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.

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 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 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. (WMT) is the largest retailer in the U.S. and has carved out an enviable position in a fragmented and competitive landscape, according to Morningstar. “The firm leverages its unmatched scale by spreading its omnichannel and distribution investments over a wider sales and profit base, allowing the firm to adapt to the dynamic retail environment while maintaining robust profitability.” As Morningstar explains, the company has built its moat around both its strong brand and leverage over suppliers and a vast supply chain network to drive down costs.

United Parcel Service Inc. is exceptionally capable of keeping would-be competitors at bay for a prolonged period. “An upstart would incur immense financial losses while trying to amass the volume and density necessary to absorb the remarkably high capital outlays and fixed costs associated with a global parcel delivery network,” according to Morningstar. “In replicating a network of planes, trucks, sorting facilities, and skilled employees, a new entrant would face massive investment before it could win a critical volume of customers from the entrenched incumbents.”

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