Cost AdvantageCost Advantage

• 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

OUTLINE

The Experience CurveThe Experience Curve

The “Law of Experience”

The unit cost value added to a standard product declines by a constant % (typically 20-

30%) each time cumulative output doubles.

Cost per unit of

output (in real $)

Cumulative Output

1992

1994

1996

1998

20002002 2004

Examples of Experience CurvesExamples of Experience Curves

100K 200K 500K 1,000K 5 10 50 Accumulated unit production Accumulated units

(millions) (millions)

1960

Yen

15K

20K

30

K

Pri

ce In

dex

50

100

20

0 3

00

70% slope

75%

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

The Importance of Market ShareThe 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 supported by PIMS data:

BUT: - Association does not imply causation

- Costs of acquiring market share offset the returns to market share

RO

S (

%)

-2

0 5

10

0-10 10-20 20-30 30-40 over 40Market Share (%)

Drivers of Cost AdvantageDrivers of Cost Advantage

PRODUCTION TECHNIQUES

PRODUCT DESIGN

INPUT COSTS

CAPACITY UTILIZATION

RESIDUAL EFFICIENCY

ECONOMIES OF LEARNING

ECONOMIES OF SCALE

• Organizational slack; Motivation & culture; Managerial efficiency

• Ratio of fixed to variable costs• Speed of capacity adjustment

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

• Standardizing designs & components• Design for manufacture

• Process innovation• Reengineering business processes

• Increased dexterity• Improved organizational routines

• Indivisibli\ties• Specialization and division of labor

Economies of Scale: The Long-Run Cost Curve for a Plant

Economies of Scale: The Long-Run Cost Curve for a Plant

Units of outputper periodMinimum

EfficientPlant Size

Cost perunit ofoutput

Sources of scale economies:- technical input/output relationships- indivisibilities- specialization

The Costs Developing New Car Models (including plant tooling)

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

10 20 50 100 200 500 1,000

Annual sales volume (millions of cases)

Ad

vert

isin

g E

xpen

dit

ure

($

pe

r ca

se)

0.02

0

.05

0.

10

0.1

5

0.20

CokePepsi

Seven Up

Dr. PepperSprite

Diet PepsiTab

FrescaDiet Rite

Diet 7-Up

Schweppes SF Dr. Pepper

Despite the massive advertising budgets of brand leaders Coke and Pepsi, smaller brands which incur the highest advertising costs per unit of sales

Scale Economies in Advertising: U.S. Soft DrinksScale Economies in Advertising: U.S. Soft Drinks

Cost Advantage in Short-Haul Passenger Air Transport

Cost Advantage in Short-Haul Passenger Air Transport

Costs per Available Seat-Mile (1993)

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

Key Stages in Applying the Value Chain to Cost Analysis: The Case of

Automobile Manufacture

Key Stages in Applying the Value Chain to Cost Analysis: The Case of

Automobile Manufacture

STAGE 1. IDENTIFY THE PRINCIPLE ACTIVITIES

STAGE 2. ALLOCATE TOTAL COSTS

PURCH-ASING

PARTSINVEN-TORIES

R&DDESIGN

ENGNRNG

COMPONENTMFR

ASSEMBLYTESTING,QUALITY

CONTROL

GOODSINVEN-TORIES

SALES &

MKITG

DISTRI-BUTION

DEALER &CUSTOMERSUPPORT

Applying the Value Chain to Cost Analysis (continued)

Applying the Value Chain to Cost Analysis (continued)

PURCH-ASING

PARTSINVEN-TORIES

R&DDESIGN

ENGNRNG

COMPONENTMFR

ASSEMBLYTESTING,QUALITY

CONTROL

GOODSINVEN-TORIES

SALES&

MKITG

DISTRI-BUTION

DEALER &CUSTOMERSUPPORT

--Plant scale for each -- Level of quality targets -- No. of dealers component -- Frequency of defects -- Sales / dealer

-- Process technology -- Level of dealer -- Plant location support -- Run length -- Frequency of

defects -- Capacity utilization under warranty

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

STAGE 3. IDENTIFY COST DRIVERS

Applying the Value Chain to Cost Analysis (continued)

Applying the Value Chain to Cost Analysis (continued)

PRCHSNG PARTS R&D COMPONENT ASSMBY TESTING GOODS SALES DSTRBTN DLR

INVNTRS DESIGN MFR QUALITY INV MKTG CTMR

Consolidation of orders to increasediscounts, increases inventories

Designing different models aroundcommon components and platforms

reduces manufacturing costs

Higher quality parts and materialsreduces costs of defects

at later stages

Higher quality in manufacturingreduces warranty costs

STAGE 5. RECCOMENDATIONS FOR COST REDUCTION

STAGE 4. IDENTIFY LINKAGES

Dynamic vs. Static Approaches to Manufacturing

Dynamic vs. Static Approaches to Manufacturing

Artisan mode: 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 - 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

PRODUCTIONSYSTEM

MANAGEMENTOF

TECHNOLOGY

DYNAMIC STATIC

Recent Approaches to Cost ReductionRecent Approaches to Cost Reduction

Dramatic changes in strategy and structureto adjust to the business conditions of the 1990’sKey elements:• Plant closures• Outsourcing• Delayering and cuts in administrative staff

The fundamental rethinking and radicalredesign of business processes to achievedynamic 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

CORPORATERESTRUCTURING

BUSINESSPROCESS

REENGINEERING