How to leveraged a low-cost structure into a strategic growth plan focused on low-risk, low-cost acquisitions.
If you could get the jump on your competition, would you? Of course you would. By simply understanding your cost structure and comparing it to your competitors, you may be able to excel when others begin to fail. We recently worked with a client in global mining that was able to use this strategy to gain market share.
Our work in helping the client evaluate profitable growth options involved an analysis of the company’s cost structure, which included four main steps:
- Understand the client’s own cost structure in detail. We carried out a very detailed cost analysis for each of the company’s individual mining operations.
- Gather industry data on competitors’ cost structures. In the mining industry there is a lot of publicly available information on cost structures, so we had a ready supply of information to use for our analysis.
- Talk to internal experts. We drew on the decades of experience of mining experts within the company. They helped us interpret the industry data and refine our estimates of relative cost structures.
- Use proxies where appropriate. In this case, we could look at regional differences in labor costs, energy prices, exchange rates, and a host of other cost structure drivers to refine our estimates.
We have used this same approach with several clients and have consistently been able to reveal surprising insights about key competitors’ cost structures and profitability. For our mining client, we were able to show that the company was in the lowest-cost quartile of mining companies. This resulted in two key benefits:
- Their operations were likely to generate a profit at any realistic price level. In fact, prices would need to be so low that more than 50 percent of competitive capacity would need to be shut off before our client would see cash losses from their best mines (a highly unlikely scenario). In other words, our client was all but certain to generate positive cash flow, regardless of prices or demand levels. An enviable position, indeed, but such is the power of a low position on the cost curve.
- For the same reason, it was virtually impossible for prices to decline to the point that the client would be forced to shut down any mines. In fact, they could safely expand operations at their current mines with little risk.
Not surprisingly, the CEO was gratified to see his company in such a favorable position on the cost curve. In fact, the company aligned around an explicit strategy to pursue only lowest-cost-quartile mining acquisitions. Although they paid rich prices for such “in the money” acquisitions, they concluded that the resulting lower risk profile of their operations more than offset the lower rewards from paying higher acquisition prices.
By contrast, some of their competitors pursued a very different but equally legitimate strategy of pursuing high-cost, “out of the money” mining acquisitions. Essentially they were placing a bet on growing prices, and stood to achieve much higher rewards from high-price market scenarios, while incurring much greater risk of shutdown and cash flow losses from low-price outcomes. As it turns out, mineral prices have held up very well in recent years, so both strategies have paid off handsomely. Our client has earned very high ROIs from their mining operations, and some plucky independent entrepreneurs made investments in very “out of the money” mines, and have become very wealthy as a result.
As you think about this case, here are three key questions to ask:
- How important is your position on the industry cost curve? Do you see low-cost rivals earning attractive profits and/or gaining share at your expense? Or do you see competition on other factors than price and cost, suggesting cost position is not so important?
- How does your cost structure compare to your competitors? Are you a low-cost producer? Or are your costs above the industry average?
- What impact does your cost curve position have on your growth strategy? Should you “fix” your current operations and lower your position on the cost curve before accelerating growth?