ASSESSMENT REFERENCE: ME/JULY12/2

STUDENT NUMBER: 8772637

ANALYZE THE STEPS TOWARDS COST LEADERSHIP WITHIN THE PRODUCTION RELATIONSHIPS OF A MODERN FIRM.

Every business entity must strive to develop a competitive advantage in order to continue as a going concern and thrive amidst severe competition in its industry. A firm can master different strategies in order to ensure its continuous growth and corner a good market share in its industry. One of such strategies is the cost leadership strategy, which seeks to offer a product or service to the consumer at the lowest price possible by identifying the cost centres within its operation and buy implementing strategies to reduce its production costs.

A firm pursuing a cost-leadership strategy attempts to gain a competitive advantage primarily by reducing its economic costs below its competitors. The ability of a valuable cost-leadership competitive strategy to generate a sustained competitive advantage depends on that strategy being rare and costly to imitate. (Ecofine 2012). In addition, Allen et al. (2007) cited in Strategy BlogSpot (2011) stated that “a cost leadership strategy is effectively implemented when the business designs, produces, and markets a comparable product more efficiently than its competitors. The firm may have access to raw materials or superior proprietary technology to lower costs”.

Examples of companies that have mastetered the cost leadership strategy include McDonalds and IKEA. For McDonald's the restaurant industry is known for yielding low margins that can make it difficult to compete with a cost leadership marketing strategy. McDonald's has been extremely successful with this strategy by offering basic fast-food meals at low prices. They are able to keep prices low through a division of labour that allows it to hire and train inexperienced employees rather than trained cooks. It also relies on few managers who typically earn higher wages. These staff savings allow the company to offer its foods for bargain prices.

However, the Swedish furniture retailer IKEA revolutionized the furniture industry by offering cheap but stylish furniture. IKEA is able to keep its prices low by sourcing its products in low-wage countries and by offering a very basic level of service. IKEA does not assemble or deliver furniture; customers must collect the furniture in the warehouse and assemble at home themselves. While this is less convenient than traditional retailers, it allows IKEA to offer lower prices that attract customers (Chron 2012)

Mcnutt (2010.pg.55-56, 61) gave the following five step analysis as the tools needed by a production firm to gain cost leadership within its industry. “Collectively the five steps define the production relationship within a firm. Step 1 is to distinguish between economies of scale and economies of size. Size should be interpreted as global economies of scale that can be achieved only once management neutralizes the zero-sum constraint. Step 2 focuses on maximizing the average productivity of labor realizing that the measure of average productivity is the inverse of the average variable cost of production. Step 3 requires the introduction of a normalized wage system within the company, offering incentives to the workforce so that a reduction in the number of employees is carefully matched with an increase in productivity.

Step 4 is about controlling cost once cost are controlled or fixed during the production cycle, management can focus on decreasing the average fixed cost. This can be achieved by hedging raw materials required during the production cycle, offering workers a fixed term or fixed term-fixed wage contract or by outsourcing or by rebalancing costs back to the suppliers in the supply chain. Finally, step 5 requires management to identify the capacity constraints within the company and to clearly demarcate excess capacity from reserve capacity at each plant within the production technology. Reserve capacity requires the building of additional capacity in the plant in the expectation of demand; excess capacity is to be avoided- it can arise if the company is unable to differentiate its products fast enough in an ever-changing consumer market. The ideal outcome is one of zero excess capacity, with a reserve capacity in production”.

The five steps stated above are discussed in detail below.

1. Distinguish between the economies of scale and scope within the production process.

Economies of scale:

this refers to the advantage that flows from producing a larger output at a given point in time. Economies of scale also occur when a company producing many products has a lower average cost than a firm producing just a few products. Mcnutt (2010) also explains that economies of scale describe a situation when the total costs rise less than proportionally to production increases conversely diseconomies of scale represent the opposite situation. For example it might cost $30000 to produce 1000 copies of the financial times but only $40,000 to produce 10,000 copies. The average cost in this case has fallen from $30 to $4 a copy because the main elements of cost in producing the financial times (editorial and design) are unrelated to the number of newspapers produced.

Some sources of economies of scale includes bulk discounts on purchases and inputs, higher efficiency of installed equipments, the ability to spread fixed costs over more output units and employees specialization as a result of high volume of production.

Economies of scale, however, have a dark side, called diseconomies of scale. The larger an organisation becomes in order to reap economies of scale, the more complex it has to be to manage and run such scale. This complexity incurs a cost, and eventually this cost may come to outweigh the savings gained from greater scale. In other words, economies of scale cannot be gleaned forever (The economist 2008).

Sources of diseconomies of scale includes ; managerial complexities arising from increase in size, physical limits to efficient size, workers motivation can decline with specialisation, distances between the market and the supplier.

Economies of scope

First cousins to economies of scale are economies of scope, factors that make it cheaper to produce a range of products together than to produce each one of them on its own. Such economies can come from businesses sharing centralised functions, such as finance or marketing. Or they can come from interrelationships elsewhere in the business process, such as cross-selling one product alongside another, or using the outputs of one business as the inputs of another. A number of conglomerates put together in the 1990s relied on cross-selling, thus reaping economies of scope by using the same people and systems to market many different products ( The economist 2008).

If the marketing team of a company is selling several products they can often do so more efficiently than if they are selling only one product. For example Unilever Nigeria plc with a range of products which includes OMO detergents, Close up tooth paste among several others. Unilever Plc can leverage the cost of the sales team travel time over a greater revenue base, so cost efficiency improves

The Learning curve

The learning curve also called the experience curve is all about the importance of experience. According to (Besanko pg 61) “the learning curve refers to the advantages that flow from accumulating experience and know how”. The learning curve describes the relationship between output and amount of inputs needed for each output as employees and managers become more experienced average cost should reduce on the long run.

2. Focusing on Increasing Average labor Productivity:

Average productivity of labor can be improved by an individual rewards and payment systems, and the effectiveness of personnel managers and others in recruiting, training, communicating with, and performance-motivating employees on the basis of pay and other incentives (Wikipedia 2012). Another means of ensuring an increase in labour productivity is through Capital deepening. Capital deepening happens when businesses invest in more or better machinery, equipment, and structures, all of which make it possible for their employees to produce more. Matching employees with better capital increases the number of goods employees produce in each hour they work. Examples of capital deepening include the purchase of more sophisticated machine tools for workers in the manufacturing sector, or a faster computer system for a travel agent (Jourel 2012). Thirdly an increase in production skills will lead to an increase in average labour productivity hence; employees increase their skills through additional education, training and on-the-job experience.

3. Normalizing the Wage Structure

In other words offer the workers incentives or bonus payments as productivity increases, revisit the organizational structure and consider the production process as a nexus of contracts. Mcnutt (2010) argues that “a company must encourage the most productive staff by way of incentives and encourage the least productive employees to leave the plant because it is important to note that average productivity can increase if existing workers are more productive”. The types of benefits and rewards that can be used to motivate workers include a guaranteed salary, a performance based bonus which can be based on the employees’ performance appraisal, profit sharing among workers at the financial year end of the company and lastly other benefits like health insurance, company vehicles will go a long way. A company should also decide if its casual worker will be employed of permanent or contractual basis.

4. Control Production costs.

Control more of the production costs to come under control during the production process. Hedge positions on material inputs, minimize exchange rate risks, and have workers on fixed-wage, fixed-term contracts with incentives per flexible manufacturing. To achieve cost leadership may require a high relative market share, which compels heavy capital investment in equipment and manufacturing/R&D, aggressive pricing, as well as a workforce committed to the low-cost strategy. The organisation must be willing to discontinue any activities in which they do not have a cost advantage and should consider outsourcing activities to other organisations with a cost advantage (Malburg, 2000).

One modern method that company use to control cost is Outsourcing. It’s a process whereby certain functions or production that would have been performed in house is handed to a third party to perform. Some of the benefits of outsourcing include;

1. Its cost saving as capital investments in machines and personnel can be invested elsewhere.

2. With Outsourcing a company enjoys the flexibility of changing third-party vendors whenever necessary. This process is less time consuming that hiring new employees because a company is dealing with an established organisation.

3. Outsourcing can also speed up production time because the vendor can focus on that singular operation

Some of the disadvantages of outsourcing are

1. A major downside to outsourcing is defective finished products that may be received from a vendor. A company may need to contract another vendor if such situation arises.

2. Outsourcing can also lead to loss of jobs, especially if such outsourcing involves an offshore country. The BRIC countries have witnessed a steady inflow of jobs from Europe and the USA.

3. Outsourcing may also lead to loss of confidentiality and data. Checks must be put in place to avoid this.

5. Demarcating between Idle and Installed Capacity.

Excess capacity can occur if the product is not sufficiently differentiated fast enough in the market to capture market sales. At the point of production in phase 1, ensure sufficient installed capacity to meet demand in later phases of production Mcnutt ( 2010). This is one of the cost drivers also introduced by porter (1985) as Capacity utilisation: refers to the relationship between the ‘potential output’ that could be produced and the ‘actual output’ that is produced with the existing installed equipment, if the capacity was fully used. For the fact that idle capacity usually has its own attendant costs, companies strives not to have idle capacity unless the cost of waste (such as unsold products) exceeds the cost of idle capacity.

A company that can successfully deploy these strategies should eventually become a cost leader in its industry all things being equal.

REFERENCE LIST

1. Besanko. , Dranove, D., Shanley, M. and Schaefer, S. (2010). Economics of Strategy. 5th Ed. New Jersey: John Wiley & Sons.

2. Chron (2012). Examples of Cost Leadership & Strategy Marketing. Available from http://smallbusiness.chron.com/examples-cost-leadership-strategy-marketing. Accessed on October 12th, 2012.

3. Ecofine (2012). Cost leadership Strategy. Available on http://www.ecofine.com/strategy/Cost. Accessed on October 12th, 2012.

4. Jourel (2012). Productivity Growth. Available from http://jourel.info/factors.html. Accessed on October 13th 2012.

5. McNutt, P. (2010). Game Embedded Strategy. 1st Ed. Singapore: Mc Graw Hill.

6. Strategy Models BlogSpot (2012). Ways of Achieving a Cost Leadership Strategy. Available from http://strategy-models.blogspot.com/2011. Accessed on October 8th 2012.

7. The Economist (2008). Economies of scale and scope. Available from http://www.economist.com/node/12446567. Accessed on October 13th 2012.

8. Wikipedia (2012). Workforce Productivity. Available from http://en.wikipedia.org/wiki/Workforce_productivity. Accessed on 13th October, 2012.