1. Cost Advantage 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 OUTLINE

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. Cost per unit of output (in real $) Cumulative Output 1992 1994 1996 1998 2000 2002 2004

3. Examples of Experience Curves 100K200K 500K 1,000K 5 10 50 Accumulated unit production Accumulated units (millions) 1960 Yen 15K 20K 30K Price Index 50 100 200 300 70% slope 75% Japanese clocks & watches, 1962-72UK refrigerators, 1957-71

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 supported by PIMS data: BUT:- Association does not imply causation - Costs of acquiring market share offset the returns to market share ROS (%) -2 0 510 0-10 10-20 20-30 30-40 over 40 Market Share (%)

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

6. Economies of Scale: The Long-Run Cost Curve for a Plant Units of output per period Minimum Efficient Plant Size Cost per unit of output Sources of scale economies: - technical input/output relationships - indivisibilities - specialization

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 Neon1.3 Honda Accord (1997 model)0.6 BMW Mini0.5 Rolls Royce Phantom (2003 model) 0.3

8. 10 20 50 100 200 500 1,000 Annual sales volume (millions of cases) Advertising Expenditure ($ per case) 0.02 0.05 0.10 0.15 0.20 Coke Pepsi Seven Up Dr. Pepper Sprite Diet Pepsi Tab Fresca Diet Rite Diet 7-Up Schweppe s SF Dr. Pepper Despite the massive advertising budgets of brand leaders Coke and Pepsi, smaller brands which incur the highest advertising costs per unit of sales Scale Economies in Advertising: U.S. Soft Drinks

9. Cost Advantage in Short-Haul Passenger Air Transport Costs per Available Seat-Mile (1993) Southwest Airlines United Airlines (cents) Wages and benefits2.43.5 Fuel and oil1.11.1 Aircraft ownership0.70.8 Aircraft maintenance0.60.3 Commissions on ticket sales0.51.0 Advertising0.20.2 Food and beverage0.00.5 Other1.73.1 Total7.210.5

10. Key Stages in Applying the Value Chain to Cost Analysis: The Case of Automobile Manufacture STAGE 1. IDENTIFY THE PRINCIPLE ACTIVITIES STAGE 2. ALLOCATE TOTAL COSTS PURCH- ASING PARTS INVEN- TORIES R&D DESIGN ENGNRNG COMPONENT MFR ASSEMBLY TESTING, QUALITY CONTROL GOODS INVEN- TORIES SALES & MKITG DISTRI- BUTION DEALER & CUSTOMER SUPPORT

11. Applying the Value Chain to Cost Analysis (continued) PURCH- ASING PARTS INVEN- TORIES R&D DESIGN ENGNRNG COMPONENT MFR ASSEMBLY TESTING, QUALITY CONTROL GOODS INVEN- TORIES SALES & MKITG DISTRI- BUTION DEALER & CUSTOMER SUPPORT --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 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 STAGE 3. IDENTIFY COST DRIVERS

12. Applying the Value Chain to Cost Analysis (continued) PRCHSNG PARTS R&D COMPONENT ASSMBY TESTING GOODS SALES DSTRBTN DLR INVNTRS DESIGN MFR QUALITY INV MKTG CTMR Consolidation of orders to increase discounts, increases inventories Designing different models around common components and platforms reduces manufacturing costs 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 STAGE 4. IDENTIFY LINKAGES

13. Dynamic vs. Static Approaches to Manufacturing Artisan mode: Scientific Management Mode: - problem solving - quest for “one best way” - employee knowledge creation - people matched to tasks - employee control over product - incentives and penalties to - product and customer ensure conformity to objectives orientation - planning and control by staff - continuous incremental - science driven improvement - focused around corporate R&D - market needs pull technology departments - product and process innovation- emphasis on product Innovation - teamwork and cross-functional and big projects collaboration PRODUCTION SYSTEM MANAGEMENT OF TECHNOLOGY DYNAMICSTATIC

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