https://hbr.org/1984/01/strategies-for-staying-cost-competitive

During years of chronic inflation, the managers of XYZ Corporation developed the habit of raising prices to cover rising costs and defend profit margins. (XYZ is a name I am using to designate a composite of several companies.) Observing that all its rivals were forced to do the same, XYZ felt secure in its strategy.

Then deflation began, market demand slackened, and a deep recession set in. A buyers’ market emerged. XYZ couldn’t count on price hikes to cover its still slowly rising costs because its volume-conscious rivals were aggressively using price as a weapon to gain market share. XYZ’s profits eroded while the others’ remained buoyant. 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.

XYZ was caught squarely in a competitive pricing trap. The company’s managers believed that competitors held a cost advantage. To catch up, they considered investment to modernize existing facilities or to build new cost-competitive plants. 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.

XYZ’s predicament is shared by companies in many capital-intensive industries. 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

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.

Once a secure geographic monopoly—and essentially a commodity business—the electric utility industry is now in the throes of price warfare in the wholesale and bulk power market segments, with low-cost producers in a position to take business away from higher-cost suppliers. 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. A number of power companies, increasing generating capacity at capital costs three to five times higher than those for facilities brought on in the 1970s, are nervous about whether the high fixed-cost charges for these new facilities will allow them to be price competitive with other electric energy suppliers.

For example, the Canadian surplus of cheap hydroelectric power and New England’s 30% electricity surplus threaten the once sound economics of New Hampshire’s Seabrook nuclear project (whose original estimated price tag of $1 billion for units 1 and 2 has ballooned to $5.2 billion). In the same way, a surplus of generating capacity in the Pacific North-west, exacerbated by projected rate increases of 100% to 200%, has brought the once strong Washington Public Power Supply System to bond default and even to the brink of bankruptcy. The future holds even more competitive pricing threats; a potential breakthrough in the development of solar thermal equipment and photovoltaic cells by General Electric, Westinghouse, United Technologies, and several Japanese companies portends important new sources of even lower-cost energy substitutes.

Of course, some companies did manage in the 1970s to avoid inflation’s trap by investing “early” in new facilities and protecting their long-run competitive position. Both Sun Oil and IBM have benefited from committing investment capital on a timely basis to strategic moves designed to yield strong cost positions vis-à-vis their competitors.

A company that finds itself in a trap like XYZ’s can do something to get out of it. From my research and work with companies facing sharply rising capital requirements, I’ve seen the value of doing strategic cost analysis to identify ways to defend against, and sometimes escape, a competitive pricing trap.

Strategic Cost Analysis

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. This involves constructing a value chain, a diagram that shows the value added at each step in the whole market process and exposes shifting cost components. Next, you assess the long-run shifts in the cost position of your competitors relative to your own. Finally, you factor the implication of future inflation into your own costs and those of the competition.

This kind of analysis provides the backdrop for formulating an effective strategy and defense to help you avoid (or escape from) the competitive pricing trap, whether you want to become the low-cost producer in the industry, focus your sales efforts on a particular segment of the market, or differentiate your product from your competitors’.

Identifying shifts in key cost components

Sustained inflation leaves an imprint on current operating costs as well as on the cost of fixed assets and new capacity. No operating component remains unmarked, whether purchased materials, direct labor costs, maintenance, energy, salaries, fringe benefits, transportation, marketing, or distribution costs. Unchecked inflation can radically change the whole cost structure of an entire industry. After adjusting for greater sales volume, for example, operating costs in electric utilities rose an average of $4 billion each year between 1970 and 1981. That’s in an industry that started from a base of $20 billion in sales and $3 billion in net income. The $44 billion increase over 11 years spawned round after round of rate increases, pushing rates in 1982 some 200% to 300% higher than in 1970. 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%.

More significant, however, is how the phenomenon of rising costs can, over time, produce strategically relevant shifts in a company’s cost structure and cost competitiveness. To begin with, companies usually experience a different rate and pattern of cost change for each cost component. 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. In 1956, they could produce a ton of cold-rolled sheet steel for $35 less than the Japanese. By 1976, Japanese companies were producing a ton for $35 less than their American competitors.³

Because every company within an industry has a slightly different cost structure for manufacturing inputs, varied inflation rates for these inputs can open up important cost differentials between competitors. Take the case of energy fuels. Price patterns across fuel types have varied widely from fuel source to fuel source and from year to year. In 1976, the price of gas fuels went up 35.2%, while that of crude petroleum increased only 8%. In 1981, however, the price of crude shot up 44.4%, while the rise in gas prices was only 23.5%. Such differences in inflation rates for particular cost components play a big long-term role in shifting the cost competitiveness of different fuel sources and energy-intensive industrial companies. 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. 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.

Manufacturing companies in such energy-intensive industries as pulp and paper, chemicals, and primary metals feel the competitive impact of fuel cost differences. An aluminum producer with plant facilities in the Pacific Northwest today can manufacture more aluminum with fewer dollars than a producer in the Midwest.

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. Increasing capital costs can push the incremental costs of fixed assets and capacity far above the historic cost of existing plant and equipment. In turn, average costs rise sharply as new capital investments are made and cause a squeeze on profit margins and a need to raise selling prices. Moreover, the size of the increase in capital requirements can impose a severe financial burden.

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. Long-term contracting for coal-fired generating capacity from neighboring utilities is now more economical.

The capital costs for a new steel mill in the United States have escalated to about nine times the cost of the embedded technology.⁴ While production costs for new plants have dropped $60 per ton (because the amount of labor and energy necessary to produce a ton has dropped), the capital costs for a new mill are $130 per ton higher and push unit costs up a net $70, or 10% above the market price per ton of steel. As a result, steel companies must either refurbish their inefficient mills or close them down.

Capital costs can rise because of unforeseen difficulties with expanding operations. Southland Corporation saw its costs for new 7–Eleven convenience food stores rise because of the explosion in the industry. When Southland first bought sites in the 1960s, few other companies were competing for the kind of location it needed. With the rise in the number of fast retail operations, other fast food chains, service stations, and retail companies began to compete for the same locations and thus drove up their prices.

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. This is where a value chain comes in.

Using a value chain

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. By including the impact of costs both inside and outside the company, the value chain helps the manager understand the sum total of the shifting cost economies up and down the whole market spectrum.

Exhibit I The value chain

The value chain is revealing but not simple. To use it, a company must recast its own historical cost accounting data into the principal cost categories that eventually make up the value of its product. Most difficult is the necessity of estimating the same cost elements for its rivals—an advanced stage in the art of competitive intelligence.

Despite the tediousness of this job, the value chain pays off by exposing the cost competitiveness of your position and the attendant strategic alternatives. 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. The shifts in the several cost components are dramatic. The major causes of the shift in cost competitiveness involved differing inflation rates in the prices for production inputs, but technological changes and higher Japanese labor productivity also worked against the United States.

Exhibit II Value chains for U.S. and Japanese steel companies: a comparison between 1956 and 1976 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).

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). 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.

To illustrate the strategic payoff of constructing a value chain, look again at Exhibit I. A relative cost shift can occur in any one of three main areas—suppliers, the company’s own segment, or forward channels. After constructing a value chain, a company may discover it can reestablish cost competitiveness only if it goes outside in-house operations. For example, if it’s losing out because of a competitive disadvantage in the cost of purchased inputs, the company’s strategic options are to negotiate with suppliers for more favorable prices, integrate backward to gain control over material costs, use lower-priced substitute inputs, or make up the difference by initiating cost savings elsewhere in the total value chain.

When the cost disadvantage is in distribution, the company can push for more favorable terms, change to more economical distribution, or make up the difference by initiating cost savings earlier in the total value chain. It is likely, of course, that a substantial portion of any cost disadvantage a company has lies within its own in-house cost structure. Here the strategy options are more complex. 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. For example, if both your operating and your capital costs are higher than those of competitors, you’re about to be caught in the pricing trap. You may find it hard to hold onto your share of the market and, more important, you probably can’t invest your way out of the cost disadvantage in the short run (because the new capital requirements are unattractively high and leave no room for a return on investment at going market prices for the product).

At the other end of the spectrum, where your company is less affected by both relative operating and capital cost increases, you are in an excellent position to use your low-cost stance to win a higher market share by offering a lower price. Companies in the middle (either more or less affected by two variables) have less clear-cut strategies. 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.

Assessing competitive shifts

In the next phase of strategic cost analysis, the company has to assess how rising cost pressures will affect its growth objectives and market share potential. For the sake of simplicity, let’s consider three basic strategic postures relating to growth: building market share, defending the current market share, or giving up market share (taking a “shrink abandon” approach). Furthermore, let’s focus the analysis on the extremes, where inflation drives up either operating costs or capital costs.

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. Eventually it will enjoy lower fixed costs than competitors that add capacity later, when investment costs are higher. It must also forecast future market volume accurately and target its market share objectives to coincide with a relatively lower-cost industry position.

If the tables are turned and inflation hits operating costs unevenly while capital costs remain equal, a company can protect cost competitiveness if it: (1) innovates around troublesome operating cost components as new investments are made in plant and equipment, (2) translates the resulting cost advantage into a gain in market share, or (3) offsets any increases in operating costs that do arise with new efficiencies associated with added sales volume and higher market share.

If the source of rising unit costs in an industry comes mainly from the added costs of new investments in plant and equipment, a “hold share” growth objective can yield attractive profit margins. Companies that don’t build new plants can gain a competitive advantage if they are able to use a higher percentage of existing capacity to produce the extra volume needed to maintain market share. This hold share strategy can work under conditions of strong or weak market demand. 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. When market demand is strong, the company can go along with the price increases that more growth-minded companies need to cover the incremental unit costs associated with new investments in plant and equipment.

Interestingly enough, a company with a long-term shrink-abandon strategy may be able to benefit handsomely from sharply rising costs for new plants and equipment. Because it is committed to cost-containing retrenchment and won’t encounter capacity-induced cost increases, a company can simply sell under the price umbrella of rivals and enjoy a long “cash harvest” as competitors raise prices to compensate for the higher costs associated with capacity expansion or capacity replacement.

Assessing future cost increases

In the final analytic step, a company turns to the impact of future cost increases on both the operating and the capital side of the production equation. For example, if a company seems likely to suffer from both high operating and high capital costs, it will have to increase prices at rates faster than inflation to hold its market, but it will soon invite customers to switch to substitutes. It will have to consider the option to harvest or divest unless the industry’s growth prospects are bullish despite inflation, or unless the industry has an immature technology and “breakthroughs” can take away some sources of rising costs.

If the inflationary combination results in a company expecting higher relative capital costs but lower operating costs and if its industry has good growth prospects and a mature technology, then there is a potential first-mover advantage from adding new capacity early. To sustain the advantage, it must be able to recoup the cost suffered from temporary excess capacity when rivals finally add or replace plant and equipment at inflated costs. The size of any first-mover advantage depends on the speed of increases in capital requirements, the extent of the industry’s need to add capacity to meet new market demand, and the potential for lower-cost substitutes to capture a lucrative share of the market. When demand is expected to remain slack, the best position to defend is a hold-share strategy, in which long-term cost competitiveness is protected by keeping new investments in fixed assets to a minimum.

Obviously, companies that expect high future operating and low capital cost increases and companies that anticipate low inflation in both types of costs have a greater degree of strategic freedom. In neither case do companies have to worry so much about the timing of decisions to add or replace production facilities. 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. A build-share growth strategy by one company can coexist with a hold-share strategy by another.

At IBM, top management decided that the economic impact of rising operating costs would outweigh that of escalating capital costs. The company made a big commitment to capital spending. John R. Opel, IBM’s CEO, once said, “We want to be the lowest-cost producer of everything we make. 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.

Factoring in Cost Economies

Whether you expect your company’s costs to be affected more by operating cost changes or by capital cost changes also determines the success of your competitive strategy. 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). Either way, you lock into a low-cost position with fewer dollars of fixed asset investment. 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.

There are some constraints on this strategy. You will have to adjust if, while pushing capacity to the limit, you find operating costs beginning to creep up. Another problem may arise if you have to cut prices to preserve volume; in that case, you won’t be able to use full capacity.

Nonetheless, if your business has relatively high and rising fixed costs per unit, successful cost leadership depends on the combination—and timing—of low capital investment and productive use of fixed assets. The key cost drivers are the timing of capacity additions and investment and capacity use. Many electric utility executives have begun to push the use of this approach.

Differentiate with a twist

Rising capital costs will hit your company hard if you rely on a differentiation strategy to win market share. There are limits to how much more buyers will pay for a product that is fancier than its rivals’. At some point, the buyers may be attracted to a more generic product at a lower price. The key is to contain new spending commitments that are affected by rising capital costs. You must try, insofar as you can, to shift the basis of your differentiation to operating cost variables—to advertising, service, inspection procedures, and manufacturing workmanship. If that is impossible and you must continue to base the strategy on the better performance of your product, then you must make certain that the costs to buy the new plant and equipment necessary to make your product the better performer can be offset by performance gains that will preserve your buyers’ preference for your product and forestall their natural motivation to switch to a lower-cost substitute. Otherwise, a strategy to be the cost leader will beat a performance-based differentiation strategy.

Focus on a particular segment

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 narrow customer base helps limit the need for capacity expansion and shields the company from the cost of escalating capital requirements. By narrowing the product line, the company can allocate expensive production capacity to its most attractive items and market segments. Higher margins can be expected both from having a favorable cost position and from “trading up” the use of existing capacity. 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.

The Operating Side

When rising costs hit the operating-cost side of the value chain harder than the capital side, a company can still be successful in pursuing a strategy of being the low-cost producer if it can find ways to innovate around the components of operating costs most susceptible to inflation. It can also try to restructure the whole value chain by substituting its own distribution networks for dealers and franchises.

Petroleum refining provides an interesting example of how to defend against long-term price increases in a key resource input. Since 1975, U.S. oil companies have invested $15 billion to upgrade refineries so that they can use cheaper, more plentiful low-quality crude oil. The investment is expected to pay a good return through the use of lower-cost crude oil and improved refining technology to increase the yields of higher-margin products.

Ashland Oil figures it will reduce raw materials costs by 20% to 25% through a $240 million upgrading of its refineries. 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.

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.

The success of differentiation strategies in an environment of rapidly rising operating costs varies according to the basis for differentiation. 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. Less vulnerable are companies that (1) differentiate in parts of the value chain less affected by costs, (2) cater to price-insensitive buyers, or (3) enhance the value of their differentiation features enough to outrun the effects of higher unit costs.

A differentiation strategy based on the intangibles of image, buyer confidence, and brand recognition has a stronger chance of being successful when the costs of creating or maintaining the intangibles are not greatly affected by the forces of rising operating costs. The key is to find cost-competitive ways to preserve the value of differentiation for the buyer and to contain customer switching by offering lower prices. Another strategic option is to try to shift more of the basis for differentiation to aspects of product performance that can be added by investments in technology and fixed assets. Such a move may produce a durable competitive edge, especially if it catches competitors by surprise.

When operating costs spiral upward faster than the costs of plant and equipment, a focus strategy can succeed if the company either concentrates on buyer groups that are less price sensitive or tries to build its product line around items that are least affected by cost changes.

Strategic Realignment

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. Managers must think strategically about the long-run implications of short-run cost increases and be creative in finding ways to capture a competitive advantage by minimizing the effects of inflationary cost pressures on the company’s strategy.

While there is nothing inherently wrong in making a series of short-run pricing changes to cover chronically rising costs, the fatal mistake is to fail to recognize why and how strategy must deal with almost certainly uneven cost changes among rival companies. Though small at first, the cost disparities that emerge can over time create big shifts in cost competitiveness and competitive advantage.

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. Success comes to a company that accentuates long-term strategic positioning.