Why Low-Cost Operations Build Powerful Businesses, and Why it Always Matters

Note: Republishing this post I shared on the Medium paid subscription a few years ago. This was originally written in May 2015.

The Basics of Cost Leadership

As Competitive Advantages go, Cost Leadership is the epitome of ‘Simple, but not easy.’ It does not take incredible insight to see that in many cases, customers will choose the lowest price amongst similar products. This is likely to be a winning strategy (depending on the industry, as we’ll see later).

There are two kinds of companies: Those that work to try to charge more and those that work to charge less. We will be the second. — Jeff Bezos

This quote is from this great post by Jake Nielson. It’s wonderfully polarizing, and a beautiful synopsis of the ethos of the cost leader.

Thanks to Ray Stern for contributing this post and quite a few other ideas this week. You were really helpful on this topic, Ray!

Cost Leadership ≠ Price Leadership

To clarify a common point of confusion: Cost Leadership is NOT necessarily Price Leadership, though the two often go together. A cost leader will be more profitable than a competitor at the same price point.

In industries that compete primarily on price, (especially in commoditized products) cost leaders usually win, as their profitability gives them more room to innovate, maneuver, and survive than their lower-margin competitors.

It’s important to remember that we’re trying to reduce costs — not just prices. Also, that the company with the lowest prices isn’t necessarily the one with the lowest costs.

How to Become the Low-Cost Operator

In nearly every function of a business, there are ways to lower costs. The challenge of remaining a cost leader is that if you don’t take an opportunity to lower your costs, a competitor will, and will overtake your position.

A low cost producer must find and exploit all sources of cost advantage.

There are no half-measures for those who want to remain cost leaders. Commit to extreme cost excellence for the long run, or find another way to compete.

Let’s look at the different ways to establish and maintain Cost Leadership:

Economies of Scale

As a company produces more of a good, it tends to get more efficient at the process. Costs of production fall as output increases. This dynamic is most common in manufacturing, but applies anywhere that scale creates gains in efficiency and decreased costs.

For examples of this, check out Foxconn, the contract manufacturer that builds iphones, ipad, blackberry, and many gaming consoles. Historically, you could also read up on Carnegie and Rockefeller, both of whom created empires by exploiting Economics of Scale in Steel and Oil production.

Thanks to Preet Anand for suggesting the fascinating story of Rockefeller and Standard Oil to the mix. There’s an amazing account in Rockefeller’s Biography, Titan.

Advantage of Size

Benefits of size often manifest in increased purchasing power. The more leverage a business has over a supplier (the more money they give them), the more they are able to extract unique deals that become advantages.

From Charlie Munger on 25iq:

On the subject of economies of scale, I find chain stores quite interesting. Just think about it. The concept of a chain store was a fascinating invention. You get this huge purchasing power — which means that you have lower merchandise costs. You get a whole bunch of little laboratories out there in which you can conduct experiments. And you get specialization.

If one little guy is trying to buy across 27 different merchandise categories influenced by traveling salesmen, he’s going to make a lot of dumb decisions. But if your buying is done in headquarters for a huge bunch of stores, you can get very bright people that know a lot about refrigerators and so forth to do the buying.

Wal-mart is the most extreme example of the power of size. As such an enormous purchaser, they can be brutal negotiators to get uniquely favorable prices. The lower they buy, the lower they sell to remain the best discount store on the planet. It’s an advantage that is hard to compete with.

From Made in America, the story of Wal-mart:

Our Vendors resented us for prying the lowest prices out of them.

Every buyer has to be tough. That’s the job. I always told the buyers: “you’re not negotiating for Wal-Mart, you’re negotiating for your customer. And your customer deserves the best price you can get. Don’t ever feel sorry for a vendor. He knows what he can sell for, and we want his bottom price.

To understand more about the inner workings of these businesses, check out Made in America (Wal-Mart), and The Everything Store (Amazon), to see how these strategic positions were developed and reinforced.

Technology

Another source of cost advantage is a technological innovation protected by trade secret or patents. If a business has a proprietary technology or process that competitors can’t match, it can become a cost leader very quickly.

A good historical example of this is Henry Ford’s Assembly line. He didn’t invent the car, but he did crush his competition by creating a much cheaper way to produce them through new technologies and processes.

Preet Anand points out that Redfin is tearing up the real estate brokerage space with a technology-powered cost leadership advantage right now:

Redfin is a digitally-powered residential real estate brokerage. They don’t have offices that customers visit and you don’t get on the phone with them to coordinate tour times or make notes. Their website and app is how they acquire and interact with customers. It provides tools for the customer to do their homework and is designed to be self-serve.

They then use this lowered cost basis to offer home buyers a commission rebate. Buying through Redfin is literally thousands cheaper as a customer than buying with most other brokerages.

In this way, industries can get turned upside down by a new entrant with a significantly lower cost structure that is based on a new technology.

Tight Scope

Don’t think that being massive is the only way to create a cost advantage. In some industries, a company with a strategy of providing only one product or service, with extreme focus and efficiency, can establish itself as a cost leader.

This is the secret behind Southwest’s entrance into the Airline industry, which is notoriously competitive and low-margin. They became a cost leader through focus and starting small. When they started, they only served 3 cities and had 3 planes, an incredibly tight scope for an Airline.

Raw Materials

Cost advantages can also be created through preferential access to crucial raw materials. If a business has rights to a resource (like data or natural resources) which competitors pay more for, they are set up for cost leadership.

This is one of the primary levers in the oil industry, where companies battle for drilling rights to specific areas. The extraction price of that oil, compared with the price they paid for the rights, will determine how profitable they can become.

Operating Efficiency

Some businesses are simply better-run than others. They get more done in less time, and spend less money doing it. Often, this is a function of the experience and expertise present in a team — better operators and managers know how to do more with less.

Companies can create cultures that are ruthless about creating cost advantages. Amazon has every employee make their own desk out of a door from Home Depot, as a symbol of their scrappiness. Mort Mandel would have his managers do a hypothetical 10% cost-cutting exercise every year, just to see what might happen:

This is a simple exercise that can lead to a lot of creating thinking. Every year, I ask my team to do the equivalent of reducing their budgets by 10% — then I ask them what they’d do with that newly freed 10%.

In every organization, there are many opportunities to do things better — for less. You need to be on the constant lookout for those opportunities. These nickels and dimes add up, every day, every week, every month.

These are also strategic decisions that can create cost advantage through operating efficiency — companies that are vertically integrated have the ability to manage their costs more tightly than a competitor who relies on suppliers or distributors with their own costs an inefficiencies. Just think how much more efficient Tesla is at distributing it’s own cars from small retail stores rather than supporting a whole network of dealerships all over the country.

Market Context for Cost Leadership

One of the interesting things about cost leadership is that it changes depending on the context. For some industries, cost leadership belongs to the largest or oldest players. In others, the newest, smallest businesses are the low-cost operators.

Fragmentation or Conglomeration

Hidden in this is an important concept — that depending on the sources of cost leadership an industry will continuously move toward conglomeration or fragmentation.

In the industries governed by economies of size and scale, where larger operators will be able to create cost advantages that are untouchable by new entrants, companies will become larger and larger. If there are 4 competitors in the space, there are likely to only be 2 over time.

On the other hand, for industries where new entrants are the cost leaders, because of low overhead and fixed costs (such as lawn care, plumbing, and house cleaning — most service businesses), it’s impossible to build a massive company on cost leadership because new entrants can always undercut you, and barriers to entry are low.

Whatever your business is — you should understand this dynamic for your industry. It will show you where the challenges are likely to come from. Should you be trying to get big or stay small?

Relative Cost Leadership

Another interesting way to look at cost leadership is that it is relative. A business can be a low-cost operator in a market segment, a middle or high price tier, and still enjoy competitive benefits.

This idea (and a great example) came from Rob McGrorty of Webgility:

An example is Evolve CFO, my old company. We’re in an industry (startup and smb bookkeeping/accounting/financial consulting) where there are clear low-price leaders like Bench.co. There are also high price, high service leaders, like any national accounting or consulting firm. Where we found our niche, and how we stole significant numbers of clients from all of our competitors, was to find a relative cost savings on recurring bookkeeping and accounting work (monthly books, financial statements, tax prep, etc) that we billed at a fixed “package” price — but kept reducing our costs for, month over month.

No matter what business you’re in, for any industry or market segment, there is an advantage to be had in a relative cost advantage.

Disadvantages of Cost Leadership

There are pitfalls to the low-cost strategy that must be carefully avoided.

Low Cost ≠ Poor Quality

In an industry or market segment where quality is the most important feature to customers, (legal services, for example) appearing to be the low-cost operator is not always desirable.

We talked a little bit about this in the Pricing Edition of Evergreen:

There’s an amazing phenomenon in pricing, where an increase in price leads to an increase in sales because of a basic guideline that is programmed into all of us. We’re so used to better products costing more, that when something costs more we assume that it is better.

Notice we said appear as the low-cost operator. That doesn’t mean you can’t maximize operating efficiency to keep costs down and quality up. To keep prices high and provide quality services with low costs is a recipe for success.

No one wants to buy the Wal-mart version of legal services, plumbing, or safety equipment. Pricing should remain a separate issue from costs, and don’t forget that pricing is an aspect of marketing.

Low-Price Customers are Disloyal

Another possible disadvantage in competing on low price is that customers are not as ‘sticky’ as those who buy from a business for brand reasons. This is a great point made by Brad Smith in Why Being a Low Cost Provider is a Recipe for Failure:

People chasing low cost aren’t loyal to you… they’re loyal to the bottom line.

This is all about behavior and psychology. But it’s undoubtedly true.

Do people shop at Wal-Mart because they love how clean it is, and how friendly and knowledgeable the staff is?

No way! They shop there because it’s cheaper than their available alternatives.

While this post assumes that a low-cost company is competing on price, which isn’t always true, it remains an interesting point. How much of your customer base would remain with you if there was a cheaper product out there tomorrow?

Thanks again to Ray Stern for suggesting this post!

Study the Masters of the Technique

There didn’t appear to be a ton of great stuff out there on the web for this topic (if you have some, comment with it!) The best lessons seem to come from personal experience in industries, or deeply studying companies and leaders that are uniquely excellent practitioners of this strategy.

To get deeper on this topic, I’d suggest picking up some books on the ruthless cost managers and trying to get in their head. See the extent of their dedication to the strategy and what tactics they employed: Walton, Bezos, Mandel, Carnegie, Rockefeller… any others?

Also, whatever industry you’re in, find out who the lost-cost operator is for each market segment, and study how they got there. What did they give up? What did they do or not do that others haven’t copied yet? What opportunities to force costs down haven’t been enacted yet?

Find those unexploited opportunities to become a cost leader in your industry and market segment — and get after them ruthlessly.