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

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

Examples of Experience Curves 100K200K 500K 1,000K Accumulated unit production Accumulated units (millions) 1960 Yen 15K 20K 30K Price Index % slope 75% Japanese clocks & watches, UK refrigerators,

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

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

Economies of Scale: The Long-Run Cost Curve for a Plant Units of output per period Minimum Efficient Plant Size: the point where most scale economies are exhausted Cost per unit of output Sources of scale economies: - technical input/output relationships - indivisibilities - specialization

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

,000 Annual sales volume (millions of cases) Advertising Expenditure ($ per case) 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, their main brands incur lower advertising costs per unit of sales than their smaller rivals. Scale Economies in Advertising: U.S. Soft Drinks

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

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

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 Applying the Value Chain to Cost Analysis: The Case of Automobile Manufacture (continued)

PRCHSNG PARTS R&D COMPONENT ASSEM- TESTING GOODS SALES DSTRBTN DLR INVNTRS DESIGN MFR BLY 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 Applying the Value Chain to Cost Analysis: The Case of Automobile Manufacture (continued)

Dynamic vs. Static Approaches to Manufacturing PRODUCTION SYSTEM MANAGEMENT OF TECHNOLOGY 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  science driven  focused around corporate R&D departments  emphasis on big projects  continuous, incremental  improvement  market needs pull technology  product and process innovation  teamwork and cross- functional collaboration

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