Cost Advantage and Economic Moats: What to Know

Companies with strong economic moats have durable, long-term competitive advantages, making them worth watching for equity investors and advisors.

As one source of an economic moat, cost advantage can be a powerful driver of profitability and sustainability. Lower production costs can lead to more competitive prices, greater market share, and in turn higher profit margins and investment returns.

The Economic Moat Sources: Cost Advantage report takes a deep dive into types of structural cost advantage and how to measure them. For a more complete picture, including a list of companies in our coverage with cost advantage moat metrics and risks—download the full report.

A cost advantage is a company's ability to produce goods or services at a lower cost than its competitors, giving it a significant edge in the market. It matters more that a company’s costs are less than its competitors’ than that its costs are low in absolute terms.

Other sources of economic moats include:

• The network effect—a product becomes more valuable as more people use it.
• Switching costs—how much it costs a customer to switch from one provider to another.
• Intangible assets—for example, patents, brands, and regulatory licenses.
• Efficient scale—companies operate in a market that supports few competitors.

Cost advantage sources can vary widely across industries. Overall, cost advantages are most often found in financial services and consumer defensive sectors, but they are most critical to energy and materials companies.

Below are just a few examples.

The heart of economies of scale is that bigger is often better. Large firms can spread high fixed costs across a larger customer or product base.

Central R&D functions can apply scientific expertise across diverse business lines, or spread domain-specific knowledge over multiple products, resulting in lower costs or more prolific product development.

Scale in advertising and marketing provides large organizations with cost-effective exposure to vast audiences that smaller competitors can’t match.

For example, global firms can afford high-profile sponsorship of international events, like the World Cup. This gives them exposure to a large audience that a smaller firm wouldn’t be able to afford. Plus, large-scale buyers can leverage a single brand name across a wide range of products when the corporate brand is associated with its individual offerings.

Access to low-cost resources can protect a company from changes in resource prices. It’s the main moat source advantage associated with resource extraction companies such as oil and gas producers and miners. 

Lower resource costs can mean lower operating costs or development, or both. Higher-quality resources will be cheaper to produce because they require less effort. 

For example, deep-water, offshore oil rigs might require more expensive infrastructure, but larger resources and its easy-to-extract nature can make operating costs lower.

Businesses can benefit from a manufacturing and processing cost advantage by producing a small number of products at a larger volume. Regardless of the product range, low volume and, by extension, a lack of distribution scale typically result in a lack of cost advantage.

A narrow product range, produced at high volume, can result in low per-unit costs and therefore a narrow moat. The combination of manufacturing and distributing a high volume of similar products can drive the greatest cost savings and create a wide moat.

Companies have buying power when their large customer base or significant market share enable them to negotiate volume discounts and favorable terms with suppliers. Through their size, these firms can secure raw materials, inputs, or finished goods at a lower unit cost than their smaller rivals.

Buying power is predominantly found in consumer defensive, consumer cyclical, and industrials.

Comparing a company's cost structure to its competitors is essential to determine whether it truly has a cost advantage or is simply operating in a low-cost industry.

Financial advisors can identify companies with cost advantages by analyzing quantitative metrics and rating companies’ relative positions by plotting them on a cost curve.

Avoid relying on a single metric. Only using historical metrics without accounting for their evolution in a forecast or using an overly narrow competitor set can lead to an incomplete picture and an inaccurate moat.

To gauge a company's competitive edge, including its cost advantage, Morningstar’s economic moat rating provides an at-a-glance signal of the strength and sustainability of its moat.

The rating can also add insights at the portfolio level with Morningstar investment research tools. Advisors can screen for equity funds by average economic moat, or compare a fund’s wide-moat coverage percentage to the category and index.

Cost advantages don’t always last. Companies may have lower costs than competitors, but for that cost advantage to be part of an economic moat, it needs to be structural and next to impossible to replicate.

Some of the risks to maintaining a durable cost advantage include:

• Technological disruption: Advances in technology can render a company's cost advantage obsolete by introducing alternative products.
• Emergence of an irrational player: Aggressive competitors can erode a company's cost advantage through overexpansion.
• Process replication: Competitors may be able to copy an efficient process.
• Cyclical demand: Excess returns may be fleeting, based on a price spike that won’t persist.
• Material changes in cost curves: New low-cost production can damage the competitive landscape.
• Poor capital efficiency or allocation: Large mispriced investments can destroy moats, particularly in capital-intensive industries.

Despite these and other risks, some firms have successfully maintained durable cost advantages, earning them wide-moat ratings.

• Walmart Inc.WMT leverages its buying power to negotiate lower prices with suppliers, passing on the savings to customers and maintaining its cost advantage.
• Anheuser-Busch InBev BUD, the world’s largest brewing company, has significant economies of scale and high production volumes across its top beer brands. This lowers per-unit costs and creates a strong cost advantage.
• Verbund AG VER, the leading energy company in Austria, generates 90% of its output from hydroelectric power. This resource has lower operating costs than fossil fuels, meaning the company’s cost advantage comes from its access to low-cost resources.

Cost advantage is a vital source of economic moats, enabling companies to achieve long-term profitability and maintain a competitive edge in their industries.

Financial advisors can leverage this knowledge to identify investment opportunities with long-term potential, helping their clients make better-informed decisions.

To better understand the role cost advantage plays in economic moat ratings and what it could mean for your client portfolios, download the Economic Moat Sources: Cost Advantage report.