Cost Leadership Provides Market Control

The term “economic moat” describes a company’s ability to maintain its competitive advantages and defend its long-term profitability. This moat investing education series explores the five primary sources of moat, according to Morningstar: 1) Switching Costs; 2) Intangible Assets; 3) Network Effect; 4) Cost Advantage; 5) Efficient Scale. Here we explore the concept of:

• Cost Advantage: Firms with a structural cost advantage can either undercut competitors on price while earning similar margins, or can charge market-level prices while earning relatively high margins.

Cost Leadership Provides Market Control

Companies that are able to produce and offer products or services at lower costs than competitors are often able to achieve higher profit margins. Within many industries, cost leaders often exert significant control over market prices, which may give them an advantage over competitors. The cost advantage moat source is the second most frequent source of economic moat ratings, according to Morningstar.

Cost advantages are often gained through economies of scale, lower distribution and manufacturing costs, and/or access to a low-cost resource base. The increasing level of competition in today’s global economy makes this competitive advantage one of the most difficult for companies to maintain. For example, over the past 30 years, the U.S. manufacturing and consumer goods industries have been flattened by punishing price competition from overseas.

Cost Advantage in Action

Walmart Inc is the largest retailer in the world. According to Morningstar, Walmart’s vast size gives it “significant bargaining power as it procures merchandise from suppliers and vendors; as a result, it can offer its customers lower prices than many of its competitors.” And, “with economies of scale and a vast distribution network, which contribute to its cost advantage, we think Walmart is positioned for additional volume gains that reinforce its ‘productivity loop,’ ultimately driving per-unit costs lower.”

Anheuser-Busch InBev SA/NV is the largest brewer in the world. The company’s size provides it with huge bargaining power as well as a lower average cost of production. Morningstar states: “Vast global scale and near-monopoly dominance in several Latin American and African markets give AB InBev significant fixed cost leverage and pricing power in procurement.”