COST ADVANTAGE Chapter 8

Introduction Historically, business strategy analysis has emphasized cost advantage as the primary basis for competitive advantage in an industry. The focus on cost advantage reflects the traditional emphasis by economists on price as the principal medium of competition- competing on price depends on cost efficiency For some industries, cost advantage is the predominant basis for competitive advantage: for commodity goods and services there are few opportunities for competing on dimensions other than cost

Objectives Identify the determinants of relative cost within the industry or activity/cost drivers/ Assess a firms cost position relative to its competitors and identify the factors responsible for cost differentials Recommend cost-reduction measures

Economies of Experience The Experience Curve In a series of studies, BCG observed a remarkable regularity in the reductions in costs/ and prices/ that accompanied increased production. Doubled of cumulative production typically reduced unit costs by 20 to 30 percent. Figure: The experience curve BCG summarized its observations in its Law of Experience

The Experience Curve The unit cost of value added to a standard product declines by a constant percentage /typically between 20 and 30 percent / each time cumulative output doubles. The experience curve became one of the best- known and most influential concepts in the the history of strategic management.

The Experience Curve The relationship between unit cost and production volume may be expressed as follows: C n =C 1 ·n -a Where, C n is the cost of the first unit of production; C 1 is the cost of the n th unit of production; n is the cumulative volume of production; a is the elasticity of cost with regard to output

Strategy Implications: The role of market share If costs decline systematically with increases in cumulative output, then a firms cost relative to its competitors depend on its cumulative output relative to that of competitors.

Strategy Implications: The role of market share If a firm can expand its output at a greater rate than its competitors, it is then able to move down the experience curve more rapidly than its rivals and can open up a widening cost differential. If Boeing holds 60 percent of the world market for large commercial jet aircraft and Airbus holds 40 percent, Boeing will reduce its costs at one – and-a half times the rate of Airbus

Strategy Implications The quest for economies of experience also has important implications for pricing policy. The firm should price its products not on the basis of current costs, but on the basis of anticipated costs The quest for experience-based economies also points to the advantages of maximizing volume by offering a broad rather than a narrow product range and expanding internationally rather than restricting sales to the domestic market

The Sources of Cost Advantage The experience curve combines four sources of cost reduction: Economies of Scale ; Economies of Learning ; Improved Process Technology and Process Design ; Improved product design To these we an add three more factors that influence a firms relative cost position: Capacity utilization ;The cost of inputs ; Residual efficiency Figure: The drivers of cost advantage

The Cost Drivers By identifying these different cost drivers, we can do the following: Diagnose a firms cost position in terms of understanding why its input costs diverge from those of its competitors Make recommendations as to how a firm can improve its cost efficiency

Economies of Scale The predominance of large corporations in most manufacturing and service industries is a consequence of Economies of Scale.Economies of Scale have been conventionally associated with manufacturing.Scale economies are also important in nonmanufacturing operations. The point at which most scale economies are exploited is the Minimum Efficiency Plant Size /MEPS/. Figure: The long-run average cost curve for a plant

Economies of Scale Scale economies arise from three principal sources: 1.Technical input-output relationships. In many activities, increases in output do not require proportionate increases in input.A 10,000- barrel oil storage tank does not cost five times the cost of a 2,000-barrel tank.

Economies of Scale 2.Indivisibilities -Many resources are lumpy- they are unavailable in small sizes./ Body press in an auto plant, catalytic cracker in an oil refinery, etc/. Hence they offer economies of scale, as firms are able to spread the costs of these items over larger volumes of output

Economies of Scale 3.Specialization. Expanding the number of inputs permits greater task specialization /Specialized workers using specialized equipment/. Specialization of labor promotes learning, avoids time loss from switching activities, and assists in mechanization and automation

Scale Economies and Industry Concentration Scale economies are the single most important determinant of an industrys level of concentration. Consolidation in the world car industry has been driven by the huge costs associated with new model development. Ford Escort /new model/ $2 billion Ford Mondeo/Contour $6 billion GM Saturn $5 billion Chrysler Neon $1,3 billion

Scale Economies and Industry Concentration Small and medium-sized auto companies have been acquired by larger rivals simply because they lacked the necessary volume over which to amortize the costs of developing new models. Thus, VW acquired Skoda, Seat, and Rolls-Royce, while Ford acquired Jaguar, Mazda, Land Rover, and Volvo. Remaining smaller auto producers typically license technology and designs from bigger auto companies.

Scale Economies and Industry Concentration The exploitation of scale economies has been a major force for globalization as companies seek to realize scale economies from consolidating activities and functions globally. A key feature of most digital products is that the initial development costs are very high but, once developed, they can be reproduced and distributed at negligible cost. Hence, in sectors,such as computer software, profitability depends critically on market dominance

Limits to Scale Economies Product differentiation. Where customer preferences are differentiated, firms may find that the price premium of targeting a single segment with a differentiated product outweighs the higher cost of small-volume production. General Motors rise to market leadership over Ford during the late1920s is an example of a multimodel differentiation strategy triumphing over a single-model, scale-economy strategy

Limits to Scale Economies Flexibility. Scale-efficient production is likely to involve highly specialized labor and equipment, which tends to be inflexible. In a dynamic environment, very large plants and firms have greater difficulties than smaller units in adjusting to fluctuations in demand and changes in technology, input prices, and customer preferences Problems of motivation and coordination.Large units tend to be more complex and more difficult to manage than smaller units

The Drivers of Cost Advantage:Economies of Learning The principal source of experience-based cost reduction is learning by organization members. Repetition reduces costs by decreasing the time required for particular jobs, thus reducing waste and defects, and improving coordination between jobs. For example, in 1943 it took40,000 labor- hours to build a Convair B-24 bomber. By 1945 it took only 8,000 hours.

The Drivers of Cost Advantage:Economies of Learning The more complex a process or product, the greater the potential for learning. Learning occurs both at the individual level through improvements in dexterity and problem solving, and at the group level through the development and refinement of organizational routines

The drivers of cost advantage:process technology and process design New process technology may radically reduce costs. At the end of 1912, it took 106 hours to assemble a Ford Model T. a little over a year later, after Ford had introduced his moving-assembly line and interchangeable parts, the labor input had been cut to just over six hours. The automobile was transformed from a rich mans luxury to a form of mass transportation.

The drivers of cost advantage:process technology and process design The full benefits of new processes typically require systemwide changes in job design, employee incentives, product design, organizational structure, and management controls. Between 1979 and 1986, GM spent $40 billion on new technology and new plants with a view to becoming the worlds most efficient volume manufacturer of automobiles.Yet, in the absence of fundamental changes in organization and management, the productivity gains were meager.

The Drivers of Cost Advantage: process technology and process design By contrast, the superiority of Japanese companies in flexible manufacturing systems reflects to adaptation of their management processes to the requirements of the new technology. Indeed, the greatest productivity gains from process innovation typically are the result of organizational improvements rather than technological innovation and new hardware!

The Drivers of Cost Advantage: Process technology and Process design Reengineering - The fundamental rethinking and radical redesign of business processes to achieve dramatic improvements in critical contemporary measures of performance, such as cost, quality, service, and speed. Reengineering without a complete understanding of the process is hazardous.

The Drivers of Cost Advantage: Product Design Design-for-manufacture - designing products for ease of production rather than simply for functionality and aesthetics - can offer substantial cost savings, especially when linked to the introduction of new process technology In automobiles. Companies have sought to offset the rising cost of developing and introducing new models by means of designing their different models around a few common platforms.

The Drivers of Cost Advantage: Capacity Utilization. Over the short and medium term, plant capacity is more or less fixed, and variations in output are associated with variations in capacity utilization. During periods of low demand, plant capacity is underutilized- this raises unit costs. In declining industries, the ability speedily to adjust capacity to the current level of demand can be a major source of cost advantage.

The Drivers of Cost Advantage: Input Costs There are several common sources of lower input costs: Locational differences in input prices. The prices of inputs may vary between locations, the most important being differences in wage rates from one country to another. In labor-intensive industries such as clothing, footwear, hand tools,, and toys, low wage rates gives an unassailable cost advantage to producers in developing countries.

The Drivers of Cost Advantage: Input Costs Ownership of low-cost sources of supply.In raw material-intensive industries, ownership or access to low-cost sources may be a key cost advantage. Non-union labor.In some labor-intensive industries, cost leaders are often the firms that have avoided unionization. Bargaining power. Where bought-in products are major cost item, differences in buying power among the firms in an industry can be important source of cost advantage.

The Drivers of Cost Advantage: Residual Efficiency Residual efficiency relate to the extent to which the firm approaches its efficiency frontier of optimal operation and depends on the firms ability to eliminate organizational slack- surplus cost that keep the firm from maximum efficiency operation. Eliminating excess costs is difficult,but when faced with bankruptcy or a precipitous fall in profitability, companies can demonstrate a remarkable capacity for paring costs. The collapse of profitability at Xerox during 2000 resulted in a campaign to reduce costs by $1 billion

Using the Value Chain to Analyze Costs Every business may be viewed as a chain of activities./Chapter 5/ In most value chains each activity has a distinct cost structure determined by different cost drivers. Analyzing cost requires disaggregating the firms value chain in order to identify:

Using the value Chain to Analyze Costs The relative importance of each activity with respect to total cost The cost drivers for each activity and the comparative efficiency with which the firm performs each activity How costs in one activity influence costs in another Which activities should be undertaken within the firm and which activities should be outsourced

The Principal Stages of Value Chain Analysis Disaggregate the firm into separate activities Establish the relative importance of different activities in the total cost of the product Compare costs by activity Identify cost drivers Identify linkages Identify opportunities for reducing costs

Managing Cost Cutting The experience of cost reduction by companies over the past two decades points to two important lessons in managing for cost efficiency: The role of dynamic approaches to cost efficiency The potential for integrated approaches to restructuring and cost reduction.

Dynamic Aspects of Cost Efficiency One of the dangers of the analytic approach to cost analysis outlined above is its static nature. The operations management experts at Harvard Business School point out that the critical advantage of Japanese over American companies in manufacturing industries such as automobiles, consumer electronics, and construction equipment was Japanese companies emphasis on dynamic efficiency through continuous improvement

Radical Cost Surgery The cost-reduction measures involved include: Plant closures to improve capacity utilization and eliminate obsolete technology Outsourcing of components and services wherever internal suppliers are less cost efficient than external suppliers Reduction in employment Increasing managerial efficiency / Reduction of administrative head, etc/ Exhibit: Cost Cutting at Chevron

Cost Cutting at Chevron After several years during which Chevrons profitability and shareholder returns lagged those of most other US oil majors, in January 1992, CEO Kenneth Derr announced an aggressive action plan involving: A company-wide program to reduce operating expenses by 50 cents a barrel sold by mid-1993 Capacity reduction and efficiency increases at the Port Arthur refinery, including 700 job cuts The sale of 600 of Chevrons 1,000 remaining US oil and gas fields

Cost Cutting at Chevron The targeted cost reduction was achieved in six months. The principal cost economies occurred in the following areas: 1. Selling, general and administrative expenses.These were cut from $459 million during the third quarter of 1992 to $359 million during the third quarter of 1993.The biggest cost savings were incurred at corporate headquarters. Between 1992 to 1993, headquarters staff was reduced from 3,600 to 2,600.

Cost Cutting at Chevron Exploration and production. In 1992, oilfield sales,a 23 percent reduction in employee numbers, and the implementation of efficiency measures suggested by employees, cut operating costs by $400 million, or $1,18 per barrel of oil.

Summary Cost efficiency may no longer be a guarantee of profitability in todays fast-changing markets, but in almost all industries it is prerequisite for success The foundation for a cost-reduction strategy must be an understanding of the determinants of a companys costs..

Summary Careful analysis of existing activities relative to competitors can pinpoint cost-reduction opportunities by lowering input costs, accessing scale economies, and better utilizing capacity. At the same time, the firm must seek opportunities for innovation and process redesign in order to exploit new sources of dynamic efficiency