Part 1: Quantifying Cost Reduction Objectives


Rates of Costs

Capsule: A company achieves low rates of costs because of the sources, the size, or the timing of its purchases. It may also have an advantage due to the components of the rate of costs.

For helpful context on this step:

Some industries see wide variations in the rates that companies must pay for major items of Purchases or for People. These major rate differences may occur in the purchase of raw materials and energy to operate facilities. They also occur in the cost of people required to produce the product. In industries where there are significant rate differences in any of the Building Block Costs (i.e., People, Purchases or Capital), the Company must evaluate its rate of cost on any Building Block Cost that varies widely from one competitor to another.

The Company would quantify differences in its rates of cost compared to the best of its competition. The Company would translate the difference it has in rate of cost into a unit cost difference for the product it sells. For example, if the Company were to pay $2.00 per hour more for its workforce than does the best competitor in the market, it would translate this $2.00 per hour cost disadvantage into a cost difference per unit of product sold. This translation eases the task of evaluating the alternatives available to correct the cost problem. For example, an alternative might substitute capital for labor in order to offset this $2.00 per hour disadvantage. Since Capital costs and labor costs have different bases of measurement, the Company must translate both costs into a cost per unit of sale in order to make trade-offs between the present approach and the alternative.

Differences in rates of costs for Purchases or People fall into common patterns of causes. The Company may use these patterns to help it identify its rate disadvantages and analyze the reasons for any disadvantages it has against the industry’s best competitors. An industry competitor’s advantage in a rate of costs on its People or Purchases is usually due to one of four causes: the source of the purchase, the size of its purchases, the time of its purchases or the components of the rate of cost. We discuss each cause below.

Source of Purchases

A competitor may enjoy an advantage in rates of costs by changing the source of its purchases. Four factors tend to account for most of the rate advantages in the source of purchases: location, quality, supplier and subsidies.

  • Location: Location means the geographic area from which the Company purchases. Location can be particularly important with People costs and difficult-to-ship raw materials.

  • Quality: Differences in quality may give rise to a rate advantage as a competitor uses a purchased material of lower quality or employees of lower skills.

  • Supplier: The choice of suppliers available to the Company may affect the rates the Company pays. Some suppliers of raw materials or semi-finished products may simply be more efficient than their peers and may offer lower prices.

  • Subsidies: Subsidies may also account for the source of a rate advantage for the Company. For example, countries, states, cities, and counties may offer subsidies, in the form of tax relief or employment subsidies, that reduce the rate of cost for People or Capital a competitor might employ.

Size of Purchase

A second powerful source of rate advantage is the size of the purchase. The industry's larger competitors purchase many of their supplies at lower prices than do the smaller competitors in the industry. In purchased materials, the largest companies in an industry often receive discounts that are 10% of the list price, or more, greater than those received by their smaller industry competitors. The advantage that the largest competitors in the market have in rate of purchasing costs is greatest when the suppliers' industry is Hostile. The supplier in a Hostile market is likely to succumb to demands for lower prices originating with the largest purchasers in the industry.

While the largest competitors in the market often enjoy substantial benefits in rates of costs in purchases, smaller competitors in the industry may also obtain low purchase rates as well. Usually these companies obtain rate advantages by concentrating their purchases, both internally and externally. Internally, they combine their purchases from all company locations in one purchase and reduce the number of suppliers to just a few. Externally, smaller companies often form co-ops to obtain some of the purchase price benefits enjoyed by their larger brethren.

Timing of Purchase

The third source of advantage in rates paid for people or purchases may come from the timing of the purchase. A company may choose to take advantage of opportunities to purchase product during slow times for the supplier, when most other companies are buying in lower quantities. The Company's willingness to make these off-season purchases always results in lower prices for the purchase.

Components of the Rate

The final source of an advantage in rates paid for people or purchases comes in the components of the rate of cost. Some competitors reduce their effective rate of cost by making part of their payments variable and contingent on productivity measures. These companies add a bonus based on specific performance that causes performance to be above average for the industry, thus reducing the effective rate of cost.

Many companies have changed the components of rates with their labor contracts, to the benefit of both the companies and the workforce. Grocery retailers have succeeded in doing the same thing by charging slotting allowances for use of their shelf space and failure fees if a product does not sell at an agreed-upon minimum volume.

Rates of Cost Examples »

Additional explanations and examples of differences in rates of cost, and alternatives companies have to reduce their rates of costs, appear in Improve/Costs/Reduce Rate of Cost for Input

Rates of Costs Questions

Analysis 56
Analysis of Rates of Cost Differential

  • Does the Company have any differences from the industry’s low cost competitor in unit cost due to rates paid for People, Purchases or Capital?

  • How much of an impact do these rate differences have on the total unit cost of the product? (Analysis 56)

  • Are there any differences among competitors in rates of costs due to the sources of their purchases?

  • Do any competitors in the market have cost advantages over the Company due to their size as purchasers?

  • Do any competitors in the market have a rate of cost advantage over the Company due to the timing of their purchases?

  • Has any competitor in the industry gained a rate of cost advantage because it has changed the components of the price for the workforce, for purchased supplies or for capital?

Once the Company has evaluated its cost differences with competition due to differences in rates, it turns its attention to cost differences due to differing approaches to managing important functional costs.

Return to Basic Strategy Guide Step 25

Summary Points Next: Approaches to Managing Functional Costs