Coca-Cola, of course, has that secret recipe and huge brand name recognition. 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. Dog eat dog refers to intense competition in a market where products or services have become commoditized. As a result, steel companies must either refurbish their inefficient mills or close them down. 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. Maunders, Accounting for British Steel (Aldershot, England, Gower, 1982), p. 124. 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. An airline company might have locked in a low-price fuel contract before prices rose, allowing it to price customers away from other airlines. 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. 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. 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. Then deflation began, market demand slackened, and a deep recession set in. 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. 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. Long-term contracting for coal-fired generating capacity from neighboring utilities is now more economical. All rights reserved. To catch up, they considered investment to modernize existing facilities or to build new cost-competitive plants. A relative cost shift can occur in any one of three main areas—suppliers, the company’s own segment, or forward channels. The key is to contain new spending commitments that are affected by rising capital costs. To understand why this is so, consider the basic definition of profit:Since a perfectly competitive firm After all, something is compelling for consumers to do business with them. Robert W. Crandall, The U.S. Steel Industry in Recurrent Crisis (Washington, D.C. In the same way, a surplus of generating capacity in the Pacific North-west, exacerbated by projected rate increases of 100% to 200%, has brought the once strong Washington Public Power Supply System to bond default and even to the brink of bankruptcy. 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. 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. Many electric utility executives have begun to push the use of this approach. By narrowing the product line, the company can allocate expensive production capacity to its most attractive items and market segments. Highly skilled labor 3. The value chain is revealing but not simple. 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. 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 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 … 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. This activity appraisal can be applied on commercial transactions, business or proposed policy, or an impending project. 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. 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. 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. 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. When over-all prices are rising rapidly, their exact course is bound to be unpredictable. 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. XYZ’s predicament is shared by companies in many capital-intensive industries. < Previous Question 1 Next > Two useful tools for determining whether a company's customer value proposition. 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. Increasing capital costs can push the incremental costs of fixed assets and capacity far above the historic cost of existing plant and equipment. The time of year can also impact how much Facebook ads are. Price patterns across fuel types have varied widely from fuel source to fuel source and from year to year. While the first step is grounded in … This is where a value chain comes in. 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. Exhibit II Value chains for U.S. and Japanese steel companies: a comparison between 1956 and 1976. Competitive advantages can be found almost anywhere. 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. Furthermore, suppose that all the firms in this industry are identical and that a representative firm’s total cost is: TC = 100 + 5q + q2 XYZ’s profits eroded while the others’ remained buoyant. 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). 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. Strategic actions to eliminate a cost … Finally, you factor the implication of future inflation into your own costs and those of the competition. 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). “IBM: The Giant Puts It All Together,” Dun’s Business Month. 7. Like all assets, intangible assets are those that are expected to generate economic returns for the company in the fu… After all, your competitive advantage is, by definition, something your competitors do not have. Walmart has enormous economies of scale. 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. Here the strategy options are more complex. Two useful tools for determining whether a company's prices and costs are competitive are: a. competitive strength analysis and SWOT analysis. 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. Total revenue is going to increase as the firm sells more, depending on the price of the product and the number of units sold. 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. Because inflation affects each company in an industry differently, the first step is to diagnose your changing cost A target cost is the maximum amount of cost that can … A buyers’ market emerged. prices. According to Hauht, the price analysis strategy is effective when applied to products that can be contrasted to other, “similar” procurements. Brand equity refers to the value a company gains from a product with a recognizable and admired name when compared to a generic equivalent. But few have factored it into their competitive strategies. Eventually it will enjoy lower fixed costs than competitors that add capacity later, when investment costs are higher. Some restaurants thrive because of their location. In 1956, they could produce a ton of cold-rolled sheet steel for $35 less than the Japanese. Intellectual property is a set of intangibles owned and legally protected by a company from outside use or implementation without consent. In peak shopping seasons, businesses tend to spend more on advertising. Joseph A. Pechman (Cambridge, Mass. 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. Sustained inflation leaves an imprint on current operating costs as well as on the cost of fixed assets and new capacity. 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. Access to natural resources that are restricted to competitors 2. 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 Because it is committed to cost-containing retrenchment and won’t encounter capacity-induced cost increases, a company can simply sell under the price umbrella of rivals and enjoy a long “cash harvest” as competitors raise prices to compensate for the higher costs associated with capacity expansion or capacity replacement. 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. When Southland first bought sites in the 1960s, few other companies were competing for the kind of location it needed. 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). 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 following graph shows the cost curves for a firm in a perfectly competitive market. Most difficult is the necessity of estimating the same cost elements for its rivals—an advanced stage in the art of competitive intelligence. 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. A narrow customer base helps limit the need for capacity expansion and shields the company from the cost of escalating capital requirements. Like the weather, inflation is a lot easier to talk about than to do something about…. Most companies are either founded on a competitive advantage or can apply certain criteria toward finding their competitive advantage. 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. It's impossible to determine whether lowering costs or increasing revenue is more important across the board for all companies. By 1976, Japanese companies were producing a ton for $35 less than their American competitors.3. Otherwise, a strategy to be the cost leader will beat a performance-based differentiation strategy. Capital costs can rise because of unforeseen difficulties with expanding operations. However, if the contracting officer has reason to believe exceptional circumstances exist and has sufficient data available to determine a fair and reasonable price, … 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). 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. There are car manufacturers that have better production processes than their competitors. Competitive advantages can be found almost anywhere. 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. 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’. Observing that all its rivals were forced to do the same, XYZ felt secure in its strategy. The most common methods or criteria used to determine whether a price is fair and reasonable are: Price competition. 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 The total revenue for a firm in a perfectly competitive market is the product of price and quantity (TR = P * Q). 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). 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 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. That’s in an industry that started from a base of $20 billion in sales and $3 billion in net income. A perfectly competitive firm can sell as large a quantity as it wishes, as long as it accepts the prevailing market price. After constructing a value chain, a company may discover it can reestablish cost competitiveness only if it goes outside in-house operations. 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. 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). 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. Each seller and buyer takes the price as determined. Higher margins can be expected both from having a favorable cost position and from “trading up” the use of existing capacity. Unchecked inflation can radically change the whole cost structure of an entire industry. It is noted that generally where the difference in prices … 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. Furthermore, let’s focus the analysis on the extremes, where inflation drives up either operating costs or capital costs. A target cost is the highest amount of cost … 5. 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. 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. 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. 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. Take the time to look at the differences between your competitor's goods and services and your own. 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. Rising capital costs will hit your company hard if you rely on a differentiation strategy to win market share. 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 … 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. 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. During years of chronic inflation, the managers of XYZ Corporation developed the habit of raising prices to cover rising costs and defend profit margins. The fixed costs, like administration, are spread over more units of production.Sometimes the company can … 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 find a lasting competitive advantage, look for something that your competitors cannot easily replicate or imitate. The key cost drivers are the timing of capacity additions and investment and capacity use. 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. To begin with, companies usually experience a different rate and pattern of cost change for each cost component. The opportunity for safe saving is lost in a period of sizable and unpredictable price increases. Petroleum refining provides an interesting example of how to defend against long-term price increases in a key resource input. Either way, you lock into a low-cost position with fewer dollars of fixed asset investment. Interestingly enough, a company with a long-term shrink-abandon strategy may be able to benefit handsomely from sharply rising costs for new plants and equipment. 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. 1. Moreover, the size of the increase in capital requirements can impose a severe financial burden. 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. Cost competitive advantages can easily disappear with the introduction of a new competitor or new technology. The most threatened are those “quality” and “service” types of differentiation strategies that require skilled craftsmanship, high labor content, customized design, elaborate marketing and distribution networks, and personalized extras—the costs of which rise at above-average rates. 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 shifts in the several cost components are dramatic. 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. 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. In these cases, it might be best to focus business strategy toward these areas, highlighting and pressing your advantage. You will have to adjust if, while pushing capacity to the limit, you find operating costs beginning to creep up. 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. The implementation of ABC … (XYZ is a name I am using to designate a composite of several companies.) 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. If the price of the product increases for every unit sold, then total revenue also increa… See R.A. Bryer, T.I. In business school, we learned that companies need to develop sustainable competitive advantages. To illustrate the strategic payoff of constructing a value chain, look again at Exhibit I. 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. 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. But there simply can’t be great confidence that the price level will rise steadily at any substantial rate, such as 4 per cent. 1. Reprinted with the permission of the publisher. Also, try changing the market price of the product to create break-even, profit, and loss situations. In 1981, however, the price of crude shot up 44.4%, while the rise in gas prices was only 23.5%. The success of differentiation strategies in an environment of rapidly rising operating costs varies according to the basis for differentiation. The offers that appear in this table are from partnerships from which Investopedia receives compensation. 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. This can be roughly … Season. 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. 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. Conduct a thorough market pricing analysis. 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). Some restaurants thrive because of their location. 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