1. C HAPTER 4 Cost Advantage

2. T ATA ’ S NANO S TRATEGY (O PENING M INICASE ) 1.What Markets Served 2. What Unique Value (why Tata wins with customers) 3. What Resources and Capabilities (how Tata delivers unique value) 4. What Barriers to Imitation

3. C OST L EADERSHIP S TRATEGY What is Cost Leadership? What benefits of Cost Leadership? What Cost Leadership is NOT?

4. O VERALL C OST L EADERSHIP Integrated tactics –Aggressive construction of efficient-scale facilities –Vigorous pursuit of cost reductions from experience –Tight cost and overhead control –Avoidance of marginal customer accounts –Cost minimization in all activities in the firm’s value chain, such as R&D, service, sales force, and advertising

5. V ALUE -C HAIN A CTIVITIES : O VERALL C OST L EADERSHIP Exhibit 5.3 Value-Chain Activities: Examples of Overall Cost Leadership Source: Adapted with the permission of The Free Press, a division of Simon & Schuster, Inc., from Competitive Advantage: Creating and Sustaining Superior Performance by Michael E. Porter. Copyright © 1985 by Michael E. Porter.

6. O VERALL C OST L EADERSHIP (C ONT.) A firm following an overall cost leadership position –Must attain parity on the basis of differentiation relative to competitors –Parity on the basis of differentiation Permits a cost leader to translate cost advantages directly into higher profits than competitors Allows firm to earn above-average profits

7. O VERALL C OST L EADERSHIP : I MPROVING C OMPETITIVE P OSITION VIS - À - VIS THE F IVE F ORCES An overall low-cost position –Protects a firm against rivalry from competitors –Protects a firm against powerful buyers –Provides more flexibility to cope with demands from powerful suppliers for input cost increases –Provides substantial entry barriers from economies of scale and cost advantages –Puts the firm in a favorable position with respect to substitute products

8. P ITFALLS OF O VERALL C OST L EADERSHIP S TRATEGIES Too much focus on one or a few value-chain activities All rivals share a common input or raw material The strategy is imitated too easily A lack of parity on differentiation Erosion of cost advantages when the pricing information available to customers increases

9. S OURCES OF C OST A DVANTAGE Economies of Scale 1 1 Learning and Experience Effects 2 2 Lower Costs due to Proprietary Knowledge 3 3 Lower Input Costs 4 4 Different Business Model 5 5

10. First electronic bank (FEB) provides a store credit card to Frys electronics. After 3 years, 25% of Frys customers have a Frys credit card but growth has slowed Should FEB: A) Spend more on marketing to increase penetration of the card at Frys B) Spend money on marketing to get other store client customers to adopt a store credit card provided by FEB What analysis would you recommend to FEB to determine what, if any, they should spend on marketing to get new customers? M INI -C ASE

11. How important is size/volume as a driver of costs (and thus profitability) in my industry? Scale/Experience Curve analysisMarket-share/profitability analysis Overview A NALYZING C OST A DVANTAGE

12. E CONOMIES OF SCALE Q1Q1 Low High Dis-economies of Scale Economies of Scale Minimum Efficient Scale (optimal quantity)

13. Specialization Specialization of machines and equipment. A firm with high volumes is able to purchase and use specialized equipment or tools that small firms simply cannot afford. Specialization of tasks and people. Small firms do not have the volume to create high levels of employee specialization. When do hire specialized may not be enough work to keep them busy Ability to Spread Fixed Costs Production: Property, plant and equipment. Scale is particularly valuable when investments in PPE are indivisible or “lumpy”—unavailable in small sizes. Non-Production: R&D, advertising, distribution, finance, G&A. W HY E CONOMIES OF S CALE L OWER C OSTS

14. Source: Boston Consulting Group S CALE E CONOMIES IN A DVERTISING : U.S. S OFT D RINKS

15. 75.5 % Scale Curve y = 32534x -0.4052 $- $5.00 $10.00 $15.00 $20.00 $25.00 $30.00 $35.00 30,000,00035,000,00040,000,00045,000,00050,000,00055,000,000 Number of Subscribers Average Cost per Subscriber (Constant Dollars) C REDIT C ARD C OMPANY S CALE C URVE

16. S EMICONDUCTOR E XPERIENCE C URVE

17. S OURCES OF C OST A DVANTAGE Economies of Scale 1 1 Learning and Experience Effects 2 2 Lower Costs due to Proprietary Knowledge 3 3 Lower Input Costs 4 4 Different Business Model 5 5

18. A B C Industry Price Best Fit Line Cost Per Unit of Output* Cumulative Output/Experience The Law of Experience Variable and average (variable + fixed) costs per unit decline by a constant percentage (typically 10-30%) each time cumulative output doubles Constant Dollars; Location of GDP deflator info: http://www.measuringworth. com/uscompare/ T HE E XPERIENCE C URVE

19. Decreasing Variable Costs Per Unit Due to Learning –Human Learning (Efficiency) –Design and Process Technology Learning Decreasing Fixed Costs Per Unit due to Scale –Economies of Scale increase ability to spread fixed costs W HY THE E XPERIENCE C URVE W ORKS

20. Relative market share (RMS) is a reasonable proxy for relative cumulative experience: Of leader relative to next largest follower Of all followers relative to leader There will be a relationship between market share and profitability in industries where experience/volume drives lower costs per unit of experience. Profitability Relative Cumulative Experience (Market Share) But Market Share is not always the cause of high profitability Companies with higher market share tend to have higher profitability if size/volume drives profitability T HE I MPORTANCE OF R ELATIVE M ARKET S HARE

21. E NSURING C AUSALITY Sometimes a third variable (e.g., quality, features) may be causing both profitability and market share to increase simultaneously. Even if a relationship seems clear within your model, it may be only correlated and not actually causal. Market Share Profitability 10%15%20%25% Market leader Quality

22. Note: Market share figures are for 2004; profit figures are avg. of 2000-2005 T HE M ARKET S HARE -P ROFIT R ELATIONSHIP : H OME I MPROVEMENT

23. First movers in a fast growing market will secure a widening cost advantage. Firm’s must grow as fast, or faster, than rivals or be at a cost disadvantage. This is behind the “be #1 or #2 or exit” philosophy. Growth/Investment Strategy As a basis for market share based pricing strategy As a basis for planning future prices As a basis for pricing a production run or contract Pricing Strategy Scale/X-curves can be plotted for a company and its competitors to assess how well each company is managing its costs. Companies that fall above the regression line may not be managing costs well. Benchmarking/Cost Analysis Scale/X-curves provide data on how much costs will likely decrease (cost synergies) if two firms combine their volume/scale. Acquisition Strategy S TRATEGIC I MPLICATIONS OF THE S CALE /E XPERIENCE C URVE

24. Guest-Tek costs fall by an average of 29 percent with every doubling of room count 1 Acquisition of Golden-Tree (200K rooms) 1.Power function (based on trend-fit) is C = 154.13 Q ^ (-.4955). Doubling volume (2^-0.4955) delivers a cost that is 71 percent of previous level. Number of Rooms (Installed Base) T HE V ALUE OF S CALE IN D ELIVERING I NTERNET S ERVICE TO H OTEL R OOMS

25. GUEST-TEK ANNOUNCES RECORD REVENUE AND CASH FLOW FOR THE THREE MONTHS ENDED JUNE August 10, 2005 - Guest-Tek announced today that the Company achieved record positive EBITDA of $1.8 million. Guest-Tek CEO Arnon Levy commented, “The contribution of the acquisition of Golden-Tree in the quarter substantially increased … cash flow, and EBITDA, as well as improved margins. We believe there are opportunities for further margin improvement once the full integration of the two organizations is completed.” G UEST - TEK R ESULT

26. Market share does not guarantee substantial cost advantages –What is the cost of market share? –Learning curve flattens with high experience “Spillovers” of knowledge to rivals lower their costs of learning Aging equipment can impede continued learning and cost advantages (e.g., airlines). L IMITATIONS OF THE E XPERIENCE C URVE

27. Firms with scale have an advantage in economic upturns but may be at a disadvantage during downturns. They have more difficulty spreading fixed costs when demand declines. Firms with heavy fixed assets can respond to this concern by: Shifting more of their cost structure from fixed cost to variable cost (e.g., outsourcing to make costs more variable; using labor instead of capital). Diversifying into businesses that are countercyclical D ISADVANTAGES OF S CALE

28. D ISADVANTAGES OF S CALE IN AN E CONOMIC D OWNTURN

29. S OURCES OF C OST A DVANTAGE Economies of Scale 1 1 Learning and Experience Effects 2 2 Lower Costs due to Proprietary Knowledge 3 3 Lower Input Costs 4 4 Different Business Model 5 5

30. Toyota Production System (TPS) vs. Mass Production Some Key Principles of Toyota Production System (TPS): 1. Use a “pull” system: to avoid overproduction 2. Just-in-time delivery: to reduce inventories 3. Level out the workload: to smooth production 4. Use visual controls: to illuminate problems and reduce defects 5. Find the bottleneck: to increase productivity TPS is a very successful, but very difficult to imitate, production system. L OWER C OSTS D UE TO P ROPRIETARY K NOWLEDGE

31. S OURCES OF C OST A DVANTAGE Economies of Scale 1 1 Learning and Experience Effects 2 2 Lower Costs due to Proprietary Knowledge 3 3 Lower Input Costs 4 4 Different Business Model 5 5

32. Walmart: Greater bargaining power over suppliers Honda: Superior cooperation with suppliers (including lower transaction costs) Honda: Superior cooperation with suppliers (including lower transaction costs) Nike: Sourcing from low cost locations (e.g., country comparative advantage) Nike: Sourcing from low cost locations (e.g., country comparative advantage) De Beers: Preferred access to inputs (e.g., DeBeers owns diamond mines) De Beers: Preferred access to inputs (e.g., DeBeers owns diamond mines) L OWER I NPUT C OSTS

33. S OURCES OF C OST A DVANTAGE Economies of Scale 1 1 Learning and Experience Effects 2 2 Lower Costs due to Proprietary Knowledge 3 3 Lower Input Costs 4 4 Different Business Model 5 5

34. W HAT IS A BUSINESS MODEL ? A business model describes the rationale of how an organization creates, delivers, and captures value. What a business does to make money.

35. B USINESS M ODEL C ANVAS Key Partners Key Activities Value Proposition s Customer Relationships Customer Segments Key Resources Channels Cost StructureRevenue Streams 35

36. N INE B UILDING B LOCKS 1. Customer Segments An organization serves one or several Customer Segments. 3. Channels Value propositions are delivered to customers Through communication, distribution, and sales Channels. 2. Value Propositions It seeks to solve customer problems and satisfy customer needs with value propositions. 36

37. N INE B UILDING B LOCKS ( CONT.) 4. Customer Relationships Customer relationships are established and maintained with each Customer Segment. 6. Key Resources Key resources are the assets required to offer and deliver the previously described elements… 5. Revenue Streams Revenue streams result from value propositions Successfully offered to customers. 37

38. N INE B UILDING B LOCKS ( CONT.) 7. Key Activities …by performing a number of Key Activities. 9. Cost Structure The business model elements result in the cost structure. 8. Key Partnerships Some activities are outsourced and some resources are acquired outside the enterprise. 38

39. Reconfigure the Value Chain and/or Supply Chain Eliminate Activities/Steps in the Value Chain and/or Supply Chain Example: Eliminate Retail Storesi.e., Netflix and Amazon.com D IFFERENT B USINESS M ODEL

40. Sources of Cost Advantage Economies of Scale Greater unit volume allows firms to have lower costs by spreading fixed costs across more units. Learning and Experience Effects Greater cumulative volume drives cost differences due to greater learning and experience within companies with more cumulative experience in production. Proprietary Knowledge Cost advantage from developing proprietary knowledge in the production of their product or service Lower Input Costs Some companies may have lower input costs than others due to bargaining power, superior cooperation, low cost locations. Different Business Model Eliminating steps in the value chain or using a different activity set may offer lower costs Walmart intel Toyota Nike Netflix