Cost Advantage
_(Originally published on_ _OUBS Blog_ _)_
In this capter Grant puts the focus on price as the principal source of competitive advantage.
Economies of Experience
In 1968 the Boston Consulting Group published an article called _Perspectives in Experience_ which brought to light the experience curve. This lead ot the “Law of Experience”:
_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._ (unit cost of value added = total cost — cost of bought components and materials)
In logarithmic form, the curve becomes a straight line with the formuly being C _n = C_ 1 * n^-a where n is the cumulative volume and a the cost elasticity.
This leads to several implications. For one, your cost relative to your competitors depends on your relative cumulative output and in that sense, market share is a strategic goal. Honda priced its motorcycles to meet market share objectives because of that, which is different than pricing based on current costs. It’s about pricing your products in regard to likely future costs in relation to future market share. There are still questions though if market share is really the right thing to achieve, because::
\- association is no the same as causation (does market share or profit come first?)
\- market share can still be unprofitable
\- fallacy of competition … if everyone tries to get the market share and there are many everyones, then you get into trouble.
The sources of cost advantage
You need to identify the cost drivers of your specific environment. You also need to understand where a companies unit costs come from and how it could improve them.
Economies of scale arise from:
\- technical input-output relationship (a 10000 barrel tank does not cost 5 times a 2000 barrel tank)
\- indivisibility (no small sizes)
\- specialization (no division of labor to promote learning, avoid time loss,…)
Scale economies are seldom in production but for consumer goods are often found in marketing. It costs the same to market Coca Cola than Pepsi but for Coca Cola, it costs a lot less per bottle. This is also something that is very hard to take away.
(The next chapter starts with a quote here, from Warren Buffet, who through Berkshire Hathaway is Coca-Cola’s biggest shareholder, which I’d like to quote here: _If you gave me $100 billion and said, “Take away the soft drink leadership of Coca-Cola in the world,” I’d give it back to you and say, “It can’t be done.”_)
Consolidation in the automotive industry also comes from costs associated with new model development. The same is true for the airline industry and in software especially.
Limits to scale economies comes in places where:
\- product differentiation leads to small segments highly profitable
\- flexibility doesn’t work well with scale-efficient production
\- problems of motivation and coordination come with big units
Economies of learning as such are important because through repetition you cut time used and waste and defects. With active-matrix flat screens, yield rate is key, and hence companies that are already in the market have a considerable lead because they have gained a lot of experience.
Process technology and design can be used to reduce the (monetary total) units of inputs for the same output. Changes in these processes often need supporting changes in a lot of different parts of the organisation. Often, changes with the greatest effect come from process changes in organizations processes rather than in technology.
Business process reengineering was defined by Michael Hammer and James Champy as follows: _the fundamental rethinking and redical redesign of business processes to achieve dramatic improvements in ciritical contemporary measures of performance, such as costs, quality, service, and speed._
You ask yourself how you would design a given process in case you were starting from zero. The book lists examples here of things that often happen, which is not the right approach though in my mind as it will limit you in your thinking. This is not about doing more of the same but about doing more totally new things. The important thing is to really understand the process you are trying to reengineer.
Product design can lead to cost savings when you design-to-manufacture for example.
Capacity utilization becomes important in industry where fixed costs are high, like the airline industry.
Input costs can be (made) important when:
\- locational differences are there
\- you own low-cost sources
\- non-union labor
\- bargaining power is on your side
Residual efficiency is about removing slack in your orgnization. Think gap analysis, just any gap.
Using the value chain to analyze costs
Disaggregate your company’s value chain to find the costs associated with each activity and better analyse each step, linkages and find potentials of outsourcing. Figure 8.6 is very thorough here.
Managing cost cutting
There are dynamic aspects of cost efficiency and companies should focus on the long term through continuous improvements. Radical cost surgery are needed in cases where major changes are needed boost financial performance and/or regain investor confidence. This needs a tough top down hand.