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. Use the sliders to adjust the firm's productive capacity, fixed costs and variable costs, and see how the cost curves change in response. Cost of acquisition is the total of expenses incurred when a business acquires a new client or a new asset. Most companies are either founded on a competitive advantage or can apply certain criteria toward finding their competitive advantage. 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. 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. 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. From: Economics for Policymaking, Selected Essays of Arthur M. Okun, ed. 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. Because every company within an industry has a slightly different cost structure for manufacturing inputs, varied inflation rates for these inputs can open up important cost differentials between competitors. Cost competitive advantages can easily disappear with the introduction of a new competitor or new technology. Economies of scale are cost reductions that occur when companies increase production. 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. Highly skilled labor 3. 1. 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. According to Hauht, the price analysis strategy is effective when applied to products that can be contrasted to other, “similar” procurements. Market orientation is a business approach that prioritizes identifying the needs and desires of consumers and creating products that satisfy them. 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. In such cases, cite the price of prior purchase and note if it was competitive or based on catalog price or other. 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. Manufacturing companies in such energy-intensive industries as pulp and paper, chemicals, and primary metals feel the competitive impact of fuel cost differences. [List the factors that affect cost analysis and cost realism analysis considerations.] Southland Corporation saw its costs for new 7–Eleven convenience food stores rise because of the explosion in the industry. Furthermore, suppose that all the firms in this industry are identical and that a representative firm’s total cost is: TC = 100 + 5q + q2 The goal is to be the very best in your field. By narrowing the product line, the company can allocate expensive production capacity to its most attractive items and market segments. Some restaurants thrive because of their location. Many electric utility executives have begun to push the use of this approach. It's impossible to determine whether lowering costs or increasing revenue is more important across the board for all companies. Rising capital costs will hit your company hard if you rely on a differentiation strategy to win market share. In 1956, they could produce a ton of cold-rolled sheet steel for $35 less than the Japanese. 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. 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. That’s in an industry that started from a base of $20 billion in sales and $3 billion in net income. 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. Intellectual property is a set of intangibles owned and legally protected by a company from outside use or implementation without consent. Strategic actions to eliminate a cost … “IBM: The Giant Puts It All Together,” Dun’s Business Month. The fixed costs, like administration, are spread over more units of production.Sometimes the company can … 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). The Brookings Institution, 1981), p. 173. After constructing a value chain, a company may discover it can reestablish cost competitiveness only if it goes outside in-house operations. At IBM, top management decided that the economic impact of rising operating costs would outweigh that of escalating capital costs. Robert W. Crandall, The U.S. Steel Industry in Recurrent Crisis (Washington, D.C. Sometimes the competitive advantage is only accessible through a certain target market, with a specific product or service or with a specific location. Avoiding pricing traps requires a strategic view of the present cost structure, of how the structure changes, and of the implications for gaining a sustainable competitive advantage. Such a move may produce a durable competitive edge, especially if it catches competitors by surprise. As a result, steel companies must either refurbish their inefficient mills or close them down. 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. When over-all prices are rising rapidly, their exact course is bound to be unpredictable. The costs are planned in the early phase of a new product by understanding the market thoroughly. 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. Conduct a thorough market pricing analysis. But there simply can’t be great confidence that the price level will rise steadily at any substantial rate, such as 4 per cent. 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. In these cases, it might be best to focus business strategy toward these areas, highlighting and pressing your advantage. Brignall, and A.R. Petroleum refining provides an interesting example of how to defend against long-term price increases in a key resource input. 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. To find a lasting competitive advantage, look for something that your competitors cannot easily replicate or imitate. Moreover, the size of the increase in capital requirements can impose a severe financial burden. The shifts in the several cost components are dramatic. However, if the contracting officer has reason to believe exceptional circumstances exist and has sufficient data available to determine a fair and reasonable price, … Both Sun Oil and IBM have benefited from committing investment capital on a timely basis to strategic moves designed to yield strong cost positions vis-à-vis their competitors. < Previous Question 1 Next > Two useful tools for determining whether a company's customer value proposition. 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. But these risks are much less serious than those associated with general inflation. 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. 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. 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 … Scanning the environment to determine a company's best and most profitable customers The spotlight in analyzing a company's resources, internal circumstances and competitiveness includes such questions/concerns as What are the company's resource strengths and weaknesses and its external opportunities and threats 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%. To understand why this is so, consider the basic definition of profit:Since a perfectly competitive firm 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. 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. A target cost is the highest amount of cost … 6. This is where a value chain comes in. 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. In business school, we learned that companies need to develop sustainable competitive advantages. To remain competitive, all the companies must offer quality products at cutthroat prices. 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. 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. Dog eat dog refers to intense competition in a market where products or services have become commoditized. and costs are competitive are .f. December 1982, p. 56. The value chain is revealing but not simple. It is noted that generally where the difference in prices … After all, your competitive advantage is, by definition, something your competitors do not have. (XYZ is a name I am using to designate a composite of several companies.) 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. 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 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 … 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. 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. 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. The most common methods or criteria used to determine whether a price is fair and reasonable are: Price competition. 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. Eventually it will enjoy lower fixed costs than competitors that add capacity later, when investment costs are higher. There are some constraints on this strategy. Some restaurants thrive because of their location. The following graph shows the cost curves for a firm in a perfectly competitive market. The success of differentiation strategies in an environment of rapidly rising operating costs varies according to the basis for differentiation. Then deflation began, market demand slackened, and a deep recession set in. Ashland Oil figures it will reduce raw materials costs by 20% to 25% through a $240 million upgrading of its refineries. A unique geographic location 4. 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. Take the time to look at the differences between your competitor's goods and services and your own. Much of this can be performed through deduction and a process of elimination. : The MIT Press, 1983), pp. 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. 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. 7. 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. A perfectly competitive firm has only one major decision to make—namely, what quantity to produce. 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. 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. 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. 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. The offers that appear in this table are from partnerships from which Investopedia receives compensation. 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 After all, something is compelling for consumers to do business with them. 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). To illustrate the strategic payoff of constructing a value chain, look again at Exhibit I. 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. To catch up, they considered investment to modernize existing facilities or to build new cost-competitive plants. 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 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. 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’. 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. An increase in price, with no current catalog or competition, should be about the current rate of inflation between the time of the last competition and the commitment of the current order. 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. Also, try changing the market price of the product to create break-even, profit, and loss situations. See R.A. Bryer, T.I. 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. You will have to adjust if, while pushing capacity to the limit, you find operating costs beginning to creep up. Cost-benefit Analysis dete… Season. In my judgment, the impact of inflation on balance sheets is considerably more serious than that on income statements. XYZ was caught squarely in a competitive pricing trap. Increasing capital costs can push the incremental costs of fixed assets and capacity far above the historic cost of existing plant and equipment. It is likely, of course, that a substantial portion of any cost disadvantage a company has lies within its own in-house cost structure. 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. 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. (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 … 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. The time of year can also impact how much Facebook ads are. 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. In a noninflationary environment, people can acquire various liquid assets, earn a reasonable return on them, and count on them as the means to acquire a basket of consumer goods in the event of especially large needs or declines in income. 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. 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. 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. The company’s managers believed that competitors held a cost advantage. Furthermore, let’s focus the analysis on the extremes, where inflation drives up either operating costs or capital costs. It must also forecast future market volume accurately and target its market share objectives to coincide with a relatively lower-cost industry position. There are limits to how much more buyers will pay for a product that is fancier than its rivals’. A narrow customer base helps limit the need for capacity expansion and shields the company from the cost of escalating capital requirements. Either way, you lock into a low-cost position with fewer dollars of fixed asset investment. You may find it hard to hold onto your share of the market and, more important, you probably can’t invest your way out of the cost disadvantage in the short run (because the new capital requirements are unattractively high and leave no room for a return on investment at going market prices for the product). 3. 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. XYZ’s profits eroded while the others’ remained buoyant. 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. 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). Long-term contracting for coal-fired generating capacity from neighboring utilities is now more economical. 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 … 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. 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. Access to natural resources that are restricted to competitors 2. At some point, the buyers may be attracted to a more generic product at a lower price. In neither case do companies have to worry so much about the timing of decisions to add or replace production facilities. 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. All rights reserved. A marketing strategy is a business's general scheme for developing a customer base for the product or service the business provides. 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. Brand equity refers to the value a company gains from a product with a recognizable and admired name when compared to a generic equivalent. 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. It is possible that Berkshire Hathaway's competitive advantage is perfectly unique: Warren Buffet's mind. Price patterns across fuel types have varied widely from fuel source to fuel source and from year to year. Exorbitant Drug Costs Harvard Business Publishing is an affiliate of Harvard Business School. These two main types of competitive advantage determine whether your company succeeds by being a cost leader or by differentiating its … Total revenue is going to increase as the firm sells more, depending on the price of the product and the number of units sold. Competitive advantages can be found almost anywhere. Like all assets, intangible assets are those that are expected to generate economic returns for the company in the fu… 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. Maunders, Accounting for British Steel (Aldershot, England, Gower, 1982), p. 124. It can also try to restructure the whole value chain by substituting its own distribution networks for dealers and franchises. 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. 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