Offering products at the lowest cost available is a strategy businesses often use to stimulate growth. A company is more competitive when it can offer its products at a lower price. To do this, an organization needs to develop a cost leadership strategy. In this article, we will discuss what cost leadership is and how to develop an effective strategy.
What is a cost leadership strategy?
Cost leadership occurs when a company is the category leader for low pricing. To successfully achieve this without drastically cutting revenue, a business must reduce costs in all other areas of the business, such as marketing, distribution and packaging. A cost leadership strategy is a company’s plan to become a cost leader in its category or market.
Benefits of being a cost leader
There are many benefits to being a cost leader. Cost leaders can charge the lowest amount for a product while remaining profitable. Other companies may have to sell their products at a loss to compete with a cost leader’s prices.
Cost leaders can also withstand recessions better than competitors because they are experienced in appealing to consumers with budgets in mind. A company with very low operational costs could go longer without achieving sales goals than a company with high costs.
Also, cost leaders can be more flexible. Since their costs are low, they can discount prices more often or potentially try out other product offerings that other companies might not be able to. Companies with flexibility are likely to attract a larger customer base.
While there are many benefits to being a cost leader, it should also be noted that choosing a cost leadership strategy can be risky. As opposed to offering superior products or brand appeal, a cost-leadership company’s greatest value to consumers tends to be low pricing. Therefore, if a competitor can reduce costs more, it will pose a substantial threat to a company’s consumer base.
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Difference between cost leadership and price leadership
Sometimes people use the terms cost leadership and price leadership interchangeably, but these words do not refer to the same principle. Cost leadership means having the lowest operational cost in an industry and market. Price leadership means having the lowest price. Very frequently, a company that is a cost leader is also the price leader.
Sometimes, a price-leading company chooses to have the lowest prices at all costs and may be less profitable as a result. For example, large online companies sometimes sell items at a loss or a small profit margin to maintain the lowest prices on some of its products and gain a larger market share. These companies would be price leaders but not cost leaders.
Other companies could have lower operational costs and choose to sell products for higher margins to make more of a profit. These companies would be considered cost leaders but not price leaders. However, it is very common for price leadership and cost leadership to overlap in a company that manufactures for the lowest cost and offers the lowest category price.
How to become a cost leader
Most cost leaders rely on a variety of these methods at the same time to keep their operational costs extremely low and maintain their cost leadership status. Ways to become a cost leader include:
- Increasing the production scale
- Implementing advanced technology
- Sourcing raw materials
- Improving efficiency
- Limiting products and services
1. Increasing production scale
Scaling a business can have a significant impact on its ability to become a cost leader. Scaling occurs when a company reduces costs by increasing the volume of materials. For instance, if a company purchases a large amount of fabric instead of only the amount it requires, the company can reduce the cost of goods with a lower per-yard price. Scaling the business helps to secure larger orders of raw materials and supplies, which can further reduce the cost of goods. It also gives a company more power over suppliers, since the company’s orders will make a larger share of the supplier’s business operations.
Scaling a business also insulates it against the competition. Cost leaders that scale tend to have more negotiating power, more flexibility with pricing and the ability to withstand competition more effectively. If a company is in an industry with intense competition, scaling gives it the ability to offer prices that competitors cannot. That company also gains the ability to offer inventory on a much larger scale, so it can capture a bigger segment of the market without worrying about running out of inventory.
2. Implementing advanced technology
Creating or investing in innovative technology can help companies become cost leaders. Sometimes, a company can lower costs by creating a technology that can manufacture more products per hour, limit the number of employees needed for production or provide some other benefit to the process’s efficiency. Patenting a unique technology will also ensure that other companies, including competitors, can’t use it for their own benefit. A company could also sell its patented technology later on to generate more revenue.
Sometimes, already existing software programs can benefit companies by saving time or reducing costs. If the program can reduce the number of employees a company needs in the operational process or the number of errors in the production process, it might be worth the investment. As companies grow, it is only natural to try to find ways to streamline processes along the way.
3. Sourcing raw materials
Buying raw materials for the manufacturing process can be expensive because the supplier also marks up their prices to make a profit. If possible, sourcing raw materials and reducing the reliance on third-party products can lower operational costs.
Sourcing materials directly also gives a company the ability to supply other companies. If a business’s raw material supply greatly exceeds its needs, it can resell it to other manufacturers at a market price as another source of income.
4. Improving efficiency
Increased efficiency can often translate into operational cost savings for companies. One example of this is to use software to reduce the number of people required to work on the process, which would reduce salary payments.
However, reducing employees is not the only way to improve efficiency and reduce costs. Quicker manufacturing times for custom orders means that a company might be able to charge more for speedy service even though a company doesn’t have to pay as much for the electricity and related expenses for making a product. Better efficiency can help companies without custom products, too.
For instance, a company can make 100 cloth diapers an hour in its sewing factory per day. It costs $3,000 a day to run the plant, pay the staff members and cover other expenses. If the company increases efficiency through technology, reorganizing the process to become more efficient, or bulk cut fabrics instead of one piece at a time, that company might be able to manufacture 200 cloth diapers a day for $3,500. The company immediately reduces the operational cost per cloth diaper sold with very little effort.
5. Limiting products and services
One strategy to become a cost leader is for a company to limit its products and services. By having fewer products to manufacture and sell, that company can focus more of its efforts on a few highly profitable products or services. This makes it easier and more likely that that company will be able to scale its operations and get the lowest costs on raw materials and other supplies.
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How to develop a cost leadership strategy
Developing an effective cost leadership strategy takes some time, research and persistence. Officials at a company will likely need to update its cost leadership strategy regularly to account for price increases in labor and raw materials, changes in the market and new competitors. Here is a how-to guide for creating a cost leadership strategy:
- Analyze existing operations.
- Research competitors.
- Identify strategies to reduce costs.
- Keep track of progress.
1. Analyze existing operations
First, assess the organization’s existing operations. It’s important to know the exact costs of every material the company buys and the labor, administration and software that goes into the production of goods and services. This should include costs that may have been overlooked, such as invoicing software, grammar-check subscriptions and word processing software. If the company needs the expense to create its products, those costs should be accounted for in sales prices.
2. Research competitors
Next, thoroughly research competitors. Companies should find out as much as they can about other businesses’ processes and costs so they can identify competitors. Assessing a competitor’s operations can help a company improve its own costs or processes, even if it doesn’t become a cost leader.
3. Identify strategies to reduce costs
Finally, identify strategies that can help to drive down costs and develop actionable plans for implementing these strategies into the business’s operations. This might include following up with suppliers, creating larger supply orders and introducing new technology into the business.
For example, after pressure from workers about compensation, fast food restaurants began to implement touch screen ordering kiosks in select stores. This piece of technology helps to reduce the number of employees needed to run the cash register and makes existing employees available to complete other tasks, including customer service.
4. Keep track of progress
As company leaders implement cost leadership strategies, they must find ways to measure and monitor progress. Cost leadership is a process, and many companies repeat these steps with some regularity.