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 9

Figure 8.1. The Experience Curve 1988 1990 Cost per unit of output (in real $) 1992 1994 1996 1998 2000 Cumulative Output 10

The “Law of Experience” Cost per unit of output (in real $) The 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. 1994 1995 Cost per unit of output (in real $) 1996 1997 1998 1999 2000 Cumulative Output 10

Examples of Experience Curves Japanese clocks & watches, 1962-72 UK refrigerators, 1957-71 15K 20K 30K 1960 Yen 50 100 200 300 Price Index 75% 70% slope 100K 200K 500K 1,000K 5 10 50 Accumulated unit production Accumulated units (millions) (millions) 11

The Importance of Market Share If all firms in an industry have the same experience curve, then: relative costs = f (relative market share) This supported by PIMS data: -2 0 5 10 ROS (%) 0-10 10-20 20-30 30-40 over 40 Market Share (%) BUT: - Association does not imply causation - Costs of acquiring market share tend to offset the returns to market share 12

Drivers of Cost Advantage Indivisibli\ties Specialization and division of labor ECONOMIES OF SCALE Increased dexterity Improved coordination/ organization ECONOMIES OF LEARNING Mechanization and automation Efficient utilization of materials Increased precision PRODUCTION TECHNIQUES Design for automation Designs to economize on materials PRODUCT DESIGN Location advantages Ownership of low-cost inputs Bargaining power Supplier cooperation INPUT COSTS CAPACITY UTILIZATION Ratio of fixed to variable costs Costs of installing and closing capacity MANAGERIAL/ ORGANIZATIONAL EFFICIENCY Organizational slack 13

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 Units of output per period Minimum Efficient Plant Size 14

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 15

Scale Economies in Advertising: U.S. Soft Drinks 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 Tab Diet 7-Up Diet Pepsi Advertising Expenditure ($ per case) 0.02 0.05 0.10 0.15 0.20 Diet Rite Fresca Seven up Dr. Pepper Sprite Pepsi Coke 10 20 50 100 200 500 1,000 Annual sales volume (millions of cases) 16

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 Commisions 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 17

Key Stages in Applying the Value Chain to Cost Analysis: The Case of Automobile Manufacture STAGE 1. IDENTIFY THE PRINCIPLE ACTIVITIES R&D DESIGN ENGNRNG TESTING, QUALITY CONTROL GOODS INVEN- TORIES SALES & MKITG DEALER & CUSTOMER SUPPORT PARTS INVEN- TORIES DISTRI- BUTION PURCH- ASING COMPONENT MFR ASSEMBLY STAGE 2. ALLOCATE TOTAL COSTS 18

Applying the Value Chain to Cost Analysis (continued) --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 -- Capaciity utilization under warrenty STAGE 3. IDENTIFY COST DRIVERS PARTS INVEN- TORIES R&D DESIGN ENGNRNG TESTING, QUALITY CONTROL GOODS INVEN- TORIES PURCH- ASING COMPONENT MFR SALES & MKITG ASSEMBLY DISTRI- BUTION DEALER & CUSTOMER 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’ --Putchases per --No. & frequency of new -- Degree of automation willingness to wait supplier models -- Sales / model -- Bargaining power -- Wage levels -- Supplier location -- Capacity utilization 19

Applying the Value Chain to Cost Analysis (continued) STAGE 4. IDENTIFY LINKAGES PRCHSNG PARTS R&D COMPONENT ASSMBY TESTING GOODS SALES DSTRBTN DLR INVNTRS DESIGN MFR QUALITY INV MKTG CTMR Designing different models around common components and platforms reduces manufacturing costs Consolidation of orders to increase discounts, increases inventories Higher quality parts and materials reduces costs of defects at later stages Higher quality in manufacturing reduces warranty costs STAGE 5. RECCOMENDATIONS FOR COST REDUCTION 20

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 PRODUCTION SYSTEM MANAGEMENT OF TECHNOLOGY 21

Recent Approaches to Cost Reduction 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 CORPORATE RESTRUCTURING BUSINESS PROCESS REENGINEERING 22