Low Cost and Experience Curves

Some Fundamental Premises for Strategy Formulation
1. Costs (and prices) always decline. Prices follow costs. Good managers know and apply the experience curve correctly. 2. Your competitive position largely determines your strategic options. Good managers know their strategic position and the possibilities and constraints it creates. 3. Customers, Competitors and Profits are always shifting. Good managers anticipate shifts and plan accordingly. 4. Simplicity is preferred over complexity. Too many products and options drive up costs.
The Benefits in Low costs

Original Price
New Price Cost 2 Cost1 New Margins
Company 2
Company 1
Note that because of Co. 1s lower costs, the drop in price affects Co. 1s margins proportionately less than co.2s (approximately 1/3 vs. in diagrams).
High R.O.I
Low Low Mkt. Share High Assumed causal relationships: High Market Share Causes
High Accumulated Volumes of Production Causes Low per Unit Costs

High Profits
An 85% Experience Curve

120 110 Deflated Direct cost per Unit 100 90 B 80 70 D C A
10th unit = $100 Then 20th unit = $100 * .85 =$85 Then 40th unit = $85*.85 = $72.25
60
50 40 30
20
10 0 10 20 30 40 50 60 70 80 90 100 120 130
Accumulated Vol. Of Production (units)
The Learning Effect Y = 2X n
Direct Labor hrs/unit
Where y = the no.(cost) of direct labor hrs required to produce the xth unit a = the no.(cost) of direct labor hrs required to produce the first unit x = the cumulative unit no. n = the learning index = (log 0)/(log 2) 0 = the learning rate 1-0 = the progress ration
1.0 .1 .01 .001 10 % progress (0 =90)
20% progress(0=80%)
30% progress (0=70%)
10 1000 100 Cumulative units as plotted logarithmetrically
Break for experience curve simulation
Paper Airplane Exercise Results on Linear Scale

$5
Trial 1
Cost Per Airplane
4 3 2 1 9
Trial 2
Trial 3
12
Accumulative Experience (Number of Planes)
$10 5
Cost Per Airplane
Paper Airplane Exercise Results on Log Scale

Slope = 74% R2 = 1.00 Trial 1
Trial 2
Trial 3
2
1 0 2
5
Accumulative Experience (Number of Planes)
1 0
15
Example Using Traditional Linear Programming

Maximize : TT = $33X1 + $39X2 +$59X3 Subject to: 10X1 +15X2 +12X3 < or = 14,400 labor hours Production Constrain 24X1 + 20X2 + 14X3 < 0R = 5,900 machine hours Here, our optimal solution would be to produce: 0 units of X1 0 units of X2 361 units of X3 With resulting contribution margin of: $59 (361) = $21,299 This would yield optimal solution if there are no learning effects present. If, however, workers learn, machines are used more efficiently, and materials usage is optimized, then we would have to modify our linear programming formula. For example, that learning occurs such that there is a 90% experience curve effect. Then, if we were to only produce X the constraints on production change: Using logs 12X3.848 < or = 14,400 labor hrs 14X3.848 < or = 5,920 machine time We obtain 36X 3 .848 < or = 13,026 materials Yields an optimal solution of $59 (1,040X) = $61,360
Experience Curve for Price of Brokerage Services

30 20
EXECUTION REVENUE PER SHARE TRADED (intuitional: 1996 Dollars
1990
Slope = 64% R2 = 099
10
5 3
2003
300 500
1,000 2,000
5,000
10,000B
CUMMULATIVE SHARES TRADED
The Perils of a Price Cut

An innocent little 3% price cut by the average S&P 1000 knocks the profits down from 8.1% to 5.1% or a whopping 37%
Full Price $1.00 3% Off $0.97
Profit 8.1% Costs: 91.9%
Profit 5.1%
Costs: 91.9%
Incremental Breakeven Analysis

q= p (1-cm) c cm- p + (1-cm) c
Definitions: q---the breakeven sales increase in percentage; p---the magnitude of a price cut; Cm---the contribution margin in percentage (before the price cut); c---the reduction in marginal costs in percentage due to the price cut.
Incremental Breakeven Analysis

q= p (1-cm) c cm- p + (1-cm) c
Definitions: using Galanz example q---the breakeven sales increase in percentage = 90.5%; p---the magnitude of a price cut = 20%; Cm---the contribution margin in percentage (before the price cut) or (price marginal cost) = 40%; c---the reduction in marginal costs in percentage due to the price cut = 35%
Circumstances for a Price War

High growth markets Heterogeneous firms with a wide distribution of cost efficiencies New technologies with significant scale economies
Source of the Experience Effect

1. 2. 3. 4. 5. 6. Labor efficiency New processes and improved methods Product redesign Product standardization Scale effect Substitution in the product
Practical Considerations
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Cost-time relationship High-volume effect Shared experience Product Definition Cost data Marginal vs. average cost Inflation Planning horizon External influences Market instability
Steps in A Typical Value-Added Chain:

Product R & D Process R & D Purchasing of Raw Materials Transportation of Raw Materials Mfg. Of Parts and Components Assembly Testing and Quality Control Marketing Sales to intermediaries Wholesale Distribution Retailing After sales Service
The Generic Value Chain

Firm Infrastructure Human Resource Management Technology Development Procurement Inbound Logistics Operations Outbound Logistics Marketing & Sales
Service
Upstream Value Activities Economies of Scale Dominate
Primary Activities
Margin Downstream Value Activities Economies of Scope Dominate
Effects of accumulated experience over the cost accrued in different stages of value added
Deflated direct cost per unit R& D Purchasing and Mfg of parts & Components 75% Subassembly Marketing Distribution Retail
95%
70%
90%
85%
95%
Accumulated Volume of production in each stage (in units)

R& D Manufacture Assembly Marketing Distribution Retail
2%
20%
15%
30%
25%
8%
Accumulated Costs in
Mkt. Leader is A w/rel. mkt share of 4 to 1 over B. Conceptualize value-added in 2 stage mfg and dist. In mfg. Stage A has the 4 to 1 advantage over B but in dist. Stage B has 3 to 1 advantage in terms of mkt share, because this is just one of many others that share the same system of dist. If we assume that experience in both stages has the same impact over costs, and that each stage contributes half the final value of the product, we could use a normalized mkt share to determine the relative standing of the 2 firms in the business. Two firm ex. W/value added as manufacturing and distribution for firm A: Market Share = (Mfg. Share x Mfg. Value-Added) + (Distribution Market Share x Distribution Value-Added) = [(4 to 1 or 4/5)] + [(1 to 3 or I/4) x (0.5)] = 0.525 Similarly for firm B Market Share = 0.475 The relative market share of firm A over firm B using this weighted measure of experience in only 0.525/0.475 = 1.10 times, for smaller than the observed to 4 to 1 product ratio in the final market.
Gillette Razor Blades

Industry Life cycle Sales Business Life Cycle
Waves of Product life cycle
Wave of Profit
Blue Blades
Stainless Steel
Super Chromium
Platinum plus
Time
Location of product in: a less developed country a newly industrialized country a fully developed country
Sales
Time
Costs Sales Profit Relationships by Stages of life Cycle

Total Sales
Costs/Unit
Price/Unit
Profit
Loss
Introduction
Rapid Growth
Maturity
loss Decline
Growth Share Matrix
22% 20 %
Mkt. Growth Rate
18% 16% 14% 12% 10% 8%
6%
4% 2%
10X
4X
1.5X
1.0X
0.5X
0.1X
Relative Competitor Position
Industry growth Rate (2009) = Relative Industry Share = Circle Size =
(Total Ind. Sales 2009) (Total Ind. Sales 2008) Total Ind. Sales 2008 Your business units sales Leading competitors sales Your business units sales Total corp. sales
4 ways to separate high-low growth Avg. industry growth single industry Overall economic growth multiple industry Weighted average growth Corporate growth target
Ideal Movement of Products and cash in the Portfolio

Question Mark Star Modest + Cash Flow
Market Growth
Large Negative Cash Flow
Large Positive Cash Flow Cash Cow
Modes = or Cash flow Dog
Relative Competitive Position = Cash Movement = Product movement
Four Basic Types of Unbalanced Portfolios

Typical Symptoms
Inadequate cash flow Inadequate profits Inadequate growth Inadequate cash flows Inadequate profits Inadequate growth Excessive cash flow Excessive cash demands Excessive demands on Management Unstable growth & profits
Problems
Too Many losers
Corrective Actions
Divest/Liquidate/harvest losers Acquire profit producer Acquire Winners Divest/Harvest/liquidate selected question marks Acquire winners Nurture/Develop selected question marks Divest selected winners if Necessary Acquire profit producers
Too many question marks Too many profit producers Too many developing winners
Using the Matrix to Guide Strategy

The process consists of 3 steps: 1. Developing matrices for ones own firm. 2. Developing matrices for ones competitors. 3. Making strategic comparisons and generating strategies. Each step may be further subdivided: 1.a. Identify the products and the business sectors. 1.b. Selecting and ranking the criteria for assessing the Bus. Pos. and Ind. Attractiveness. 1.c. Gathering the data. 1.d. Quantifying each products position. 1.e. Drawing the matrices; past, present, and future. 1.f Assessing the implications of each products position in the matrix.

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Low Cost and Experience Curves

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Some Fundamental Premises for Strategy Formulation

The Benefits in Low costs

New Price Cost 2 Cost1 New Margins

High Accumulated Volumes of Production Causes Low per Unit Costs

An 85% Experience Curve

Accumulated Vol. Of Production (units)

The Learning Effect Y = 2X n

Direct Labor hrs/unit

1.0 .1 .01 .001 10 % progress (0 =90)

10 1000 100 Cumulative units as plotted logarithmetrically

Break for experience curve simulation

Paper Airplane Exercise Results on Linear Scale

Cost Per Airplane

Accumulative Experience (Number of Planes)

Paper Airplane Exercise Results on Log Scale

Example Using Traditional Linear Programming

Experience Curve for Price of Brokerage Services

Slope = 64% R2 = 099

CUMMULATIVE SHARES TRADED

The Perils of a Price Cut

Profit 8.1% Costs: 91.9%

Incremental Breakeven Analysis

Incremental Breakeven Analysis

Circumstances for a Price War

Source of the Experience Effect

Steps in A Typical Value-Added Chain:

The Generic Value Chain

Upstream Value Activities Economies of Scale Dominate

Margin Downstream Value Activities Economies of Scope Dominate

Accumulated Volume of production in each stage (in units)

Gillette Razor Blades

Costs Sales Profit Relationships by Stages of life Cycle

Growth Share Matrix

Mkt. Growth Rate

18% 16% 14% 12% 10% 8%

Relative Competitor Position

Industry growth Rate (2009) = Relative Industry Share = Circle Size =

Ideal Movement of Products and cash in the Portfolio

Large Negative Cash Flow

Large Positive Cash Flow Cash Cow

Modes = or Cash flow Dog

Relative Competitive Position = Cash Movement = Product movement

Four Basic Types of Unbalanced Portfolios

Using the Matrix to Guide Strategy

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