Low-cost inputs are essential for supporting competitive advantage, especially if the firm adopts a cost leadership strategy.
What’s it: A low-cost input refers to a resource used by the company to produce output and has a lower price than average. It can be labor, capital, land, and raw materials.
Under a cost leadership strategy, the company competes as a low-cost producer. To achieve a competitive advantage, they must have a lower cost structure than competitors to excel. One way to do this is to obtain low-cost inputs.
Low-cost producers usually sell standard products and target the mass market. The potential demand available in such a market is significant, allowing them to sell larger outputs and achieve economies of scale.
Then, in selling their products, low-cost producers can choose two alternatives. First, they set prices at the same level as competitors’ averages.
Second, they set it slightly below the competitor’s average. By doing it, they can increase their market share and sell more because low prices attract more consumers to buy.
What is the alternative strategy to gain a competitive advantage?
Before discussing further, let’s briefly discuss what competitive advantage is.
Competitive advantage is a company’s superior position compared to the average competitors. We can measure it from the company’s success in obtaining above-average profits, measured using return on invested capital (ROIC). A higher-than-average ROIC indicates the company can generate higher returns than competitors for every capital invested.
To obtain above-average profits, the company must earn higher revenues or have a lower cost structure than competitors. Combining the two is ideal.
How to do it? Porter’s generic strategy tells us the company’s main foundation for achieving it. He proposed two alternative strategies:
- Cost leadership
- Differentiation
Cost leadership strategy
A cost leadership strategy relies on a lower cost structure than competitors. Although selling products at an average price, the company earns more profit due to lower costs.
Or, the company may lower its price slightly below the industry average. It allows the company to attract more demand, increase market share, and strengthen its market position.
Cost leadership benefits by achieving economies of scale as quickly as possible. This strategy is suitable for price-conscious target markets where consumers care more about price than any other aspect of the product.
It is also suitable if substitute products are abundantly available in the market. Any small increase in price can change consumer preferences, prompting them to turn to substitutes.
Cost leadership strategies are usually popular among consumer staples such as food and beverages. As a result, companies in the market face high demand but compete with many substitutes.
Differentiation strategy
A differentiation strategy relies on uniqueness to attract customers and encourage them to be willing to spend more on the product. Uniqueness can be designed from quality, performance, or other product attributes.
Branding is another strategic aspect. Through it, companies can influence consumers’ perceptions of products. For example, clothes from fashion houses can be expensive because they invest in branding, and the fashion house did it successfully.
Then, by charging a higher price, the company can get the same total revenue as cost leadership but sell less volume. That’s because, under a differentiation strategy, they enjoy higher profit margins.
How do low-cost inputs affect competitive advantage?
As I have already mentioned, competitive advantage through a cost leadership strategy requires companies to achieve a lower-than-average cost structure. It can be done by:
- Achieving higher economies of scale
- Building efficient and effective business processes
- Increasing productivity
- Getting input at a lower price
Under a cost leadership strategy, companies typically manufacture standardized products. Then, they market them to the mass market, where there is significant demand. Thus, when they can sell output at high volumes and produce at higher economies of scale, their average cost lowers.
The next way is to build efficient and effective business processes. Superior business process management streamlines operations and eliminates some unnecessary activity or expense. It can also add value to the customer, for example, by enabling faster product delivery.
Increasing productivity can also increase profits. Although it may not affect the existing cost structure, the company can produce more output.
Take a simple example. A company has 10 staff, each producing 20 units per hour. When their productivity increases, for example, to 25 units per hour, the company can produce and sell more output. At the same time, labor costs are fixed because the number of staff does not change.
Finally, lowering input prices can lower the cost structure. As a result, companies save money that they would otherwise spend on paying suppliers.
Input includes raw materials, labor, used financial capital, and fixed assets. There are many ways to lower input costs, including buying in bulk to get a discount.
How do firms obtain low-cost inputs?
There are several ways for firms to obtain low-cost inputs.
Labor costs. Companies relocate production facilities to developing countries where wages are low to save on labor costs. Another way is to get a more productive workforce. Although it may pay higher wages, the firm can produce more output.
Capital costs. Companies can access the capital market. For example, issuing bonds or shares cost less than borrowing from a bank. Using internal sources—if sufficient—is also inexpensive because the company does not have to pay regular interest like bonds or bank loans.
Land costs. The company develops online channels rather than relying on conventional shops to sell products.
- Manufacturers can choose from the agglomeration area where many other manufacturers are located. There, they can obtain cost savings through external economies of scale.
- Small businesses often also operate in the owner’s home to save costs. They don’t have to pay rent.
Raw materials and other inputs. Choosing a location close to the source of raw materials can save costs such as logistics. Choosing the right supplier also saves raw material costs, such as buying from large-scale suppliers. They are usually efficient because they have high economies of scale.
- Another way is to work with suppliers with lenient credit policies. Soft credit gives companies more flexibility. They can use the money for other purposes before handing it over to suppliers.
- Ordering on a large scale also allows companies to obtain discounts. Instead of buying from several suppliers, they can choose one supplier for several related inputs.
