COST: THE LAST CONSIDERATION

by Donald V. Potter

A driver taking an icy curve feels the car break away and begin to skid to the right. Every human instinct says, “Turn to the left!” Yet the driver, if lucky, will have learned that the right choice is to turn right, into the direction of the skid. Survival depends on ignoring the first instinct and doing what is not obvious.

Something similar happens when companies enter market hostility. As margins fall and profitability slides, the obvious first response is to cut costs. Knowing why that is the wrong choice requires an understanding of the difference between effective cost control in a hostile and a non-hostile market.

Unique Advantages Disappear

In a non-hostile market, high returns are commonly the result of high market prices. Sometimes, a supplier’s high returns may be the result of lower costs. But many low costs have short lives. Costs may be low because the supplier has locked up a favorable rate of labor, raw materials, and so forth – but rate advantages are unusual in hostility because rates are visible and readily lateralized across competitors. More likely, the cost advantage depends on a unique approach to one or more steps in the process of designing, developing, making, selling, or servicing the product.

Unique approaches to functional cost management are the internal equivalent of unique product features. Both offer an advantage as long as the market is not hostile because competitors are not under pressure to duplicate them. Once hostility sets in though, competitors find the needed motivation. Products can be reverse engineered and their unique features replicated, often within a year. Unique approaches to managing functional costs may take longer to replicate because, in bad times as well as good, organizations resist the internal disruption and uncertainty that comes with any change in the way work gets done. And the work of most managers is managing a functional cost. Nevertheless, unique approaches are also copied, usually within five years. And, hostility almost always lasts much longer than that.

Long-Term Advantage: Productivity

Now how can a company achieve a longer-term cost advantage? In a hostile market, the key opportunity for advantage is productivity.

Productivity is a measure of a company’s units of sales versus its units of input – that is, the materials, people, capital, and so forth that go into producing the product or service. A company’s productivity is high relative to competitors if it can use its units of input more thoroughly or continuously than others can.

In practice, suppliers competing in a hostile market can succeed following one of two courses:

1. Seek volume broadly in order to exploit the natural advantage of scale, spreading costs over a large number of units of sale.
2. Target a select group of customers that offer loyal volume but can also be served with carefully chosen units of cost input. Learn exactly what those customers require, then hone operations so that only what is absolutely essential is bought or done.

Either approach can work, though any given community may have a greater likelihood of success with one or the other.

When Cost Cutting Equals “Turning Left”

Like turning left in the skid, reducing costs during hostility is the wrong choice when it results in lost sales, since it is not costs, per se, that matter, but costs in relation to total sales volume. In fact, even during market hostility, it can be wise to increase costs if the investment will win sales volume. In hostile markets, service levels industrywide are usually getting better, and matching those higher levels can add costs but still be essential to staying in the game.

Above all, suppliers must be sure that any cost cutting is invisible to its current customers. Because they are already being served, current customers will be the first to spot any downgrading of product quality or service. Losing current customers is especially serious because a supplier already has a cost advantage with those buyers. The investment to attract their business has already been made, and the relationship is in place. Competitors who want to break into that relationship must invest to do so, increasing their relative cost to serve that customer. But, once a supplier loses a customer, that supplier will have to reinvest, often more heavily than ever before, in trying to regain that customer’s goodwill and business. A key consideration in cost control, then, is keeping the customers you already have.

Certainly, in a hostile market, costs need to be watched and controlled. But cost cutting should be the last consideration, after satisfying customers and securing or gaining volume. Then costs might be cut – as long as the customer doesn’t notice.

Closing Thought

A productivity cost advantage cannot be copied without the competitors’ first winning the customer. This advantage of an established relationship usually outlasts hostility.

(Note: This Perspective was written in the context of the economy in 1995. While some of the companies may have changed their policies or indeed no longer exist, the patterns they exhibit still hold today.)

Recommended Reading

For a greater overall perspective on this subject, we recommend the following related items: Analyses: Analysis 53: Return on Capital Employed by Competitor Analysis 54: Pre-Tax Return on Sales by Competitor Analysis 55: Capital Intensity by Competitor Analysis 56: Analysis of Rates of Cost Differential Analysis 57: Cost Advantages and Disadvantages Due to Differences in Approach to Managing Functions Symptoms and Implications: Symptoms developing in the market that would suggest the need for this analysis. The industry cannot pass on cost increases Customers are adding suppliers because incumbent suppliers failed them While still growing some competitors are losing share Outsourcing is a growing phenomenon in the industry Some industry leaders have lower returns than the smaller competitors ***