If you increase the number of units sold at a given price, then total revenue will increase. Inflation, of course, raises the construction costs of new facilities, the prices of new equipment, the cost of equity and debt capital, and the needed amount of working capital. Reprinted with the permission of the publisher. However, if the contracting officer has reason to believe exceptional circumstances exist and has sufficient data available to determine a fair and reasonable price, … And we now expect to begin realizing the productivity gains…made possible by our sizable investments.”6 The investment move allows IBM to take the offensive with its pricing strategy. A relative cost shift can occur in any one of three main areas—suppliers, the company’s own segment, or forward channels. An aluminum producer with plant facilities in the Pacific Northwest today can manufacture more aluminum with fewer dollars than a producer in the Midwest. During the 1970s, the annual cost increases for British Steel’s key components rose as little as 8% to as much as 24%, and the year-to-year patterns from component to component fluctuated markedly.2, This kind of cost differential helped reverse the international advantage U.S. steel producers once had. Cost-benefit Analysis dete… Cost competitive advantages can easily disappear with the introduction of a new competitor or new technology. The Brookings Institution, 1981), p. 173. Avoiding pricing traps requires a strategic view of the present cost structure, of how the structure changes, and of the implications for gaining a sustainable competitive advantage. Source: Compiled from data in the U.S. Federal Trade Commission, The United States Steel Industry and its International Rivals: Trends and Factors Determining International Competitiveness (Washington, D.C.: U.S. Government Printing Office, 1978) and in Robert W. Crandall, The U.S. Steel Industry in Recurrent Crisis (Washington, D.C.: The Brookings Institution, 1981). Like the weather, inflation is a lot easier to talk about than to do something about…. By narrowing the product line, the company can allocate expensive production capacity to its most attractive items and market segments. Cost realism analysis Cost examination Price realism analysis Cost analysis 6) If an offeror is expected to be exempted from submitting cost or pricing data, you should: [Determine whether to use price analysis or cost analysis to evaluate the … 7. The opportunity for safe saving is lost in a period of sizable and unpredictable price increases. A buyers’ market emerged. One analytical approach is to compare your own cost structure with that of your rivals to discover who has been most affected by operating cost and capital cost changes. Such focus directs corporate attention to the best use of existing capacity and has a tight strategic fit with the economic need to enhance the revenue productivity of expensive capital assets. Take the case of energy fuels. The success of differentiation strategies in an environment of rapidly rising operating costs varies according to the basis for differentiation. Because inflation affects each company in an industry differently, the first step is to diagnose your changing cost economics all the way from the raw materials stage to the final price paid by the ultimate consumer. The following graph shows the cost curves for a firm in a perfectly competitive market. whether a company's costs are competitive with close rivals depends on how the costs of its internally performed value chain activities compare with the costs of the internally performed value chain activities of close rivals which of the following is not an indicator of how well a company's current strategy is working A narrow customer base helps limit the need for capacity expansion and shields the company from the cost of escalating capital requirements. If all competitors feel the same inflationary impact on operating costs but the fixed asset-capacity cost increases that they suffer from differ greatly, then an “invest and grow” strategy to build market share can work to the advantage of a company, provided it invests early in new capacity. A target cost is the maximum amount of cost that can … (XYZ is a name I am using to designate a composite of several companies.) A company can show the makeup of costs all the way from the raw materials phase to the end price paid by the ultimate customer on a value chain (see Exhibit I).5 Strategic cost analysis cannot be restricted to one’s own internal costs because economywide inflation often affects suppliers and distribution channels. Finally, you factor the implication of future inflation into your own costs and those of the competition. To add insult to injury, XYZ’s rivals no longer went along with industrywide price increases; even when such hikes became timely, the other companies raised their prices by a smaller percentage than XYZ or delayed them altogether. Conduct a thorough market pricing analysis. Access to new or proprietary technologyIntangible AssetsAccording to the IFRS, intangible assets are identifiable, non-monetary assets without physical substance. [List the factors that affect cost analysis and cost realism analysis considerations.] And most managers have learned to adjust to the effect inflation has on current operating costs. Most difficult is the necessity of estimating the same cost elements for its rivals—an advanced stage in the art of competitive intelligence. Also, try changing the market price of the product to create break-even, profit, and loss situations. Then, given the capacity you have, you try to produce at rates close to practical capacity in order to enhance the revenue productivity of your fixed investment. The company made a big commitment to capital spending. The concept of value chains is discussed and analyzed in Michael E. Porter and John R. Wells, “Strategic Cost Analysis,” unpublished working paper, Harvard Business School, 1982. Success comes to a company that accentuates long-term strategic positioning. There are car manufacturers that have better production processes than their competitors. Nearly every electric utility that is constructing nuclear power stations to meet future generating needs is being squeezed by escalating capital costs and a market place replete with generating capacity. Companies also consider the huge research and development (R&D) costs incurred to bring a drug to market, a consideration that often leads to high prices for new drugs. and costs are competitive are .f. Virginia Electric and Power Company, for example, will mothball a nuclear power plant, despite a $540 million initial investment, because the estimated final price tag has risen from $1.2 billion to $5.1 billion. A target cost is the highest amount of cost … To remain competitive, all the companies must offer quality products at cutthroat prices. Only a detailed analysis will reveal the trade-offs between higher and lower capital costs and lower and higher operating costs and what to do about them. In a slack market, low-cost companies are in the position to use a price-cutting strategy to protect their sales volume and preserve capacity utilization. No company can totally avoid the impact of increasing costs. It could be that you are able to offer a comparable service at a lower price, in which case it is time to review your processes to determine where you reap cost savings. Scanning the environment to determine a company's best and most profitable customers The spotlight in analyzing a company's resources, internal circumstances and competitiveness includes such questions/concerns as What are the company's resource strengths and weaknesses and its external opportunities and threats Unchecked inflation can radically change the whole cost structure of an entire industry. Highly skilled labor 3. 1. Market orientation is a business approach that prioritizes identifying the needs and desires of consumers and creating products that satisfy them. Manufacturing companies in such energy-intensive industries as pulp and paper, chemicals, and primary metals feel the competitive impact of fuel cost differences. This hold share strategy can work under conditions of strong or weak market demand. From: Economics for Policymaking, Selected Essays of Arthur M. Okun, ed. Maunders, Accounting for British Steel (Aldershot, England, Gower, 1982), p. 124. This can be roughly … When Southland first bought sites in the 1960s, few other companies were competing for the kind of location it needed. For example, if you want to be the low-cost producer in the market but you anticipate rising capital costs as a major problem, your company’s best bet is either to build early (if demand projections are bullish) or not to build new plants at all (if the market is mature). XYZ’s profits eroded while the others’ remained buoyant. Their risk of falling into the pricing trap is lower, and they are more secure in raising prices when short-run cost changes squeeze profits. Two useful tools for determining whether a company's prices and costs are competitive are: a. competitive strength analysis and SWOT analysis. In the North American pulp and paper industry, a $100 per ton production cost difference exists between higher-cost new facilities and less costly, fully depreciated mills.1. Therefore, in a perfectly competitive market, the main problem for a profit-maximizing firm is not to determine the price of its product but to adjust its output to the market price so that profit is maximized. In business school, we learned that companies need to develop sustainable competitive advantages. John R. Opel, IBM’s CEO, once said, “We want to be the lowest-cost producer of everything we make. Otherwise, a strategy to be the cost leader will beat a performance-based differentiation strategy. The most threatened are those “quality” and “service” types of differentiation strategies that require skilled craftsmanship, high labor content, customized design, elaborate marketing and distribution networks, and personalized extras—the costs of which rise at above-average rates. The fixed costs, like administration, are spread over more units of production.Sometimes the company can … Plainly, the chain’s makeup will vary from company to company as well as from business segment to business segment (product line, customer type, geographic area, or distribution channel). In peak shopping seasons, businesses tend to spend more on advertising. XYZ was caught squarely in a competitive pricing trap. In a noninflationary environment, people can acquire various liquid assets, earn a reasonable return on them, and count on them as the means to acquire a basket of consumer goods in the event of especially large needs or declines in income. Exhibit II shows a simplified value chain comparison of the shifting costs and competitive advantage between U.S. and Japanese steel producers from 1956 to 1976. If the price of the product increases for every unit sold, then total revenue also increa… 5. The offers that appear in this table are from partnerships from which Investopedia receives compensation. But the capital investment costs for such construction were so high that XYZ could expect to earn an attractive return on its investment only by selling products at prices well above the going level—prices that its rivals could continue to undercut. Coca-Cola, of course, has that secret recipe and huge brand name recognition. < Previous Question 1 Next > Two useful tools for determining whether a company's customer value proposition. : The MIT Press, 1983), pp. To begin with, companies usually experience a different rate and pattern of cost change for each cost component. Strategic actions to eliminate a cost … The implementation of ABC … The costs are planned in the early phase of a new product by understanding the market thoroughly. The company’s managers believed that competitors held a cost advantage. In the electric utility industry, where fuel costs account for 40 to 60% of operating expenses, each power company has experienced a different net inflationary impact, depending on the particular mix of coal, fuel oil, natural gas, nuclear power, and hydroelectric generation. As a result, steel companies must either refurbish their inefficient mills or close them down. It can also try to restructure the whole value chain by substituting its own distribution networks for dealers and franchises. Capital costs can rise because of unforeseen difficulties with expanding operations. Given the realistic probability that rising operating and capital costs will affect each competing company in a different way, it is important for each company to probe the nature and size of the differences in order to understand the potential shift in competitive advantage. Exhibit II Value chains for U.S. and Japanese steel companies: a comparison between 1956 and 1976. Variations in fuel costs, along with differences in capital construction needs, have driven big wedges between the rates charged for electric power across the United States. In 1981, however, the price of crude shot up 44.4%, while the rise in gas prices was only 23.5%. You will have to adjust if, while pushing capacity to the limit, you find operating costs beginning to creep up. Many U.S. steel companies have seen their variable operating costs rise more quickly than those of Asian producers, and the capital costs of modernizing large, integrated mills seem prohibitive. Copyright © 2020 Harvard Business School Publishing. Although it makes sense to start with a value chain for a whole business, searching for variations by segment can reveal important differences in each product’s cost competitiveness and the company’s unwitting cross-subsidy of unprofitable products. A unique geographic location 4. It's impossible to determine whether lowering costs or increasing revenue is more important across the board for all companies. The major lesson in strategy formulation that emerges from this analysis is that a company must closely gear its strategy to the long-term changes in the industry’s cost economics. They may actually tend to outpace the price level on the average in the long run, but only with wide swings and great uncertainty. The total revenue for a firm in a perfectly competitive market is the product of price and quantity (TR = P * Q). There are some constraints on this strategy. Customers became so price sensitive that they cut their use of electricity and average loads from a rapid annual 6% to 8% growth rate down to a mature industry rate of 1% to 3%. Making these kinds of investments “early” can mean major savings in capital costs; Standard Oil of California, which spent $1.3 billion to upgrade its Pascagoula, Mississippi refinery in 1981 and 1982, has estimated that the same improvement would have cost $2 billion in 1983. Essentially, the goal of this general analysis is to assess whether a price is reasonable, and this depends on the type of market where the supplier operates. To illustrate the strategic payoff of constructing a value chain, look again at Exhibit I. Sometimes the competitive advantage is only accessible through a certain target market, with a specific product or service or with a specific location. Intellectual property is a set of intangibles owned and legally protected by a company from outside use or implementation without consent. In countering these strategies, the Sun Company decided not to upgrade its Pennsylvania refinery and gambled that the industry’s shift to low-quality crude would leave Sun ample access to high-quality crude and that the price difference between high-quality crude and low-quality crude would not average the $6 to $7 per barrel that the other companies had used to justify their investments. In an industry where new fixed assets or capacity additions are expensive, a company with relatively modern facilities and adequate capacity may well find it competitively advantageous to use a focus strategy and concentrate on selected groups of buyers. A company that finds itself in a trap like XYZ’s can do something to get out of it. Rising capital costs will hit your company hard if you rely on a differentiation strategy to win market share.