Cost Advantage and Value Chain

Cost advantage is one of the two types of competitive advantage a firm may possess. Cost is also of vital significance to differentiation strategies because a differentiator must maintain cost proximity to competitors. Unless the resultant price premium surpasses the cost of differentiating, a differentiator will not succeed to attain superior performance. The behavior of cost also exerts a strong influence on overall industry structure.

Managers recognize the significance of cost, and many strategic plans start "cost leadership or "cost reduction as goals. Though, the behavior of cost is seldom well understood. Wide disagreement often exists among managers about a firm's relative cost position and the reasons underlying it. Cost studies tend to focus on manufacturing costs and overlook the impact of other activities like marketing, service, & infrastructure on relative cost position. Furthermore, the cost of separate activities is analyzed in sequence, without identifying the linkages among activities that can affect cost. Lastly, firms have huge difficulty assessing the cost positions of competitors, a necessary step in assessing their own relative positions. They often resort to simplistic comparisons of labor rates and raw material costs.

The absence of a systematic framework for cost analysis in most firms underlies these problems. Most cost studies address narrow issues and take a short-term viewpoint. Popular tools like the experience curve are often misused in cost analysis. The experience curve can serve as a starting point, but it ignores many of the important drivers of cost behavior and obscures important relationships among them. Cost analyses also tend to rely heavily on existing accounting systems. While accounting systems do contain useful data for cost analysis, they frequently acquire in the way of strategic cost analysis. Cost systems categorize costs in line items-such as direct labor, indirect labor, and burden-that may obscure the underlying activities a firm performs. This leads to aggregation of the costs of activities with very different economics, and to the artificial separation of labor, material, and overhead costs related to the same activity.

The value chain provides the basic tool for cost analysis. I begin by showing how to define a value chain for cost analysis purposes and how to associate costs and assets with value activities. I then describe how to analyze the behavior of cost, using the concept of cost drivers. Cost drivers are the structural determinants of the cost of an activity, and differ in the extent to which a firm controls them. Cost drivers determine the behavior of costs within an activity, reflecting any linkages or interrelationships that affect it. A firm's cost performance in each of its major discrete activities cumulates to establish its relative cost position.