Cost Advantage

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

2
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
3
Examples of Experience Curves
Japanese clocks watches, 1962-72
UK refrigerators, 1957-71
1960 Yen 15K 20K 30K
Price Index 50 100 200 300
75
70 slope
100K 200K 500K 1,000K 5
10 50 Accumulated unit
production Accumulated
units (millions) (millions)
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 () -2 0 5 10
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
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
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
7
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

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 Pepsi
Diet 7-Up
Diet Rite
Advertising Expenditure ( per case) 0.02
0.05 0.10 0.15 0.20
Fresca
Seven Up
Dr. Pepper
Sprite
Pepsi
Coke
10 20 50
100 200 500
1,000 Annual sales volume (millions of
cases)
9
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 Air
craft 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
10
Applying the Value Chain to Cost Analysis The
Case of Automobile Manufacture
STAGE 1. IDENTIFY THE PRINCIPLE ACTIVITIES

RD 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
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
RD 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
RD/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
12
Applying the Value Chain to Cost Analysis The
Case of Automobile Manufacture (continued)
STAGE 4. IDENTIFY LINKAGES

• PRCHSNG PARTS RD
  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
13
Dynamic vs. Static Approaches to Manufacturing
DYNAMIC (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 RD
• departments
• emphasis on big
• projects

MANAGEMENT OF TECHNOLOGY
14
Recent Approaches to Cost Reduction

• Dramatic changes in strategy and structure
• to adjust to the business conditions of the
  1990s
• 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