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 9

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. 1992 1994 Cost per unit of output (in real $) 1996 1998 2000 2002 2004 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: 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: -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 offset the returns to market share 12

Drivers of Cost Advantage Indivisibli\ties Specialization and division of labor ECONOMIES OF SCALE Increased dexterity Improved organizational routines ECONOMIES OF LEARNING Process innovation Reengineering business processes PRODUCTION TECHNIQUES Standardizing designs & components Design for manufacture PRODUCT DESIGN Location advantages Ownership of low-cost inputs Non-union labor Bargaining power INPUT COSTS CAPACITY UTILIZATION Ratio of fixed to variable costs Speed of capacity adjustment Organizational slack; Motivation & culture; Managerial efficiency RESIDUAL EFFICIENCY 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: the point where most scale economies are exhausted 14

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 15

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. 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 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 17

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: The Case of Automobile Manufacture (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 -- Capacity utilization under warranty 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’ --Purchases 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: The Case of Automobile Manufacture (continued) STAGE 4. IDENTIFY LINKAGES PRCHSNG PARTS R&D COMPONENT ASSEM- TESTING GOODS SALES DSTRBTN DLR INVNTRS DESIGN MFR BLY 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) STATIC (Scientific Management Mode) problem solving people matched to tasks create employee knowledge employees control production customer orientation quest for “one best way” planning & control by staff Incentives and penalties to ensure conformity to objectives PRODUCTION SYSTEM continuous, incremental improvement market needs pull technology product and process innovation teamwork and cross- functional collaboration science driven focused around corporate R&D departments emphasis on big projects 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