Cost Advantage
OUTLINE
• Economies of experience curve and the
benefits of market share
• Sources of cost advantage
• Using the value chain to analyze costs
• Current approaches to managing costs
The Experience Curve
The “Law of Experience”
1992
1994
Cost per
unit of
output (in
real $)
The unit cost value added to a standard
product declines by a constant % (typically
20-30%) each time cumulative output doubles.
1996
1998
2000
Cumulative Output
2002
2004
Examples of Experience Curves
75%
100K 200K
500K
1,000K
Accumulated unit production
(millions)
UK refrigerators, 1957-71
Price Index
50 100 200 300
1960 Yen
15K
20K 30K
Japanese clocks & watches, 1962-72
70% slope
5
10
50
Accumulated units
(millions)
The Importance of Market Share
If all firms in an industry have the same experience curve, then:
Change in relative costs over time = f (relative market share)
ROS (%)
-2 0
5
10
This implies that market share is linked to profitability. This is
confirmed by PIMS data:
0-10
10-20 20-30 30-40
Market Share (%)
over 40
BUT: - Association does not imply causation
- Costs of acquiring market share offset the returns to market
share
Drivers of Cost Advantage
ECONOMIES OF SCALE
ECONOMIES OF LEARNING
PRODUCTION TECHNIQUES
PRODUCT DESIGN
INPUT COSTS
CAPACITY UTILIZATION
RESIDUAL EFFICIENCY
• Indivisibli\ties
• Specialization and division of labor
• Increased dexterity
• Improved organizational routines
• Process innovation
• Reengineering business processes
• Standardizing designs & components
• Design for manufacture
• Location advantages
• Ownership of low-cost inputs
• Non-union labor
• Bargaining power
• Ratio of fixed to variable costs
• Speed of capacity adjustment
• Organizational slack; Motivation &
culture; Managerial efficiency
Economies of Scale: The Long-Run
Cost Curve for a Plant
Sources of scale economies:
- technical input/output relationships
- indivisibilities
- specialization
Cost per
unit of
output
Minimum
Efficient Plant
Size: the point
where most
scale economies
are exhausted
Units of
output
per period
The Costs Developing New Car Models
(including plant tooling)
$ billion
Ford Mondeo / Contour
GM Saturn
Ford Taurus (1996 model)
Ford Escort (new model 1996)
Renault Clio (1999 model)
Chrysler Neon
Honda Accord (1997 model)
BMW Mini
Rolls Royce Phantom (2003 model)
6
5
2.8
2
1.3
1.3
0.6
0.5
0.3
Scale Economies in Advertising: U.S. Soft Drinks
Advertising Expenditure ($ per case)
0.20
0.15
0.10
0.05
0.02
Despite the massive advertising budgets of brand leaders Coke and Pepsi, their
main brands incur lower advertising costs per unit of sales than their smaller rivals.
Schweppe
s
SF Dr. Pepper
Diet 7-Up
Tab
Diet Pepsi
Diet Rite
Fresca
Seven Up
Dr. Pepper
Sprite
Pepsi
10
20
50
100
200
500
Annual sales volume (millions of cases)
Coke
1,000
Cost Advantage in Short-Haul
Passenger Air Transport
Costs per Available Seat-Mile
Southwest Airlines
(cents)
Wages and benefits
2.4
Fuel and oil
1.1
Aircraft ownership
0.7
Aircraft maintenance
0.6
Commissions on ticket sales
0.5
Advertising
0.2
Food and beverage
0.0
Other
1.7
Total
7.2
United Airlines
(cents)
3.5
1.1
0.8
0.3
1.0
0.2
0.5
3.1
10.5
Applying the Value Chain to Cost Analysis:
The Case of Automobile Manufacture
STAGE 1. IDENTIFY THE PRINCIPLE ACTIVITIES
PURCHASING
PARTS
INVENTORIES
R&D
TESTING,
COMPONENT
ASSEMBLY
DESIGN
QUALITY
MFR
ENGNRNG
CONTROL
GOODS
INVENTORIES
SALES DISTRI- DEALER &
&
BUTION CUSTOMER
MKITG
SUPPORT
STAGE 2. ALLOCATE TOTAL COSTS
Applying the Value Chain to Cost Analysis: The Case
of Automobile Manufacture (continued)
STAGE 3.
IDENTIFY
COST
DRIVERS
PURCHASING
PARTS
INVENTORIES
--Plant scale for each
component
-- Process technology
-- Plant location
-- Run length
-- Capacity utilization
-- Level of quality targets
-- Frequency of defects
R&D
COMPONENT ASSEMBLY TESTING,
DESIGN
QUALITY
MFR
ENGNRNG
CONTROL
Prices paid
--Size of commitment
depend on:
--Productivity of
-- Order size
R&D/design
--Purchases per
--No. & frequency of new
supplier
models
-- Bargaining power
-- Supplier location
GOODS
INVENTORIES
-- Plant scale
-- Flexibility of production
-- No. of models per plant
-- Degree of automation
-- Sales / model
-- Wage levels
-- Capacity utilization
-- No. of dealers
-- Sales / dealer
-- Level of dealer
support
-- Frequency of defects
under warranty
SALES
&
MKITG
DISTRI- DEALER &
BUTION CUSTOMER
SUPPORT
--Cyclicality &
predictability of sales
--Customers’
willingness to wait
Applying the Value Chain to Cost Analysis: The Case
of Automobile Manufacture (continued)
STAGE 4. IDENTIFY LINKAGES
Consolidation of orders to increase
discounts, increases inventories
PRCHSNG
PARTS
INVNTRS
R&D
DESIGN
Designing different models around
common components and platforms
reduces manufacturing costs
COMPONENT
MFR
Higher quality parts and materials
reduces costs of defects
at later stages
ASSEMBLY
TESTING GOODS
QUALITY
INV
SALES DSTRBTN DLR
MKTG
CTMR
Higher quality in manufacturing
reduces warranty costs
STAGE 5. RECCOMENDATIONS FOR COST REDUCTION
Dynamic vs. Static Approaches to
Manufacturing
DYNAMIC
(Artisan Mode)
PRODUCTION
SYSTEM
MANAGEMENT
OF
TECHNOLOGY
 problem solving
 people matched to tasks
 create employee knowledge
 employees control
production
 customer orientation
STATIC
(Scientific
Management Mode)
 quest for “one best way”
 planning & control by staff
 Incentives and penalties to
ensure conformity to
objectives
 continuous, incremental
 science driven
 improvement
 focused around
corporate R&D
 market needs pull technology
 product and process innovation departments
 emphasis on big
 teamwork and crossprojects
functional collaboration
Recent Approaches to Cost Reduction
CORPORATE
RESTRUCTURING
BUSINESS
PROCESS
REENGINEERING
Dramatic changes in strategy and structure
to adjust to the business conditions of the 1990’s
Key elements:
• Plant closures
• Outsourcing
• Delayering and cuts in administrative staff
The fundamental rethinking and radical
redesign of business processes to achieve
dynamic improvements in performance. e.g.:• Several jobs combined into one
• Steps of a process combined in natural order
• Minimizing steps, controls, and reconciliation
• Use case managers as single points of contact
• Hybrid centralization/ decentralization