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 The unit cost value added to a standard
product declines by a constant % (typically
20-30%) each time cumulative output doubles.
1994
Cost per
unit of
output (in 1996
real $)
1998
2000
2002 2004

Cumulative Output
 Examples of Experience Curves

Japanese clocks & watches, 1962-72 UK refrigerators, 1957-71

50 100 200 300

20K 30K

Price Index
1960 Yen

75%
15K

70% slope

100K 200K 500K 1,000K 5 10 50

Accumulated unit production Accumulated units
(millions) (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)
This implies that market share is linked to profitability. This is
confirmed by PIMS data:
10
ROS (%)
-2 0 5

0-10 10-20 20-30 30-40 over 40

Market Share (%)
BUT: - Association does not imply causation
- Costs of acquiring market share offset the returns to market
share
 Drivers of Cost Advantage

ECONOMIES OF SCALE Indivisibli\ties

Specialization and division of labor

ECONOMIES OF LEARNING Increased dexterity

Improved organizational routines

Process innovation
PRODUCTION TECHNIQUES Reengineering business processes

PRODUCT DESIGN Standardizing designs & components

Design for manufacture

Location advantages
INPUT COSTS Ownership of low-cost inputs
Non-union labor
Bargaining power

CAPACITY UTILIZATION Ratio of fixed to variable costs

Speed of capacity adjustment

RESIDUAL EFFICIENCY 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 Units of
Efficient Plant output
Size: the point per period
where most
scale economies
are exhausted
The Costs Developing New Car Models
(including plant tooling)

$ billion
Ford Mondeo / Contour 6
GM Saturn 5
Ford Taurus (1996 model) 2.8
Ford Escort (new model 1996) 2
Renault Clio (1999 model) 1.3
Chrysler Neon 1.3
Honda Accord (1997 model) 0.6
BMW Mini 0.5
Rolls Royce Phantom (2003 model) 0.3
 Scale Economies in Advertising: U.S. Soft Drinks

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.
Advertising Expenditure ($ per case)
0.20

Schweppe
s SF Dr. Pepper
0.15

Tab
Diet 7-Up Diet Pepsi
0.10

Diet Rite
Fresca
Seven Up
0.05

Sprite Dr. Pepper

Pepsi
Coke
0.02

10 20 50 100 200 500 1,000

Annual sales volume (millions of cases)
 Cost Advantage in Short-Haul
Passenger Air Transport

Costs per Available Seat-Mile

Southwest Airlines United Airlines
(cents) (cents)
Wages and benefits 2.4 3.5
Fuel and oil 1.1 1.1
Aircraft ownership 0.7 0.8
Aircraft maintenance 0.6 0.3
Commissions on ticket sales 0.5 1.0
Advertising 0.2 0.2
Food and beverage 0.0 0.5
Other 1.7 3.1
Total 7.2 10.5
 Applying the Value Chain to Cost Analysis:
The Case of Automobile Manufacture

STAGE 1. IDENTIFY THE PRINCIPLE ACTIVITIES

R&D TESTING, GOODS SALES DISTRI- DEALER &

PARTS
PURCH- DESIGN COMPONENT ASSEMBLY QUALITY INVEN- &
INVEN- BUTION CUSTOMER
ASING ENGNRNG MFR CONTROL TORIES MKITG SUPPORT
TORIES

STAGE 2. ALLOCATE TOTAL COSTS

 Applying the Value Chain to Cost Analysis: The Case
of Automobile Manufacture (continued)

--Plant scale for each -- Level of quality targets -- No. of dealers

STAGE 3. component -- Frequency of defects -- Sales / dealer
IDENTIFY -- Process technology -- Level of dealer
-- Plant location support
COST -- Run length -- Frequency of defects
DRIVERS -- Capacity utilization under warranty

PARTS R&D COMPONENT ASSEMBLY TESTING, GOODS

PURCH- SALES
INVEN- DESIGN QUALITY INVEN- DISTRI- DEALER &
ASING MFR &
TORIES ENGNRNG CONTROL TORIES BUTION CUSTOMER
MKITG SUPPORT

Prices paid --Size of commitment -- Plant scale --Cyclicality &

depend on: --Productivity of -- Flexibility of production predictability of sales
-- Order size R&D/design -- No. of models per plant --Customers
--Purchases per --No. & frequency of new -- Degree of automation willingness to wait
supplier models -- Sales / model
-- Bargaining power -- Wage levels
-- Supplier location -- Capacity utilization
 Applying the Value Chain to Cost Analysis: The Case
of Automobile Manufacture (continued)

STAGE 4. IDENTIFY LINKAGES

Designing different models around

Consolidation of orders to increase common components and platforms
discounts, increases inventories reduces manufacturing costs

PRCHSNG PARTS R&D COMPONENT ASSEM- TESTING GOODS SALES DSTRBTN DLR
INVNTRS DESIGN MFR BLY QUALITY INV MKTG CTMR

Higher quality parts and materials Higher quality in manufacturing

reduces costs of defects reduces warranty costs
at later stages

STAGE 5. RECCOMENDATIONS FOR COST REDUCTION

 Dynamic vs. Static Approaches to
Manufacturing

STATIC
DYNAMIC
(Scientific
(Artisan Mode)
Management Mode)

problem solving quest for one best way

people matched to tasks planning & control by staff
PRODUCTION create employee knowledge Incentives and penalties to
employees control ensure conformity to
SYSTEM objectives
production
customer orientation

continuous, incremental science driven

improvement focused around
MANAGEMENT market needs pull technology corporate R&D
OF product and process innovation departments
TECHNOLOGY teamwork and cross- emphasis on big
functional collaboration projects
 Recent Approaches to Cost Reduction

Dramatic changes in strategy and structure

to adjust to the business conditions of the 1990s
Key elements:
CORPORATE Plant closures
RESTRUCTURING Outsourcing
Delayering and cuts in administrative staff

The fundamental rethinking and radical

redesign of business processes to achieve
dynamic improvements in performance. e.g.:-
BUSINESS Several jobs combined into one
PROCESS Steps of a process combined in natural order
REENGINEERING Minimizing steps, controls, and reconciliation
Use case managers as single points of contact
Hybrid centralization/ decentralization