Chapter 8 Cost Advantage

1
Chapter 8 Cost Advantage

• The key to cost analysis is to consider both
  quantitative and qualitative factors.
• Seven factors drive cost advantage
• Economies of Scale
• Economies of Learning
• Process Technology Design
• Product Design
• Input Costs
• Capacity Utilization
• Managerial/Organizational Efficiency

Experience Curve
2
The Experience Curve

• Generalized by BCG to encompass not just direct
  labor hours, but the behavior of all added costs
  with cumulative production.
• If costs decline systematically with increases in
  cumulative output, then the experience curve
  implies that a firms primary strategic goal
  should be market share.
• However, there are some doubts about this
  strategy

3
The Experience Curve

• Difficulties in interpreting the experience curve
  and market share as a strategy
• Association is not the same as causality Which
  comes first market share or superior profits?
  Most likely they are the consequence of some
  underlying factor (E,Q, I).
• The reduced profitability of pursuing market
  share if all firms pursue this strategy, then
  superior profitability will be eroded.
  Overinvestment in this strategy and aggressive
  pricing may even result in industry wide losses.

4
Experience Curve Economies of Scale

• Conventionally associated with manufacturing.
• Can also be important in purchasing, RD,
  distribution, and advertising.
• Scale economies are derived from 3 sources
• Technical input-output relationships increases
  in output do not require proportionate increases
  in input
• Indivisibilities lumpy resources that are
  unavailable in smaller sizes
• Specialization promotes learning, avoids losses
  from switching activities, assists in automation,
  etc.

5
Experience Curve Economies of Scale

• Limits to Scale Economies
• Reluctance to fully exploit EOS is a result of 3
  factors
• Product differentiation the price premium of
  targeting a single segment may outweigh the
  higher cost of small volume production.
• Flexibility huge facilities have greater
  difficulty adjusting to changes in demand,
  technology, input prices, and customization.
• Motivation and coordination large units are
  more complex and difficult to manage than smaller
  units.

6
Experience Curve Economies of Learning

• May be the principal source of experience-based
  cost reductions.
• EOL decrease time required for particular tasks
  and improve coordination between jobs.
• The more complex a task (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 organizational level through
  the development and refinement of organizational
  routines (capabilities).
• e.g. Time-in-motion studies

7
Experience Curve Process Technology and Design

• New product technology may radically reduce
  costs.
• When process innovation is embodied in new
  capital equipment only, diffusion is likely to be
  rapid.
• The full benefits of new processes require
  system-wide changes in job design, incentives,
  organizational structure, and management
  controls.
• The greatest productivity gains from process
  change are the result of organizational
  improvements rather than technological
  innovation.
• JIT, TQM, quality circles, teamwork,
  partnerships, etc

8
Process Innovation

• Reengineering
• Fundamental rethinking and radical redesign of
  business processes to achieve dramatic
  improvements in performance.
• Business processes cut across functions
• Focus on processes rather than functions forces
  firms to adopt a different approach
• May result in RIFs or hiring
• Almost always changes scope of responsibilities
• Always requires change at the deepest level of
  organizational culture

9
Implementing Strategic Change

• Reengineering and TQM go hand-in-hand

BPR
performance
TQM
BPR
TQM
Time
10
Experience Curve Product Design

• Design for manufacture designing products for
  ease of production rather than just functionality
  or aesthetics can offer substantial cost
  savings.
• To do this, the organizational functions must be
  tightly linked RD, engineering, production,
  marketing, etc.

11
EOS, Learning, Experience Curves
A

EOS
Unit Costs
Learning, Technology, Process/Product Design
B

Average Costs

C
Output
MES
12
Cost Advantage Capacity Utilization

• The ability to adjust capacity to the current
  level of demand can be a major source of cost
  advantage.
• During periods of low demand, plant capacity is
  underutilized. Unit costs increase because fixed
  costs must be spread over the units of
  production. Thus, firms with high fixed costs
  are more sensitive to demand fluctuations.
• Some firms try to manage upstream relationships
  or use tapered vertical integration.

13
Cost Advantage Input Costs

• Differences in costs incurred by different firms
  for similar inputs can be an important source of
  cost advantage.
• Locational differences wage rates, raw
  materials, knowledge, exchange rates, etc.
• Supply ownership VI or contracts
• Non-union labor costs and flexibility
• Bargaining power power of the buyer

14
Cost Advantages Residual Efficiency

• Even after taking aforementioned cost drivers
  into accountthere are still firm differences.
• Residual efficiency depends on a firms ability
  to eliminate organizational slack the
  inability of employees and managers to operate at
  maximum efficiency.
• Low levels of residual efficiency are typically
  the result of an organizational culture and
  management style that are tolerant toward
  manifestations of unnecessary costs.

15
Using the Value Chain to Analyze Costs(The Fat
Arrow in Detail)

• Analyzing costs requires disaggregating the firms
  value chain in order to identify
• Relative importance of each activity with respect
  to total cost
• Cost drivers for each activity
• How costs in one activity influence costs in
  another (holism)
• Which activities should be undertaken within the
  firm and which activities should be outsourced

16
Stages of Value Chain Analysis

• Disaggregate the firm into separate activities
  subjective, but current structure may be a guide.
• Establish the relative importance of activities
  on the total cost of the product Activity-based
  costing.
• Compare costs by activity benchmark
• Identify cost drivers what factors determine
  your level of cost relative to competition?
• Identify linkages trace defects to their source
  (TQM)
• Identify opportunities for reducing costs if
  EOS applies, can volume be increased can wages
  be decreased outsourcinginsourcing?