determining whether a company's prices and costs are competitive

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. Strategic actions to eliminate a cost … 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. The key is to contain new spending commitments that are affected by rising capital costs. When over-all prices are rising rapidly, their exact course is bound to be unpredictable. The following graph shows the cost curves for a firm in a perfectly competitive market. (1) Cost analysis is the review and evaluation of any separate cost elements and profit or fee in an offeror’s or contractor’s proposal, as needed to determine a fair and reasonable price or to determine cost realism, and the application of judgment to determine how well the proposed costs represent what the cost of the … A unique geographic location 4. In peak shopping seasons, businesses tend to spend more on advertising. By 1976, Japanese companies were producing a ton for $35 less than their American competitors.3. 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. Like all assets, intangible assets are those that are expected to generate economic returns for the company in the fu… 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. It must also forecast future market volume accurately and target its market share objectives to coincide with a relatively lower-cost industry position. 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. 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. 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. The goal is to be the very best in your field. 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. John R. Opel, IBM’s CEO, once said, “We want to be the lowest-cost producer of everything we make. Competitive advantage refers to the ability of a company to deliver products, services or benefits, either at a lower cost or an improved level than other players in the same industry. Joseph A. Pechman (Cambridge, Mass. 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. Higher margins can be expected both from having a favorable cost position and from “trading up” the use of existing capacity. A narrow customer base helps limit the need for capacity expansion and shields the company from the cost of escalating capital requirements. An airline company might have locked in a low-price fuel contract before prices rose, allowing it to price customers away from other airlines. Some restaurants thrive because of their location. A target cost is the highest amount of cost … 2. Competitive advantages can be found almost anywhere. Exhibit II Value chains for U.S. and Japanese steel companies: a comparison between 1956 and 1976. 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. Furthermore, suppose that all the firms in this industry are identical and that a representative firm’s total cost is: TC = 100 + 5q + q2 Industrial espionage is the illegal and unethical theft of business trade secrets for use by a competitor to achieve a competitive advantage. Southland Corporation saw its costs for new 7–Eleven convenience food stores rise because of the explosion in the industry. 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. 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. 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. See R.A. Bryer, T.I. In 1976, the price of gas fuels went up 35.2%, while that of crude petroleum increased only 8%. XYZ was caught squarely in a competitive pricing trap. 3, 12–13; © 1970 by New York University Press. Unchecked inflation can radically change the whole cost structure of an entire industry. To remain competitive, all the companies must offer quality products at cutthroat prices. This can be roughly … 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. prices. But there simply can’t be great confidence that the price level will rise steadily at any substantial rate, such as 4 per cent. 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. Increasing capital costs can push the incremental costs of fixed assets and capacity far above the historic cost of existing plant and equipment. By narrowing the product line, the company can allocate expensive production capacity to its most attractive items and market segments. Companies in the middle (either more or less affected by two variables) have less clear-cut strategies. This activity appraisal can be applied on commercial transactions, business or proposed policy, or an impending project. Robert W. Crandall, The U.S. Steel Industry in Recurrent Crisis (Washington, D.C. 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. Despite the tediousness of this job, the value chain pays off by exposing the cost competitiveness of your position and the attendant strategic alternatives. Each seller and buyer takes the price as determined. 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. Take the case of energy fuels. Brignall, and A.R. 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. Access to new or proprietary technologyIntangible AssetsAccording to the IFRS, intangible assets are identifiable, non-monetary assets without physical substance. After constructing a value chain, a company may discover it can reestablish cost competitiveness only if it goes outside in-house operations. 7. 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. Much of this can be performed through deduction and a process of elimination. To begin with, companies usually experience a different rate and pattern of cost change for each cost component. The most common methods or criteria used to determine whether a price is fair and reasonable are: Price competition. It's impossible to determine whether lowering costs or increasing revenue is more important across the board for all companies. After all, your competitive advantage is, by definition, something your competitors do not have. Cost-benefit Analysis dete… 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. They may actually tend to outpace the price level on the average in the long run, but only with wide swings and great uncertainty. 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. Take the time to look at the differences between your competitor's goods and services and your own. Dog eat dog refers to intense competition in a market where products or services have become commoditized. Companies in perfect competition are considered to be price takers, meaning that they have no scope to set prices—this is the reason why marginal profit is equal to marginal cost. Otherwise, a strategy to be the cost leader will beat a performance-based differentiation strategy. As a result, steel companies must either refurbish their inefficient mills or close them down. 1. : The MIT Press, 1983), pp. 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 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. To build value for the long term, you needed to develop distinct competencies that your competitors would not be able to imitate, and then find a way to apply them as an advantage in the markets in which you … These two main types of competitive advantage determine whether your company succeeds by being a cost leader or by differentiating its … A perfectly competitive firm has only one major decision to make—namely, what quantity to produce. 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. To understand why this is so, consider the basic definition of profit:Since a perfectly competitive firm 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). At IBM, top management decided that the economic impact of rising operating costs would outweigh that of escalating capital costs. It is possible that Berkshire Hathaway's competitive advantage is perfectly unique: Warren Buffet's mind. In neither case do companies have to worry so much about the timing of decisions to add or replace production facilities. 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’. The total revenue for a firm in a perfectly competitive market is the product of price and quantity (TR = P * Q). ABC assigns job costs based on the actual use of resources, enabling firms to price their products appropriately, determine in which markets they can compete effectively, make better capital allocation decisions, and calculate the incremental costs associated with potential courses of action. Maunders, Accounting for British Steel (Aldershot, England, Gower, 1982), p. 124. 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. In 1981, however, the price of crude shot up 44.4%, while the rise in gas prices was only 23.5%. 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. 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. 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. A build-share growth strategy by one company can coexist with a hold-share strategy by another. 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. 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. And most managers have learned to adjust to the effect inflation has on current operating costs. Cost-benefit analysis is a process used by project leaders, business owners, and practitioners to understand the systematic calculating and later comparing costs and benefits of a project. The Brookings Institution, 1981), p. 173. Rising capital costs will hit your company hard if you rely on a differentiation strategy to win market share. There are car manufacturers that have better production processes than their competitors. 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. To illustrate the strategic payoff of constructing a value chain, look again at Exhibit I. In such cases, cite the price of prior purchase and note if it was competitive or based on catalog price or other. Either way, you lock into a low-cost position with fewer dollars of fixed asset investment. To catch up, they considered investment to modernize existing facilities or to build new cost-competitive plants. December 1982, p. 56. The levelized cost of energy (LCOE) is a measure of a power source that allows comparison of different methods of electricity generation on a consistent basis. Competitive advantages can be found almost anywhere. “IBM: The Giant Puts It All Together,” Dun’s Business Month. 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. While the first step is grounded in … 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. Most difficult is the necessity of estimating the same cost elements for its rivals—an advanced stage in the art of competitive intelligence. Copyright © 2020 Harvard Business School Publishing. That’s in an industry that started from a base of $20 billion in sales and $3 billion in net income. The fixed costs, like administration, are spread over more units of production.Sometimes the company can … 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. Brand equity refers to the value a company gains from a product with a recognizable and admired name when compared to a generic equivalent. 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. This is where a value chain comes in. Coca-Cola, of course, has that secret recipe and huge brand name recognition. A perfectly competitive market is characterized by many buyers and sellers, undifferentiated products, no transaction costs, no barriers to entry and exit, and perfect information about the price of a good. Intellectual property is a set of intangibles owned and legally protected by a company from outside use or implementation without consent. Economies of scale are cost reductions that occur when companies increase production. 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. 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. 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. The implementation of ABC … Reprinted with the permission of the publisher. Total revenue is going to increase as the firm sells more, depending on the price of the product and the number of units sold. 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. If you increase the number of units sold at a given price, then total revenue will increase. 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. View Test Prep - Ch 4 quiz from MGT 590 at RMU. It intends to satisfy the growing needs and requirements of a consumer about price, features, and quality of a product.. Target costing is estimated as the expected selling price of a product minus the desired profit from selling the product. If the price of the product increases for every unit sold, then total revenue also increa… Petroleum refining provides an interesting example of how to defend against long-term price increases in a key resource input. The LCOE can also be regarded as the minimum constant price at which electricity must be sold in order to break even over the lifetime of the project.

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