Understanding the Competitive Advantage of Low-Cost Producers
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"When a company is selling a product with commodity-like economic characteristics, being the low-cost producer is all-important."
Warren Buffett, Berkshire Hathaway shareholders letter, 2000, emphasis ours
“In many industries (reference to commodities), differentiation simply can’t be made meaningful. A few producers in such industries may consistently do well if they have a cost advantage that is both wide and sustainable. By definition such exceptions are few, and, in many industries, are non-existent. For the great majority of companies selling “commodity” products, a depressing equation of business economics prevails: persistent over-capacity without administered prices (or costs) equals poor profitability.” - Warren Buffett, Berkshire Hathaway shareholders letter, 1982, emphasis ours
This is the eights article in our series of articles discussing our analytical framework for identifying and assessing the existence and persistence of competitive advantages. In this article, we discuss a very limited form of moat – one driven by low cost advantage that is not a result of scale of operations.
Defining low-cost producer (LCP) moats
LCP moats exist when the business is one of, if not the, lowest cost producers in its industry. Importantly, the cost advantage should not be a result of economies of scale (EoS). Instead, the advantage that we are interested in here is a result of advantaged source of production or advantaged access to raw materials used in production. This is especially the case with natural resource producers or companies that use natural resources as their raw materials.
LCP moats are not the same as economies of scale
Frequently, analysts classify such moats as economies of scale because of the basic characteristic of both these moats; low costs in relation to competitors. However, LCP-based moats are a specific case of competitive advantage where the cost of production isn’t just a factor of the scale of production or the type of production technology employed. These in turn are the primary determining factors for economies of scale (EOS) moats as the per-unit fixed cost declines as output increases and the per-unit variable cost reduction is a factor of operational efficiencies and synergies.
LCP moats – differentiating characteristics
The distinguished source of advantage for LCP moats as compared to EoS moats gives birth to two important differentiating factors. Firstly, as the cost advantage of LCP moats is not a factor of scale, they are harder and frequently impossible to replicate. On the other hand, a motivated entrant with access to capital always has the possibility of replicating the EoS advantages.