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 cost efficiency
Figure 8.1. The Experience Curve
1988
1990
Cost per
unit of
output (in
real $)
1992
1994
1996
Cumulative Output
1998
2000
The Experience Curve
The “Law of Experience”
1994
1995
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
1997
1998
Cumulative Output
1999
2000
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:
relative costs = f (relative market share)
-2 0
ROS (%)
5
10
This supported by PIMS data:
BUT:
0-10
10-20
20-30
30-40
Market Share (%)
over 40
- Association does not imply causation
- Costs of acquiring market share tend to offset the returns to market
share
Drivers of Cost Advantage
ECONOMIES OF SCALE
ECONOMIES OF LEARNING
PRODUCTION TECHNIQUES
PRODUCT DESIGN
INPUT COSTS
CAPACITY UTILIZATION
MANAGERIAL/ ORGANIZATIONAL
EFFICIENCY
• Indivisibli\ties
• Specialization and division of labor
• Increased dexterity
• Improved coordination/ organization
• Mechanization and automation
• Efficient utilization of materials
• Increased precision
• Design for automation
• Designs to economize on materials
• Location advantages
• Ownership of low-cost inputs
• Bargaining power
• Supplier cooperation
• Ratio of fixed to variable costs
• Costs of installing and closing capacity
• Organizational slack
Economies of Scale: The Long-Run
Cost Curve for a Plant
Cost per
unit of
output
Sources of scale economies:
- technical input/output relationships
- indivisibilities
- specialization
Minimum
Efficient
Plant Size
Units of
output
per period
The Costs of Product Development:
New Autos of the 1990s
$ billion
Ford Escort (1997 model)
2
Ford Mondeo/ Contour
6
Ford Taurus (1996 model)
2.8
GM Saturn
5
Chrysler Neon
1.3
Honda Accord (1997 Model)
0.6
Renault Clio (1999 model)
1.3
Rolls Royce (1998 Silver Seraph)
0.33
Scale Economies in Advertising: U.S. Soft Drinks
Advertising Expenditure ($ per case)
0.02 0.05 0.10 0.15 0.20
Despite the massive advertising budgets of brand leaders Coke and Pepsi,
smaller brands which incur the highest advertising costs per unit of sales
Schweppes
SF Dr. Pepper
Diet 7-Up
Tab
Diet Pepsi
Diet Rite
Fresca
Seven up
Sprite
Dr. Pepper
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 (1993)
Southwest Airlines
(cents)
Wages and benefits
2.4
Fuel and oil
1.1
Aircraft ownership
0.7
Aircraft maintenance
0.6
Commisions 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
Key Stages in 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
(continued)
STAGE 3.
IDENTIFY
COST
DRIVERS
PURCHASING
PARTS
INVENTORIES
--Plant scale for each
component
-- Process technology
-- Plant location
-- Run length
-- Capaciity 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
--Putchases 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 warrenty
SALES
&
MKITG
DISTRI- DEALER &
BUTION CUSTOMER
SUPPORT
--Cyclicality &
predictability of sales
--Customers’
willingness to wait
Applying the Value Chain to Cost Analysis
(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
ASSMBY 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
Scientific
Management Mode:
- problem solving
- quest for “one best way”
- employee knowledge creation - people matched to tasks
- employee control over product - incentives and penalties to
- product and customer
ensure conformity to objectives
orientation
- planning and control by staff
- continuous incremental
MANAGEMENT
OF
TECHNOLOGY
STATIC
- science driven
improvement
- focused around corporate R&D
- market needs pull technology
departments
- product and process innovation- emphasis on product Innovation
- teamwork and cross-functional and big projects
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