1. 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

2. 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

3. Examples of Experience Curves
Japanese clocks & watches,
UK refrigerators,
15K K 30K
1960 Yen
Price Index
75%
70% slope
100K 200K K ,000K
Accumulated unit production Accumulated units
(millions) (millions) 11

4. 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:
ROS (%)
over 40
Market Share (%)
BUT: - Association does not imply causation
- Costs of acquiring market share offset the returns to market
share 12

5. 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

6. 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

7. The Costs Developing New Car Models (including plant tooling)
$ billion
Ford Mondeo / Contour
GM Saturn
Ford Taurus (1996 model) 2.8
Ford Escort (new model 1996) 2
Renault Clio (1999 model) 1.3
Chrysler Neon
Honda Accord (1997 model) 0.6
BMW Mini
Rolls Royce Phantom (2003 model) 15

8. 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)
Diet Rite
Fresca
Seven Up
Dr. Pepper
Sprite
Pepsi
Coke
,000
Annual sales volume (millions of cases) 16

9. Cost Advantage in Short-Haul Passenger Air Transport
Costs per Available Seat-Mile
Southwest Airlines United Airlines
(cents) (cents)
Wages and benefits
Fuel and oil
Aircraft ownership
Aircraft maintenance
Commissions on ticket sales
Advertising
Food and beverage
Other
Total 17

10. 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

11. 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

12. 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

13. 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

14. 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