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Step 2: Use Activities to Analyze Relative Costs

Competitive cost analysis is the usual starting point for the strategic analysis of competitive advantage. In pure commodity businesses such as wheat farming, customers refuse to pay a premium for any company’s product. In such a setting, a low-cost position is the key to added value and competitive advantage. But even in industries that are not pure commodities, differences in cost often wield a large influence on differences in profitability.

Cost analysis was one of the efforts that managers at Collins Kitchens undertook in the mid-1990s as they struggled to understand why their financial performance was poor and their market share plummeting. They cataloged the major elements of their value chain and calculated the costs associated with each class of activities. As Figure 7 shows, although Collins sold the typical package of snack cakes to retailers for 72¢, raw materials (ingredients and packaging material) accounted for only 18¢ per unit. Operation of automated baking, filling, and packaging production lines, largely depreciation, maintenance, and labor costs, amounted to 15¢.

Outbound logistics—delivery of fresh goods directly to convenience stores and supermarkets, and maintenance of shelf space—constituted the largest portion of costs, 26¢. Marketing expenditures on advertising and promotions added another 12¢. A mere penny remained as profits for Collins.

The managers then determined the set of cost drivers associated with each activity. Cost drivers are the factors that make the cost of an activity rise or fall. For instance, the managers realized that the cost of outbound logistics per snack cake fell rapidly as a firm increased its local market share; total delivery costs depended largely on the number of stops that a truck driver had to make, and the larger was a firm’s market share, the greater was the number of snack cakes a driver could deliver per stop.

Urban deliveries tended to be more expensive than suburban because city traffic slowed down drivers. Outbound logistics costs also rose with product variety; a broad product line made it difficult for drivers to restock shelves and remove out-of-date merchandise. Finally, the nature of the product affected logistics costs: snack cakes with more preservatives could be delivered less frequently. The managers developed numerical relationships between activity costs and drivers, for outbound logistics activities and for the other activities in Figure 7.

Cost drivers are critical because they allow managers to estimate competitors’ cost positions. One usually cannot observe a competitor’s costs directly, but one can often observe the drivers. One can see, for instance, a competitor’s market share, the portion of its sales in urban areas, the breadth of its product line, and the ingredients in its products. Using its own costs and the numerical relationships to cost drivers, a management team can estimate a competitor’s cost position.

When Collins’ managers did this for Betsy Baking, they found the results sobering. Because Betsy Baking used inexpensive raw material, purchased in bulk, and tapped national scale economies, its operations costs totaled 21¢, in contrast to 33¢ for Collins. Betsy Baking packed its product with preservatives so that deliveries could be made less frequently, kept its product line very simple, and benefited from growing market share. Consequently, its logistics costs per unit were less than half of Collins’.

Also, Betsy Baking did not run promotions. Altogether, the managers estimated, a package of Betsy Baking snack cakes cost only 34¢ to produce, deliver, and market. Comparisons with the two other major competitors, Ontario Baking and Savory Pastries, were not so discouraging. Indeed, Collins had a small cost advantage over each. (See Figure 8.)

This specific example illustrates a number of general points about relative cost analysis:²³

• When reviewing a relative cost analysis, it is important to focus on differences in individual activities, not just differences in total cost. Ontario Baking and Savory Pastries, for instance, had similar total costs per unit. The two firms had different cost structures, however, and as we will discuss below, these differences reflected distinct competitive positions.

Good cost analyses typically focus on a subset of all of a firm’s activities. The cost analysis in Figure 8, for example, did not cover all the activities in the snack cake value chain. Effective cost analyses usually break out in greatest detail and pay the most attention to cost categories that (1) pick up on significant differences across competitors or strategic options, (2) correspond to technically separable activities, or (3) are large enough to influence the overall cost position significantly.

•         Activities that account for a thicker slice of costs deserve deeper treatment in terms of cost drivers. For instance, the snack cake managers assigned several cost drivers to outbound logistics and explored these drivers in depth. They spent little time considering the drivers of advertising costs. The analysis of any cost category should focus on the drivers that have the biggest impact on it.

•         A particular driver should be modeled only if it is likely to vary across the competitors or the strategic options that will be considered. In the snack cake example, manufacturing location influenced wages rates and therefore operations costs. All of the rivals manufactured their snack cakes in western Canada, however, and manufacturing elsewhere was not an option because shipping was costly and goods had to be delivered quickly. Consequently, manufacturing location was not considered as a cost driver.

•         Finally, since the analysis of relative costs inevitably involves a large number of assumptions, sensitivity analysis is crucial. Sensitivity analysis identifies the assumptions that really matter and therefore need to be honed. It also tells the analyst how confident he or she can be in the results. Under any reasonable variation of the assumptions, Betsy Baking had a substantial cost advantage over Collins.

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A number of references discuss cost drivers in greater detail and suggest specific ways to model them numerically.²⁴ The catalog of potential drivers is long. Many relate to the size of the firm: economies of scale, economies of experience, economies of scope, capacity utilization, etc. Others relate to differences in firm location, functional policies, timing (e.g., first-mover advantages), institutional factors such as unionization, government regulations such as tariffs, and so forth. Differences in the resources possessed by a firm may also drive differences in activity costs. A farm ^ with more productive soil, for instance, will incur lower fertilization costs.

A number of pitfalls commonly snare newcomers to cost analysis. Many companies, particularly ones that produce large numbers of distinct products in a single facility, still have grossly inadequate costing systems that must be cleaned up before they can be used as reference points for estimating competitors’ costs.   

As courses on management accounting point out, conventional accounting systems often overemphasize manufacturing costs and do a poor job of allocating overhead and other indirect costs. As firms increasingly sell services and transact on the basis of knowledge, these outdated systems make it harder and harder to analyze costs intelligently.²⁵

Also problematic is a tendency to compare costs as a percentage of sales rather than in absolute dollar terms. This confounds cost and price differences. It is also common, but dangerous, to mix together recurring costs and one-time investments.

Some analysts confuse differences in firms’ costs with differences in their product mixes. One can avoid this problem by comparing the cost positions of comparable products; compare Ford’s four-cylinder, mid-sized family sedan to Toyota’s four-cylinder, mid-sized family sedan, not some imaginary “average” Ford to some “average” Toyota. Finally, a focus on costs should not crowd out consideration of customer willingness to pay—the topic of the next section.