January 2020 – Understanding a “Cost” Moat
Cost competitiveness does not immediately present itself as unique characteristic that would give a company a permanent edge over others. For one, all companies compete on cost and it would be hard to find a company that does not report “Cost” as being an important metric for its organization to focus on. A Cost Moat however is much more than ensuring that you are always seeking competitive pricing for a project or a piece of capital machinery by seeking 3 bids.
A Cost Moat is an ingrained way of doing things that is unique to your organization and cannot easily be replicated by competitors. It can also be found in something that is owned by the organization that gives the company a cost advantage that cannot be replicated, like land or a patent for the use of a specific technology.
Here are a few examples of Cost Moats:
Aggregate and Limestone
Aggregate and Limestone are commodities that are heavily used for many construction activities. Due to the volume that is required in construction activity, contractors generally will opt for the cheapest source of the material available. This is usually determined by the distance of the pit/quarry from a construction site primarily because aggregate/limestone is a low cost, dense/heavy commodity where every kilometre it is transported adds significantly to its total cost. For example, in big metropolitan areas, there will only be a limited number of gravel pits or limestone quarries approved and these are usually going to be on the outskirts of the city. A city will always have very high demand for this commodity due to sustainable infrastructure expenses and the closest producer to them will always have a cost advantage over its competitors and end up getting a majority of the business.
Railways have a cost advantage on a few fronts. One it is much cheaper to ship long distances by rail than it is by truck or air. This is especially true for heavy freight where the relative value of the goods being transported is quite low. The railways second big cost advantage is that it would be relatively impossible for any entrepreneur to try and set up a competing railway in today’s world. Establishing a new “Right-of-Way” across the country would be nearly impossible due to the associated costs with negotiating with so many landowners across a proposed route as well the cost of purchasing this land to develop.
The most important thing for a bank is to have access to a low-cost source of funds. The cheapest place for a bank to raise capital (other than government) is from cheap deposits from their customers. For various reasons some banks are able to pay less interest on their deposits than their competitors. Since many bank customers have a history of never leaving their financial institution, these cheap deposits can translate into a long-term cost competitive advantage. Customers get used to using a bank and don’t measure its value by how much they get paid for interest in their savings account. They measure it by the ease of doing business with them.
The size of a retailer helps establish a Cost advantage in terms of it being able to negotiate with suppliers very aggressively on certain aspects of the company’s cost structure that are material to their bottom line. This advantage translates to the ability for a retailer like Costco or Wal-Mart to negotiate with suppliers for their private label brands. For example, Costco’s (NASDAQ: COST) Kirkland brand has a lower cost structure than its competitors because it doesn’t have to invest as much in the marketing of each product. The Kirkland brand has guaranteed shelf space at one of the biggest retailers in the north America. Most other suppliers are forced to provide very low pricing to their biggest customers, but they are also forced to supply them with competing products which can be placed on more attractive displays at their retail locations.
Some airlines have been known to have a Cost Moat because they do a multitude of things better than their competition. Having the ability to sustainably save a few seconds/minutes on each critical step it takes to land an aircraft and get it back into the air can create that long term Cost Moat. Southwest Airlines (NYSE: LUV) has been known to have a Cost Moat because they can do over a dozen things better than their competition. Southwest’s competitors have difficulty replicating its low-cost process due to their ingrained rigid/inflexible organization. Agility and flexibility in Southwest’s labor force and overall operations has been an enormous reason as to how it has gotten where it is today.
A Cost Moat is sometimes elusive and can not be determined as clearly as some other moats. You are more likely to find a company with a Cost Moat in an industry where the product or service being sold is highly commoditized which forces companies to compete against each other on costs.
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Enjoy the Journey,