost realism analysis considerations.] If you increase the number of units sold at a given price, then total revenue will increase. The easier it is to replicate, the faster competition catches up. During years of chronic inflation, the managers of XYZ Corporation developed the habit of raising prices to cover rising costs and defend profit margins. 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. Unchecked inflation can radically change the whole cost structure of an entire industry. 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. You will have to adjust if, while pushing capacity to the limit, you find operating costs beginning to creep up. A narrow customer base helps limit the need for capacity expansion and shields the company from the cost of escalating capital requirements. See R.A. Bryer, T.I. It must also forecast future market volume accurately and target its market share objectives to coincide with a relatively lower-cost industry position. And most managers, particularly those in capital-intensive industries, have not paid enough attention to the way increasing capital requirements affect […]. “IBM: The Giant Puts It All Together,” Dun’s Business Month. 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. < Previous Question 1 Next > Two useful tools for determining whether a company's customer value proposition. A perfectly competitive firm has only one major decision to make—namely, what quantity to produce. When market demand is strong, the company can go along with the price increases that more growth-minded companies need to cover the incremental unit costs associated with new investments in plant and equipment. Target costing is an approach to determine a product's life-cycle cost which should be sufficient to develop specified functionality and quality, while ensuring its desired profit.It involves setting a target cost by subtracting a desired profit margin from a competitive market price. Capital costs can rise because of unforeseen difficulties with expanding operations. This is where a value chain comes in. Most companies are either founded on a competitive advantage or can apply certain criteria toward finding their competitive advantage. Strategic actions to eliminate a cost … 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. In countering these strategies, the Sun Company decided not to upgrade its Pennsylvania refinery and gambled that the industry’s shift to low-quality crude would leave Sun ample access to high-quality crude and that the price difference between high-quality crude and low-quality crude would not average the $6 to $7 per barrel that the other companies had used to justify their investments. The time of year can also impact how much Facebook ads are. A unique geographic location 4. 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. 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. There are limits to how much more buyers will pay for a product that is fancier than its rivals’. Furthermore, suppose that all the firms in this industry are identical and that a representative firm’s total cost is: TC = 100 + 5q + q2 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. A buyers’ market emerged. 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. 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 … Managers must think strategically about the long-run implications of short-run cost increases and be creative in finding ways to capture a competitive advantage by minimizing the effects of inflationary cost pressures on the company’s strategy. To begin with, companies usually experience a different rate and pattern of cost change for each cost component. 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. 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. 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. Harvard Business Publishing is an affiliate of Harvard Business School. An aluminum producer with plant facilities in the Pacific Northwest today can manufacture more aluminum with fewer dollars than a producer in the Midwest. Economies of scale are cost reductions that occur when companies increase production. Sustained inflation leaves an imprint on current operating costs as well as on the cost of fixed assets and new capacity. According to Hauht, the price analysis strategy is effective when applied to products that can be contrasted to other, “similar” procurements. No company can totally avoid the impact of increasing costs. In 1976, the price of gas fuels went up 35.2%, while that of crude petroleum increased only 8%. 3, 12–13; © 1970 by New York University Press. Cost of acquisition is the total of expenses incurred when a business acquires a new client or a new asset. If we all knew that 4 per cent a year inflation would last through the next decade, nominal interest rates would probably become adjusted to levels offering a reasonable real return, and people would know how much of a consumer market basket their savings accounts could command in 1980. The company’s managers believed that competitors held a cost advantage. Rising capital costs will hit your company hard if you rely on a differentiation strategy to win market share. 5. Exhibit II Value chains for U.S. and Japanese steel companies: a comparison between 1956 and 1976. 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. : The MIT Press, 1983), pp. By including the impact of costs both inside and outside the company, the value chain helps the manager understand the sum total of the shifting cost economies up and down the whole market spectrum. The key is to contain new spending commitments that are affected by rising capital costs. And most managers have learned to adjust to the effect inflation has on current operating 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. In neither case do companies have to worry so much about the timing of decisions to add or replace production facilities. Copyright © 2020 Harvard Business School Publishing. Despite the tediousness of this job, the value chain pays off by exposing the cost competitiveness of your position and the attendant strategic alternatives. Some restaurants thrive because of their location. Such a move may produce a durable competitive edge, especially if it catches competitors by surprise. 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. prices. 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). However, if the contracting officer has reason to believe exceptional circumstances exist and has sufficient data available to determine a fair and reasonable price, … Conduct a thorough market pricing analysis. 3. Here the strategy options are more complex. Otherwise, a strategy to be the cost leader will beat a performance-based differentiation strategy. 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. 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 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. Much of this can be performed through deduction and a process of elimination. Two useful tools for determining whether a company's prices and costs are competitive are: a. competitive strength analysis and SWOT analysis. Also, try changing the market price of the product to create break-even, profit, and loss situations. It can also try to restructure the whole value chain by substituting its own distribution networks for dealers and franchises. This hold share strategy can work under conditions of strong or weak market demand. 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. 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. 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 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. A target cost is the highest amount of cost … 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. 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. At some point, the buyers may be attracted to a more generic product at a lower price. The total revenue for a firm in a perfectly competitive market is the product of price and quantity (TR = P * Q). 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. 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 … But the capital investment costs for such construction were so high that XYZ could expect to earn an attractive return on its investment only by selling products at prices well above the going level—prices that its rivals could continue to undercut. 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. When Southland first bought sites in the 1960s, few other companies were competing for the kind of location it needed. Companies in the middle (either more or less affected by two variables) have less clear-cut strategies. 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. Then deflation began, market demand slackened, and a deep recession set in. 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. 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). 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. While the first step is grounded in … 2. 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. Reprinted with the permission of the publisher. Competitive advantages can be found almost anywhere. It's impossible to determine whether lowering costs or increasing revenue is more important across the board for all companies. 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. Some assets offer a degree of protection against inflation in the sense that their values are likely to move up as consumer prices rise. Cost-benefit Analysis dete… There are car manufacturers that have better production processes than their competitors. The goal is to be the very best in your field. Once a potential competitive advantage is identified, find out how rare it is. These two main types of competitive advantage determine whether your company succeeds by being a cost leader or by differentiating its … 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. Cost-benefit analysis is a process used by project leaders, business owners, and practitioners to understand the systematic calculating and later comparing costs and benefits of a project. 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. 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 … 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. (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 … Dog eat dog refers to intense competition in a market where products or services have become commoditized. By 1976, Japanese companies were producing a ton for $35 less than their American competitors.3. The most common methods or criteria used to determine whether a price is fair and reasonable are: Price competition. 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. To find a lasting competitive advantage, look for something that your competitors cannot easily replicate or imitate. View Test Prep - Ch 4 quiz from MGT 590 at RMU. Competitive advantages can be found almost anywhere. Exorbitant Drug Costs Intellectual property is a set of intangibles owned and legally protected by a company from outside use or implementation without consent. 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. Total revenue is going to increase as the firm sells more, depending on the price of the product and the number of units sold. In my judgment, the impact of inflation on balance sheets is considerably more serious than that on income statements. This can be roughly … 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. 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. 7. In 1956, they could produce a ton of cold-rolled sheet steel for $35 less than the Japanese. 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. Most companies that are making a profit have a competitive advantage of some kind. The key is to find cost-competitive ways to preserve the value of differentiation for the buyer and to contain customer switching by offering lower prices. 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. Cost competitive advantages can easily disappear with the introduction of a new competitor or new technology. A target cost is the maximum amount of cost that can … 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. 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. 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. 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. Southland Corporation saw its costs for new 7–Eleven convenience food stores rise because of the explosion in the industry. Sometimes the competitive advantage is only accessible through a certain target market, with a specific product or service or with a specific location. 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. Once you find this advantage, focus your company's efforts on heightening it. The value chain is revealing but not simple. After all, something is compelling for consumers to do business with them. 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. 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). From: Economics for Policymaking, Selected Essays of Arthur M. Okun, ed. 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. 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