Cost Leadership Strategy: Pros and Cons of Cost Leadership

Cost leadership is a business-level strategy employed by companies who wish to gain a competitive advantage by being the lowest-cost producer of a service, production process, or commodity. Michael Porter, an economic theorist and strategic management expert, coined cost leadership as one of three competitive strategies (the other two being differentiation strategy and focus strategy).

Though sometimes used interchangeably, cost leadership is not the same as price leadership. Price leadership is a strategy that prioritizes offering the lowest prices in an industry, while cost leadership strategies prioritize having the lowest operating costs. As a result, a price leader may be less profitable than a cost leader despite offering similarly low prices. Some cost leaders may be able to beat the competition by having the lowest operating costs and the lowest prices, making them industry price leaders and cost leaders in some circumstances.

There are several potential benefits to using a cost leadership strategy.

1. 1. Low costs enable low prices. Cost leaders focus their attention on increasing the efficiency of production processes to lower production costs. Low costs allow them to lower prices while still making a profit.
2. 2. Cost leaders are more able to withstand price wars. Cost leaders are sufficiently equipped to reduce their costs, which can deter competition. Higher-priced competitors are less likely to want to directly compete with cost leaders if they cannot guarantee they're going to win.
3. 3. Cost leaders may enjoy increased market share. A large share of consumers are price-sensitive and gravitate toward the companies offering the lowest-priced goods. This means that the company with the lowest prices is likely to sell the most units. The more units a company sells, the more its market share increases. In turn, when the market share of a company rises, the unit cost decreases, potentially fueling even greater profits.

Using a cost leadership strategy can have several downsides. Consider the potential drawbacks to cost leadership.

1. 1. The cost leadership approach can be risky. Cost leaders must constantly innovate new ways to reduce costs. As soon as a company discovers an effective method of cost reduction, competitors are likely to copy the method. Cost leaders must be able to sustain consistent cost reduction or they could face significant losses.
2. 2. It may be difficult to maintain perceptions of quality. Maintaining the perception of quality becomes difficult when your marketing strategy hinges on offering the cheapest products possible. Cost leaders have to find a way to maintain a positive image and encourage brand loyalty while offering cheap goods and services.
3. 3. Cost leaders are dependent on a high volume of sales. Cost leaders inevitably operate with thin profit margins. This means they have to maintain a high volume of sales to be successful.
4. 4. Cost leaders may be slow to adapt to market changes. When your business-level strategy is centered around cost reduction, it can be challenging to keep up with consumer trends and tastes. Cost leaders may be committed to developing advanced technologies in order to reduce production costs, only to find that consumer tastes have shifted, rendering the technology obsolete.

There are several generic strategies that can give cost leaders a competitive edge. Most cost leaders will employ several of these strategies simultaneously.

1. 1. Creating economies of scale: An economy of scale is a business strategy focused on reaping the cost advantages of mass production. In microeconomics, the underpinning logic is that production comes with fixed costs such as real estate, machinery, employee salaries, raw material costs, and taxes. These costs make it expensive to produce the initial units of merchandise, but when a business increases its scale of production, the unit cost of each item decreases. The business's fixed costs remain the same, but the output increases.
2. 2. Developing advanced technology: Cost leaders can invest in the development of new technology that will increase efficiency and lower operating costs, enabling them to increase production and lower prices.
3. 3. Sourcing raw materials: Most suppliers of raw materials mark up prices to make a profit. By having ownership or control over the source of raw materials, a company can potentially reduce the overall cost of production and add value to the product in the process. This is known as value chain control.

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