In my previous article I referenced Competitive Advantage, written by Michael Porter, and having subsequently had a number of insightful conversations with some of you, I felt it worth dedicating further attention to the approaches he covers. Therefore, today I am highlighting the first of his three strategies:
- Cost leadership means you provide reasonable value at a lower price
Whichever way you want to look at it, whatever your industry sector or business model the most important goal is to make money and keep it, which depends on liquidity and efficiency. Without having an adequate gross profit margin, a business cannot pay its expenses and retain earnings for future growth. Fundamentally, a business competing on price has to be constantly innovating, improving and responding to market changes in order to be able to keep reducing its prices and maintaining its margins.
Businesses that operate with a low profit margin generally sell a large volume of goods, as any decrease in sales is likely to result in a struggle to cover their expenses. Typically, they will benefit from economies of scale and Walmart, the American mega-store, is an outstanding example of a business that has achieved success this way, making it one of the wealthiest businesses in the World. The price is low but daily sales are over $1.3bn, they have a large pool of customers and a high level of customer loyalty. All are essential components for successfully surviving on small margins.
So what are some of the key ways to compete effectively on price and still maintain a good margin?
Lean - the business needs to be as lean as possible. At a basic level this means mapping out every step and process across the organisation, auditing from point to point and eliminating anything that does not add value or reduces efficiency. You would be amazed at how many unnecessary things most businesses do unknowingly every day. Successful and forward thinking companies use such mapping processes to anticipate likely developments and provide a fresh perspective on the firm's opportunities and challenges.
High quality - a culture of high quality needs to run throughout the organisation, which should result in low waste. When aiming to compete on price eliminating wasteful spending is crucial, alternatively the business is squandering time, resource and materials without providing any additional value to the customer. Key areas to target are inventory, over-production, over-processing, transport and downtime. Successful companies will account for waste and activity at every stage and will include this within the cost of their overheads. Such due diligence enables them to monitor continually the price of their product or service against the operating costs and enables them to prevent profit margins from shrinking.
Technology - everything moves so quickly in today’s market that a company competing on price needs to lead the way on technology as a competitor who has found a technological solution can cut prices, forcing rapid market erosion or heavy reductions in margins. With artificial intelligence rapidly advancing, progressive and dynamic businesses and bold and liberal entrepreneurs are out in front, using this essential tool to become more productive, efficient and informed.
Automation - if there is a cost effective way of automating a process, companies competing on price need to be early adopters enabling them to do more with less, introducing smart workflows and removing redundant tasks. There is a concern that automation will create unemployment but wider thinking, beyond the fear of employees replaced by robots, shows how such progress allows successful companies to step away from mundane micro-management tasks, freeing up essential time to work on important growth and development opportunities such as higher quality customer service, retention strategies and niche offerings. In turn, business owners and boards embracing such development are free to concentrate their efforts on the big picture visionary goals that ultimately determine the growth of the organisation. The iconic Sir James Dyson is a firm believer that automation will increase employment.
Economies of scale - often by expanding their scale of production and being larger, companies can exploit the cost advantages of better purchasing power, thereby reducing overheads as well as benefiting from shipping and logistical synergies; such savings increase profitability. Economies of scale can be internal or external and create a competitive advantage for larger organisations over small, who do not have the same leverage to compete. There is however, an alternative opportunity available to smaller organisations and independent businesses who plan to capitalize on the benefit of geographical economies. Such entrepreneurship is created when similar enterprises, such as art galleries, independent eateries and bohemian retail outlets, cluster together in a ring-fenced location. I assume, that evidence of such success is what lies behind the thinking of the current plans for box-city in Cardiff Bay.
Cash - a business competing on price needs to be able to withstand price wars with competitors and for this, it needs enough cash to avoid eradication by ruthless adversaries prepared to sacrifice profits for market share. It is crucial that an organisation has a clear understanding of the difference between profit and cash, all too often, profit is prioritised at the expense of cash and this can lead to an untenable future. From experience, poor cash management is often the reason behind a business becoming insolvent.
So why do businesses need cash? Any successful business needs to be able to pay the monthly expenses that make the business run; hence, cash flow is the single most important financial factor to consider.
Beyond this, in order for the business to grow there will be varying requirements for investment - machinery, technology, staff training, product development are all evidence of investment needs and capital expenditure will be required to fulfill these needs. Of course, assuming credit facilities are available, a loan could finance such expenditure but this would increase the monthly expenses mentioned previously.
On the subject of growth maybe the business owner/s have a goal to make an acquisition. Such opportunities can be highly beneficial for a company’s growth potential. When you find the right company to purchase, however, even if it is at a reasonable price, cash will be a requirement to make the transaction possible, especially if loan facilities are not available or if lenders’ terms make credit an unfavourable source of revenue.
Many businesses will know the hardship of suddenly facing an unexpected legal bill or a downturn in the economy. With cash available, the business is more likely to survive these setbacks without having to take drastic measures such as laying off employees, cutting back on production or worst of all, closing the business completely.
In the aftermath of Carillion, where it appears mismanagement of low margins significantly contributed to the company’s demise, it is important to remember that there are businesses who are very successful in operating with this business model. Aside from WalMart, mentioned earlier, McDonalds is known for yielding low margins but still competes successfully in the restaurant industry by aligning their offering, methodology and target market. Similarly, Nando's operates on the same basic principles. IKEA are another shining example, a global success story of fine tuning costs throughout their manufacturing and delivery chains enabling these savings to pass to their customers. The airline industry has typically been an industry where profits are hard to come by without charging high-ticket prices but when EasyJet entered the market it was confident it could operate with a low cost model and given the news of last year’s results they are clearly doing something right.
These examples indicate that the cost leadership model can be highly successful, but for businesses thinking of operating this way it is important to remember it is not always easy to deploy the strategy. If you are marketing your company as the cheapest source for product or service you need to minimise costs to be able to pass the savings on to your customers. Low Cost Holidays, Monarch and BHS are all examples of organisations whose decline can be attributed to mismanagement of the low cost model and for those of us old enough to remember, the sad decline of 99 year old Woolworths epitomizes all that should be monitored for an organisation who wishes to operate with this strategy.