Cost Leadership

Cost leadership is a strategic approach where a company aims to become the lowest-cost producer in its industry. This strategy often involves streamlining operations, optimizing supply chain management, and leveraging economies of scale to reduce costs. By maintaining lower prices than competitors, cost leaders can attract a broader customer base, potentially increasing market share.

Companies pursuing cost leadership typically focus on efficiency and may invest in technology or processes that enhance productivity. This approach can be particularly effective in highly competitive markets where price sensitivity is significant. However, while cost leadership can lead to increased sales volume, it also requires careful management to ensure that quality is not compromised.

Firms adopting this strategy must be vigilant about their cost structure and continuously seek ways to improve efficiency. Overall, cost leadership can provide a competitive edge, but it demands a commitment to ongoing improvement and adaptation in a dynamic market landscape.

Published in: 2021

By: Joseph Dewey, PhD

Subject Terms

Cost Leadership

Last reviewed: February 2017

Abstract

“Cost leadership” refers to a business marketing plan in which the company resolves to monitor all its costs and produce a good, product, or service at the lowest possible price. A business that uses a cost-leadership model tracks every expenditure and measures each production decision against its potential impact on the bottom line. Ineffectively implemented, cost leadership as a model can generate an atmosphere of worry and insecurity in employees, deflecting the human factor in favor of keeping a company directed to minimizing costs and passing the savings on to the consumer.

Overview

Within a free market all types of business, whether producing a product, selling that product, or providing a service, are necessarily competitive. A business, to maintain its status as a growing and hence successful entity, needs to create and define its image against its own competitors as a way to give consumers a choice, a reason to select its good or its service. It is not enough for a company to monitor its operations, oversee its spending, maintain its trained workforce, and secure transmission routes to get a good or service to the buying public. Branding requires that a company name or logo must be associated with a specific idea, and that idea, ideally, represents the principles by which the entire company—from the people it hires to the processes through which provides its goods or service—is organized and operated.

In the mid-1970s, economist Michael Porter, on the faculty of the prestigious Harvard Business School, began to explore this process of a business and self-definition. How does a business, he posed, decide how to do that business? Can a company run effectively without framing some broad generic goal? Because he was an academic and himself had no specific business experience—he had never run a company, had never hired anybody, had never sold any product or service, indeed had never made critical day to day decisions typical of executives and entrepreneurs—for Porter the question was more an abstract conjecture, a provocative theory to pose and then test.

However, though Porter had no specific background in general business or marketing, he did have a wealth of experience in athletics. As an undergraduate, he led the Princeton University golf team to consecutive Ivy League titles and maintained a dominating presence on the university’s baseball and football teams. Porter conceived of business as a competitive field in which, as in sports, each team, based on its talent and its executive administration, is particularly recognized for playing offense or defense, clock management, or risky play-calling. Keeping his theory deliberately broad (indeed he gathered no quantitative evidence, interviewed no CEOs, extrapolated no financial and/or marketing data), Porter conjectured that a business and/or service basically had two choices: be known for providing eith a high-end product that is significantly different from other goods in the same market and hence significantly more expensive (termed “differentiation”) or a product at a low cost (termed “cost leadership”). In other words, a company can be known for its product or for its prices.

Companies, Porter argued, cannot effectively pursue both differentiation and cost leadership because they are “fundamentally different approaches to creating and sustaining a competitive advantage, each strategy involv[ing] different resources, strengths, and organizational arrangement” (Li & Li, 2008). Only by clearly and absolutely defining its ultimate mission and branding itself as either high quality or low cost can a company work efficiently and effectively.

Porter acknowledged nearly thirty years later that the simplicity of the model was what made cost leadership a foundational idea in business (Colvin, 2012). Over the next three decades, in more than twenty books and dozens of academic articles, Porter worked through the implications of his landmark theoretical model. Indeed, that model has become a standard way for companies to focus their productivity, their creative energies, and their decisions about operations expenses. Porter remained on the faculty of the MBA program at Harvard and held the endowed chair in the department’s Institute for Strategy and Competitiveness beginning in the mid-1990s, tirelessly advocating what he called Generic Strategies.

Porter further argued that a company seeking cost leadership cannot be content to produce a cheap product to be sold cheaply. Neither does cost leadership equate low price with cut-rate service. Within a competitive consumer business environment, he reasoned, such businesses would quickly fold. Rather, the strategy requires a business to watch every penny, to ruthlessly monitor its own processes to find every opportunity for cost cutting and more efficient production, and yet strive to produce a quality good and/or service. That business becomes, long term, known for being a leader in cost.

Applications

Cost leadership needs to be distinguished from quick-term, end-oriented sales strategies. While effective at spiking short-term profits, these strategies—for example, clearance sales, holiday and/or seasonal discounts, and end of the model year sales—are more conveniences, a way to clear unsold merchandise or to generate market interest as a way to attract a deeper and more focused commitment. The prices fall, but the drop is designed to be temporary—the business and/or service that provides that discounted good does not examine its methods and operations. Rather the strategy has its impact in a very tight and focused way, for example, capturing opportunistic sales or patronage in a specific quarter of the larger business year.

Cost leadership, in contrast, represents a company’s conscious decision to produce a good or provide a service significantly below the market average while minimizing the impact on the product or service’s quality. Cost leadership signals a company’s interest in its long-term viability. The decision represents a company’s interest in shaping the broadest possible market—unlike the differentiation model that seeks to create a smaller but more fiercely committed market share willing to pay more for the privilege of that brand. Companies committing to the cost-leadership strategy will realize their greatest profits by the widest possible appeal to the broadest number of potential consumers. Indeed, differentiation brings with it systemic risks as that market is often fickle and production costs cannot be sustained (Banker, Mashruwala & Tripathy, 2014).

In applying the cost-leadership template to its operations, a company takes a long and careful critical look at the entire range of its operations to ensure that every penny of investment into that operation maximizes its impact. Total efficiency of operations is an ideal, however the long-term evaluation of operations helps move the company as close as it can to maximum efficiency, thus setting the foundation for long-term price management rather than sales spikes. If a company produces, for example, a 16-ounce jar of peanut butter and that peanut butter jar sells very competitively for $1.89 (by contrast, the name brand, or differentiated, peanut butter sells for $2.49), under the cost-leadership model the goal for that company would be to sell the same jar a year, five years, or ten years out at approximately the same price despite inevitable spikes in the business’s outlay—that is, in expenses such as materials, labor, processing systems, and delivery/transportation networks. To do that, the business studies its market and makes efficient, “customer-centric decisions” (Hermann, 2014).

All elements of business operations fall under scrutiny. “Companies, which base their work on this strategy, rely on efficiency technologies, efficient organization of manufacturing and human resource” (Stankevičiūtė, Grunda & Bartkus, 2012). To maximize the cost efficiency of a manufacturing process, relational process, or office management system, a company first looks at staffing. One of the fundamental strategies is for the business to rely as much as possible on unskilled general service employees; managerial and administrative positions are by definition costlier. McDonald’s fast food restaurants, often held up as a cost-leadership exemplum, maintains its services by using counter workers, maintenance staff, and kitchen work under the direction of one or two supervisors. Similarly, industrial manufacturing plants rely on the assembly line strategy, assuming a minimum management presence will ensure efficient operations.

Non-management employees are interchangeable, and therefore the loss of one does not significantly impact the larger operations as long as there is no shortage of lower-skilled workers. Indeed, part of cost leadership is to minimize otherwise expensive training procedures by creating a work environment where every job has a relatively small learning curve—that is, the time it takes for an employee to master a part of the larger process. The goal is to develop or adopt the cheapest methods of production or service without compromising the product or service.

Workers, however, may unionize to prevent the exploitation of their labor by companies that maximize profits by keeping wages low. Because labor unions can demand higher wages and/or benefits by using such measures as work stoppages, a company, under the cost-leadership imperative, may choose to outsource manufacturing or customer service positions to low-wage countries. Expensive human resources can also often be replaced with digital or robotic technologies to maximize efficiency.

Another application of the cost-leadership model impacts the materials actually used to produce the designated product. Businesses seek to acquire necessary materials at the cheapest possible price without impacting safety or quality. Focus is directed at where and how critical office supplies, data storage systems, and communication networks are acquired as a way to minimize expenses. Every element from pencils to printers can be evaluated for cost effectiveness.

An additional application for businesses with national and/or global distribution focuses on how goods are transported. Walmart—like McDonald’s—frequently use as a model for cost leadership strategy, maintains an intricate transportation system, fleets of trucks and airplanes to deliver materials to stores efficiently and quickly. Called a distribution channel, the components of this system are all linked by a sophisticated computer network in which a store in one state can talk to a store in another state as a way to acquire goods for the shelves effectively and efficiently.

Businesses following the cost-leadership model may also cut back on amenities in the store complex itself, forsaking stylized interior and exterior designs for basic environment. Southwest Airlines, for example, has defined itself as a no-frills travel service. Patrons fly Southwest understanding that the low price for airfare means minimum services while in-flight. Customer forgo in-flight drinks and movies and tolerate reduced overhead storage and narrower aisles but receive safe transportation services for a lower cost. According to Porter’s proposition, cost leadership produces market presence and profit by producing something that sells for more than the cost of its production—which is good in that it saves money for the consumer who buys it and enriches the company that sells it (Driver, 2012).

Viewpoints

Although creating a corporate environment committed to efficient operations and to providing goods or services at a low cost may seem logical for any business that does not pursue high-end brand recognition, cost leadership has its risks (Amit, 1986). First, cost leadership must provide a corporate structuring mission—it cannot be targeted for a quarter or two and then ignored or minimized. The commitment to cost-effective operations represents a day-in-day-out endeavor to ensure quality at minimum costs. If either element of that business equation lapses, the business faces enormous challenges to maintain its bottom line. Allow a lapse in quality and the product or service, particularly in the era of digital customer evaluations, quickly loses market share; fail to minimize costs and the business quickly loses its brand. Maintain cost leadership and the company may actually be able to offer not only lower prices in the marketplace over all but also deeper sale prices than the competition (Duica & Duica 2014).

Constant attention to bottom line operations, however, can misfire. Competing companies can escalate their cost consciousness into a price war, a destructive spiral of lowering costs to the point where profit itself is undercut or even eliminated in an effort to drive a competitor out of the market or so damage its revenue stream that recovery will divert attention and resources for a significant period of time. The effects of a price war can negatively impact even the perceived winner. To drop costs for the moment can involve drastic cuts in labor or staffing as well as cutting corners in areas of production and/or delivery.

Perhaps the most significant issue around cost-leadership modeling is the impact it has on employee status and morale. Under the cost-leadership model, employees can be routinely denied the opportunity to move up within a network, stabilized at particular positions or with particular duties. Further, workers cannot expect job security because management is always looking for ways to cut positions or outsource some elements of the business. Income security and quality of life, while critical to workers are perpetual targets for cost cutting as ways are sought to suppress wages, limit benefits, and eliminate perks. The physical environment and conditions are subject to change with opportunities to lower utility and/or operational costs. Management may replace critical positions with technology, hire new employees below market value, or target applicants willing to work for relatively little. Cost leadership as a model can generate an atmosphere of worry and insecurity in employees, but the cost-leadership template deliberately deflects the human factor in favor of keeping a company directed to minimizing costs and passing the savings on to the consumer.

Terms & Concepts

Brand: In business, how a company frames its reputation within a competitive field.

Differentiation: In business modeling, the concept of a company focusing on a unique item or service for which consumers are willing to pay higher prices.

Distribution Channels: The physical and/or digital avenues through which and by which a company maintains its business operations.

Generic Strategies: In Michael Porter’s classic business model, concepts such as cost and production that can be applied to any business.

Outsourcing: A business decision to move assembly operations to a state and/or a country where the labor operations can be completed maintaining the same level of quality but at a much cheaper price.

Price War: A pitched and often ruinous competition between businesses and/or services in which prices are unrealistically dropped in an effort for one party to assume a greater market share.

Saturation Advertising: A marketing strategy that involves using multiple media for the same product, service, or event usually in a limited time span.

Bibliography

Amit, R. (1986). Cost leadership strategy and experience curves. Strategic Management Journal, 7(3), 281–292. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=5214729&site=ehost-live

Banker, R. D., Mashruwala, R., & Tripathy, A. (2014). Does a differentiation strategy lead to more sustainable financial performance than a cost leadership strategy?. Management Decision, 56(5), 872–896. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=99523318&site=ehost-live

Colvin, G. (2012). There’s no quit in Michael Porter. Fortune International Europe, 166(7), 68–71. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=82590069&site=ehost-live

Driver, M. (2012). An interview with Michael Porter: Social entrepreneurship and the transformation of capitalism. Academy of Management Learning & Economics, 11(3), 421–431. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=83067015&site=ehost-live

Duica, A., & Duica, M. (2014). Organizational implications of the cost leadership strategy. Valhalian Journal of Economic Studies, 5(2), 33–40. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=113852992&site=ehost-live

Hermann, B. (2014). Digital marketing: Turn cost management into cost leadership. Brand Quarterly 2014, 64–67. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=97748093&site=ehost-live

Li, C., & Li, J. (2008). Achieving superior financial performance in China: Differentiation, cost leadership, or both. Journal of International Marketing, 16(3), 1–22. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=34017702&site=ehost-live

Stankevičiūtė, E., Grunda, R., & Bartkus, E. V. (2012). Pursuing a cost leadership strategy and business sustainability objectives: Walmart case study. Economics & Management, 17(3), 1200–1206. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=95278141&site=ehost-live

Cost Leadership

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Subject Terms

Cost Leadership

Abstract

Overview

Applications

Viewpoints

Terms & Concepts

Bibliography

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