Unit 3: Discussion 1 Week 3 MBA695

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Strategic Management

Jeff Dyer

Third Edition

Chapter 4

Cost Advantage

Professor’s Goals for this Lecture

There are many types of problems that can be solved for a company by doing a cost analysis. A cost analysis can be used to solve problems as diverse as marketing (e.g., how much to spend to acquire additional customers) or HR (how much labor costs go down per unit with increases in volume). The principle tools to be learned in this chapter are designed to help the student examine the relationship between a company’s size (measured in volumes produced or market share) and cost per unit. This is primarily reinforced by teaching students how to create a scale/experience curve (both done in the same way with “cost per unit” on the “Y” axis but the scale curve uses volume for a given year on the “X” axis whereas the experience curve uses cumulative volume on the “X” axis. The students will have the opportunity to examine the relationship between scale/experience in the following assignments:

- the homework assignment involving calculating an experience curve in semiconductors

- Fry’s Credit Card Mini-case (in lecture); considers the relationship between total number of subscribers (X axis) and cost per subscriber (Y axis)

- the Southwest Case (after lecture); considers the relationship between total passengers flown (or market share) and performance (profitability) in the industry

Two Generic Strategies

Companies typically choose between one of two “generic” strategies for offering unique value to customers: cost advantage or differentiation advantage. By designing cars

to be manufactured at the lowest cost possible, and by designing a distribution system to get the cars to customers at the lowest cost possible, Tata has a cost advantage over every other carmaker in India, which allows it to sell the Nano at the lowest price.

Cost advantage

Differentiation advantage

The Cost Advantage Strategy

Cost Advantage Strategy

A firm reduces its prices below all of its competitors, thereby allowing it to gain market share.

A firm may choose the same price as competitors, which results in greater profits rather than higher market share.

Sources of Cost Advantage: Economies of Scale

Economies of Scale

Learning and Experience Effects

Lower Costs due to Proprietary Knowledge

Lower Input Costs

Different Business Model

Summary of the sources of cost advantage. If we were going to do a logic tree and what drives cost advantage, there are these five things that I would point to as one way to organize that logic tree as to why companies have cost advantage. It’s because of economies of scale, it’s because of learning and experience effects, lower cost due to prior knowledge, lower input cost or a different business model.

One of the first things to appreciate is how you solve various different kinds of problems for a company or how you help them by understanding how to do cost analysis.

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?

Additional Mini-Case

Q: Fry’s Electronic Bank does store credit cards for First Electronic Bank. After a number of years, 25 percent of Fry’s customer base have a Fry’s credit card, but growth is slow. So, should First Electronic Bank spend more money on marketing to increase penetration of the Fry’s card, should they spend money on marketing to get other store client customers to adopt the credit card provided by First Electronic Bank, and what analysis would you give FEB to determine what, if any, they should spend to get new customers?

A: as we think about this, this is sort of the cost per card or per subscriber. This is our cost per customer, per subscriber, per card, or you might even think about it as a cost per transaction. If you wanted to take it down to the individual transaction, some customers or subscribers may have more transactions than others, so you can look at how your cost per transaction is changing over time. And then you look at the total number or subscribers. So now I’ve got my total number of subscribers and then I can just start plotting years.

So, I start 1995 or whatever, and I plot the first year. What was my cost per subscriber, and what was the total number of subscribers? And to get my cost per subscriber all I have to do is take my total costs, divide it by the total number of subscribers, and I’ve got my cost per subscriber. And I can do that each year! You can usually get that data off of an annual report. That’s part of the reason why I wanted you to do that assignment for today. To get a sense for this data and actually analyze it from publicly available data.

Alright so you look, you plot your one, you plot your two, and you see what this looks like. It usually doesn’t look that plain, but let’s assume that it does. You plot the best fit line, your regression line, and then that will tell you how much our cost decreases if we double our number of subscribers. We can now do a skill curve against an experience curve. So then this now tells us how much our cost will decrease. Well let’s say I am here and I am trying to figure out whether or not to invest to grow my subscribers. Now, I’m actually, if I think I can grow my subscribers, the question is how much I can grow my subscribers, but I think I can get down here. What that means is I can now look at my cost going, dropping from this to this per subscriber, I take that across all my subscribers, and I know, that’s the value of this many more customers here because I’ve now been able to drop my cost per subscriber, I’ve added a certain number of additional subscribers, if it costs me more than that in marketing, then it probably doesn’t make sense to do it. But if it costs me less than that in marketing, then it probably makes sense for me to make the investment. And the other thing you have to realize is that the marketing expense may be a one year expense, or it may be a multiple year expense if you keep them. If it’s only a one year expense, you may want to keep the money to get the additional customers, but the nice thing is now this gets built in because you have more subscribers, and your cost per subscriber is lower for everybody.

How important is size/volume as a driver of costs (and thus profitability) in my industry?

Scale/Experience Curve analysis

Market-share/profitability analysis

Overview

Additional Mini-Case: Analyzing Cost Advantage

If we think about this case with First Electronic Bank what you’re trying to understand is how important is increased volume as the driver of my costs. The more increased volume as the driver of my costs the more I can invest, the more I should be willing to invest in order to increase my volume. Right, so then, if Frist Electronic Bank finds that if they could double their number of subscribers, and their cost dropped by 20 percent, then they now can sort of estimate here’s how much it is worth to spend on marketing to get new customers.

And the goal is just to make sure that you’re smart about your business. That you know what happens when we increase customers, how much more money are we likely to make. If we lose customers, in an economic downturn, let’s say we lose customers, how much is that going to affect our cost per customer, or our cost per unit. So that then you can hopefully make smart decisions about how to make sure…this is one of the reasons why Southwest wanted to grow slowly, and in a controlled way. Because what they learned was that when you have lots of planes and you have an economic downturn, this actually hurts your profitability, and they didn’t want to have to lay people off, they wanted to maintain this certain kind of culture, where people felt like they had stable employment, which was very unlike many of the other airlines that had lots of layoffs. And, so, these influence the choices that you make around how quickly that you grow and how much investment we make to try and get new customers.

So you’re trying to answer this question, how important is size and volume as a driver of profitability to do, to understand that you have to be able to know how to do experience curve analysis, and scale curve analysis, or a market share profitability analysis.

Economies of Scale

Economies of scale- A reduction in costs per unit due to increases in efficiency of production as the number of goods being produced increases.

Economies of scale arise from four principle sources:

Economies of scale- A reduction in costs per unit due to increases in efficiency of production as the number of goods being produced increases.

Economies of scale arise from four principle sources: the ability to spread fixed costs of production, the ability to spread nonproduction costs, specialization of equipment, and specialization of people.

Ability to Spread Fixed Costs of Production

Ability to Spread Nonproduction Costs

Specialization of Equipment

Specialization of People

Why Economies of Scale Lower Costs

Why do economies of scale lower costs, ok. Well, two main reasons. One is the ability to spread fixed costs, property, plant, and equipment, but also you have non-production costs like research and development. Once you’ve made that investment to develop that new drug, if you only sell in the United States you could only spread your R&D costs over a U.S. population, whereas you’d rather spread it across a global population. A lot of times those costs really become fixed costs. And then the second reason that your costs go down with economies of scale is specialization. So, you now can have specialized machines and equipment that are designed for a specific task instead of maybe using labor, uh, or you can have people who now specialize on how to do a particular task and they get really good at it, and it’s just the whole notion of practice makes perfect, and more people can do the same task over and over, the better they will get. And that’s why costs go down with economies of scale. We see this in a lot of different industries.

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

ProduScale is particularly valuable when investments in PPE are indivisible or “lumpy”—unavailable in small sizes.

Property, plant and equipment.

Non-Production: R&D, advertising, distribution, finance, G&A.

Economies of Scale and Scope

Scale Curve- A graphic representation of the relationship between cost per unit and scale (volume) of production in a given time period.

Minimum Efficient Scale- The smallest level of output (unit volume) that a plant or firm can produce to minimize its long run average costs. In a graphic

presentation of output/unit volume (x-axis) and cost per unit (y-axis), it is the output level where costs per unit flatten and no longer continue going down with increased output.

Diseconomies of Scale- An increase in marginal cost when output is increased.

Economies of Scope- The average total cost of production decreases as a result of increasing the number of different goods produced.

Figure 4.1: Economies of scale

Low

High

Dis-economies of

Scale

Economies of Scale

Minimum Efficient Scale (optimal quantity)

Economies of scale is taking, for given years, cost per unit of production and volume of production for a given year. And what we tend to find is that over time it drops, but at some point manufacturing plants become so large it’s so complex, that actually the costs start to go back up. They become very hard to manage. You have to draw workers from a larger and larger area, you have to pay more wages that in fact at some point you’re plant can become too big, and you’re costs will actually start to go up. The place where this curve starts to flatten out is what we often think of as the “minimum efficient scale”. So this is the minimum volume that we need to produce in order to be, pretty much, at the lowest cost possible. And that is where you typically want to produce. Is wherever you’re minimum efficient scale is or, any sort of production facility. Alright, so, you’re getting economies of scale, here is your minimum efficient scale where it’s flattening out, and that’s where you tend to want to, produce and then you can get to this economies of scale.

Cost per Unit of Production 1 3 5 7 9 11 13 15 17 19 21 100 69 49 36 28 22 19 17.5 19 22 26

Volume of Production

Cost per Unit of Production

Source: Boston Consulting Group

Example: Scale Economies in Advertising: U.S. Soft Drinks

I just wanted to note that what you can do is, you can actually do this for specific kinds of costs in a company. So you could do it for advertising, you could do it for marketing, let’s see how it works for research and development. We could pick a variety of different costs, and look at how the costs per, in this case, per case of soft drinks sold goes down as we increase the annual sales volume of cases. And what you see here with Pepsi and Coke is that, yeah, they’re spending a lot of time and money. It looks like 230 million looks like a lot of money. It is a lot of money, but when you actually look at the cost per case relative to some of the competitors, they’re actually spending less per case because of the volumes that they’re turning. So, they’re able to get that brand awareness but they’re able to get it at a relatively low cost per unit.

Schweppes 15 0.2 Diet Dr. Pepper 20 0.18 Tab 100 0.17 Diet Pepsi 150 0.15 Diet 7-UP 25 0.15 Diet Rite 40 0.13 Fresca 55 0.1 Sprite 75 0.04 Dr. Pepper 200 0.05 7-Up 400 0.09 Pepsi 500 0.03 Coke 950 0.04

Annual Sales Volume (millions of cases)

Advertising Expenditure ($ per case)

75.5 % Scale Curve

y = 32534x

-0.4052

$5.00

$10.00

$15.00

$20.00

$25.00

$30.00

$35.00

30,000,000

35,000,000

40,000,000

45,000,000

50,000,000

55,000,000

Number of Subscribers

Average Cost per Subscriber

(Constant Dollars)

Example: Credit Card Company Scale Curve

This is an example of a credit card company scale curve, so what you see on this one, I’m going to show this on another one, with the Intel case. What you often actually see is a rolling pattern with the scale or experience curves. Why do you think that happens?

(also evident in next slide and similar to Intel case)

At some point along the way, you usually have to make some larger fixed costs investments to service, to serve that next group of customers. It’s often related to plant equipment that are needed for production, so you see it more in manufacturing industries than other industries. But, not necessarily, maybe there’s just a big marketing push, that needs to occur every once in a while to pull in more customers. Or maybe you invest more in R&D for certain periods.

Sources of Cost Advantage: Learning and Experience Effects

Economies of Scale

Learning and Experience Effects

Lower Costs due to Proprietary Knowledge

Lower Input Costs

Different Business Model

One of the first things to appreciate is how you solve various different kinds of problems for a company or how you help them by understanding how to do cost analysis.

Learning and Experience

Cost Advantage Strategy- A strategy in which the unique value offered to customers is lower-priced products or services.

Learning Curve- The concept that labor costs per unit decrease with increases in volume due to learning. New skills or knowledge can be quickly acquired initially,

but subsequent learning becomes much slower.

Experience Curve- A representation of the relationship between cumulative volume and product cost.

Figure 4.3: Semiconductor Experience Curve

SEMICONDUCTOR INDUSTRY

y = 3693.8x-0.3261

438736.47930000001 885648.17249999847 1226790.7649759999 1551455.759658 1855493.7813132 2196025.9578180001 2529945.2946347999 2867843.2355495999 3258643.8939684001 3625256.8195284 3975955.3286963999 4294788.6707963999 4580223.539 0435997 50 44.160231660231617 38.030888030888043 31.901544401544399 32.818532818532809 34.507722007722002 33.928571428571431 32.239382239382238 31.177606177606179 27.075289575289581 26.496138996138999 20.945945945945919 22.007722007722009

Cumulative Volume (Units)

Cost Per Unit ($)

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

The Experience Curve

So when you think about an experience curve, the general notion is that companies are out selling similar kinds of products, and there’s an industry price, and if they’re producing the product in a similar way, they’re all coming down an experience curve, and you’ve got curves A, B, and C, and we would expect that over time C is probably going to be the most profitable company because they have the lowest cost per unit. And the law of experience means that the variable and average, or variable plus fixed cost per unit declined by a constant percentage, typically somewhere between 15 and 30 percent each time doubles. That’s what you would expect to have happen in most industries.

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

Why the Experience Curve Works

Why does it work? Well you get decreasing variable cost per unit because of things like bargaining power as you get bigger. But you also get increased learning, human learning in regards to increased dexterity and improved coordination of work tasks. You have design and process improvements that you get, and you also get decreased fixed cost per unit because you can spread those fixed costs

Design and Process Technology Learning (Effectiveness)

Mechanization and automation

Efficient utilization of materials

Designs to economize on materials

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

The Importance of Relative Market Share

The other way you can think about looking at the value volume or market share you can do what I have described as this sort of market share profitability. So we expect that relative market share to be a proxy for experience or for volume. The more market share we have, the more volume we have. So we may not be able to do a cost per unit, but we would typically expect there to be a relationship so that profitability is going to go up as experience, or relative cumulative experience or market share goes up. However, market share is not always the cause of high profitability. So, I think we talked about that like the second or third day. It could be for example that Toyota has emerged over the last 20 to 30 years as the leader of automobiles, not because of market share profitability, but because quality drove both market share and profitability at the same time. Sometimes there’s a third variable, something that isn’t on this chart that could be driving both. So just be aware of that. But at least it gives you a sense of whether not being big is likely to be an important factor for success in an industry. That’s why I wanted to have you do it for the airline industry, because once you do that graphic you realize, “Oh, okay. Being big isn’t critical for being successful.” That’s helpful to know. Yes?

Ensuring Causality

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

Note: Market share figures are for 2004; profit figures are avg. of 2000-2005

Figure 4.4: The Market Share-Profit Relationship: Home Improvement

So let me give you an example. This is actually from the home improvement, we think about the home improvement in retailing. We’ve got Home Depot, Lowe’s, and this is an estimate for Walmart, that was based upon some data, but we don’t know for sure how costs are allocated at Walmart, so this could be quite a bit higher… and then you’ve got Sears, True Value, and Ace. And clearly what you see here, so just that if you’re going to succeed in home improvement, you’re better off if you’re Home Depot or Lowe’s, that you’re a big player. Although, you can see that Home Depot is a lot bigger at the time, but not a lot more profitable. But at least, if you do this kind of chart, it gives you a sense of whether or not being big really makes a difference to success and to a particular industry.

This is net profit margin which is a percentage of sales. So the way you typically do these as a percentage of sales, the best measure is operating income divided by your revenues because that’s what you’re generating. Your operating income is the profit you’re getting from your operations, and you’re dividing that by your revenue. And then sometimes you’ll have funny things with financing and your taxation stuff that comes to your net income.

So, typically in strategy we like to look at operating income divided by revenues as the profit of measurability. So you’re always going to see this as a percentage basis over here. Because it’s right, Walmart because of lower prices may only make one percent on margins but when you divide that by the assets they have employed or the remnants that are really that much more profitable than their competition. You typically prefer to do a return on assets.

Wal-Mart

0.04 3.2000000000000001E-2 Sears

3.7999999999999999E-2 1.4E-2 Tru Value

Tru Value

8.0000000000000002E-3 1.0999999999999999E-2 Ace Hardware

0.01 1E-3 Lowes

8.5000000000000006E-2 6.0999999999999999E-2 Home Depot

0.17 6.8000000000000005E-2

Market Share in Revenues

Net Profit Margin

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

Strategic Implications of the Scale/Experience Curve

So what do we learn from this? There are some strategic implications for managing business from doing this kind of analysis, experience curve and scale curve analysis. Number one, it helps you put growth in investment strategy.

The slogan or the saying to be number one or number two in your industry which came from General Electric years ago. Jack Welch said, “Well, we’re just going to be number one or number two, or we’re just not going to be in there.” It comes from GE competing in a lot of businesses that have some experience curves. Because if you are not number one or number two in a steep experience curve business, you are not going to make much money. You’re not a leader in micro processers, you’re not going to make a lot of money. Now, that’s not true in airlines. But in micro processers, it’s true. In GE, in the engine business, it’s true, in their appliance business, it’s true, in their lighting business, it’s true. So in the businesses that they were in with relatively steep experience curves, it’s like, “It’s a steep experience curve, you better get big fast, or get out.” That’s sort of the implication.

Number 2: It also helps you with pricing strategy. If you know how fast cost comes down as units increase, you can now price for future profits because you can say, “Oh, well we can price maybe even at our cost today because we know that if we price at our cost then we drive more volume then our cost will be 20 percent lower than this.” Let’s say if we can double our volume over the next year or whatever time frame. You may not choose to do that, but at least if you understand how your costs are going down then you can using it for pricing contract or just use it for pricing decisions in the marketplace.

Three: it can also help you with benchmarking or cost analysis. So, scale curves can be plotted for your company, you could plot it for a competitor, and then you can say, “Are we doing a good job in terms of our managing costs, or are we doing a bad job?” When you look at the auto industry, General Motors for example, we had all the car companies going through bankruptcy, you know, three, four, five years ago, well what happened is GM had high market share but they didn’t have high profits. Their costs were high, and a lot of it had to do with their union labor, the fact that they had very high medical costs and pensions, and they had spent a lot of money on plant equipment over the past. And they weren’t able to keep the volumes going because people weren’t buying cars as much as they needed them to. And so they ended up needing to restructure and pulling back their volumes, their total volumes, because they simply weren’t able to sell them in the marketplace. They just had too much plant equipment and too many workers and the benchmarking analysis can help you figure that out.

The last thing that can help you out with is acquisition strategy. So, you’ve all heard about synergies right? You acquire a company, and there are going to be synergies. Who can tell me what is a synergy? Yes?

It’s this notion that 1+1=3. That’s a synergy. But where does that actually come from? How do you get it?

There may be synergy on the marketing side perhaps with sort of cross-selling customers. There can also be synergies on the cost side. Like, “Well, we don’t need two customer service areas, we can cut one of them back by 50 percent” let’s say, or, “We don’t need as many plants we can actually close one of the plants because now we have, um, sort of redundancy.” So it eliminates some of the redundancies.

Guest-Tek costs fall by an average of 29 percent with every doubling of room count1

Acquisition of Golden-Tree (200K rooms)

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)

Figure 4.5: The Value of Scale in Delivering Internet Service to Hotel Rooms

Let me give you an example. So here we have total operating room costs per room per day is the cost per unit in the Internet service provider business. So we’ve got, Guess Tech which is coming down this experience curve, this is their data right here, then they acquire Golden Tree which has 200 thousand rooms. So they jump from here out to here. Now the question is, is there any way they can predict what their costs will be after the acquisition? And the answer is, yeah. If you look at an experience curve and you calculate how much your costs are coming down per unit, and then you say, “Okay, now if we jump from here to here, how much will our costs come down?” Then when we do an acquisition we can estimate what the synergies will come on the cost side per unit by putting our two operations together. Of course what you tend to find because of the integration costs, you tend to find you usually are going to have, you’ll actually see, you’ll usually see a bump then this sort of goes sort of flat, but usually you’ll see it’s going to jump up for a while before it goes back down because now you’re trying to figure out how to put these together, and there’s often costs associated with integration.

Guest-Tek 520201 492913 472809 435000 390000 205000 205000 196650 202618 194643 166190 190546 141788 187819 124263 107000 83900 171204 176227 180440 183514 0.22 0.26 0.22 0.23 0.3 0.34 0.4 0.42 0.43 0.5 0.61

Total Operating Cost Per Room Per Day

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.”

Guest-tek Result

What we actually saw from Guess Tech when they acquired Golden Tree is that because they were able to bring, because they were in the same business they were direct competitors, one benefit from acquiring a direct competitor is now you don’t have to compete with them. So now there is less pressure on the pricing side, but also now you get to, to bring your costs together, and you can eliminate redundancies in the costs and hopefully it still allows you to keep going on the experience curve, and that’s why Guess Tech were able to have record profits after that acquisition and after they integrated it.

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).

Limitations of the Experience Curve

I want to highlight some limitations of the experience curve. Market share does not guarantee substantial cost advantages because there’s this question, “What’s the cost of market share? What are we going to have to spend to get it?” And the learning curve flattens with high experience. So the next thing is spillovers of knowledge to rivals to lower their costs of learning and aging equipment can also impede and you can continue to get lower cost reduction. Sometimes your equipment can become obsolete, and a new entrant can come in with newer, more advanced equipment and lower their costs.

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

Disadvantages of Scale

There are disadvantages of scale when you get a downturn. Now you’ve got a lot of fixed assets that you can’t spread across as many customers. So firms with heavy fixed assets can respond to this by one, you try and shift more of your cost structure from a fixed cost to a variable cost. That means there’s less leverage, so it’s less good in an upturn, but it’s better in a downturn. A variable cost means let’s outsource it to another company. That way if our costs go down, we just don’t buy as much. Whereas if we have our own plant and equipment and labor, and our volumes go down, we still have to pay for that regardless. So that’s what I mean by shifting it to variable cost.

Another way is to try and be in different kinds of businesses that might have different cyclicality. And that’s one of the benefits to General Electric because they’re in a lot of different businesses. Some, like lighting goes with the economy, and financial services sort of goes with the economy. Medical equipment, people sort of need medical equipment in good and bad times, when you have those sort of businesses in your portfolio it helps smooth the ups and the downs, so you’re much more predictable and that moves your cost to capital.

Example: Disadvantages of Scale in an Economic Downturn

We saw this in the airline industry, as you may recall, that from the 2002 to 2006 time period if you were bigger, if you had greater market share or more airline seat miles flown, you actually were less profitable during that downturn time period.

SouthWest

7.2217647943753099E-2 8.6 JetBlue

1.40159447744566E-2 12.512 America West

2.8701807418892299E-2 -4.8679999999999897 US Air

7.6419935875753395E-2 -9.4880000000000013 Alaska Air

2.3511226388342601E-2 -4.2120000000000006 Delta

0.15828444864784999 -20.423999999999999 Northwest

0.11425238801012901 -11.006 Continental

0.100742667589807 -3.7180000000000009 American

0.19961459588611499 -16.97 United

0.167044188825579 -28.771999999999991

Average Market share for each Airline

(2002-2006)

Operating Profit/Sales

(2002-2006)

Sources of Cost Advantage: Lower Costs due to Proprietary Knowledge

Economies of Scale

Learning and Experience Effects

Lower Costs due to Proprietary Knowledge

Lower Input Costs

Different Business Model

One of the first things to appreciate is how you solve various different kinds of problems for a company or how you help them by understanding how to do cost analysis.

Proprietary Knowledge

Proprietary Knowledge- Information that is not public and that is viewed as the property of the holder.

Some Key Principles of TPS:

Use a “pull” system: to avoid overproduction

Just-in-time delivery: to reduce inventories

Level out the workload: to smooth production

Use visual controls: to illuminate problems and reduce defects

Find the bottleneck: to increase productivity

TPS is a very successful, but very difficult to imitate,

production system.

Lower Costs Due to Proprietary Knowledge

Another way to have low costs is that you develop some proprietary knowledge about how to produce a product or a service that others just can’t figure out very easily. We mentioned this last time with Southwest, and I showed you that graph about the Toyota production system. And they just have a variety of key principles, and it’s been really successful over time because it’s really hard to imitate. It’s hard for somebody to understand how the whole thing works and be able to put it together and make it work, and make it work with your suppliers as well. So the more you can learn something that’s valuable and keep it proprietary, the better off you are. So you don’t want others to know how you do it.

Sources of Cost Advantage: Lower Input Costs

Economies of Scale

Learning and Experience Effects

Lower Costs due to Proprietary Knowledge

Lower Input Costs

Different Business Model

One of the first things to appreciate is how you solve various different kinds of problems for a company or how you help them by understanding how to do cost analysis.

Lower Input Costs

Inputs- Resources such as people, raw materials, energy, information, or financing that are put into a system to obtain a desired output.

There are four primary ways that companies achieve cost advantage through lower-cost inputs:

Exercising Strong Bargaining Power Over Suppliers

Cooperating Especially Well With Suppliers

Getting Inputs From Low-Cost Locations

Arranging Better Access to Inputs than Other Companies Have

Walmart: Greater bargaining power over suppliers

Honda: Superior cooperation with suppliers

(including lower transaction costs)

Nike: Sourcing from low cost locations

(e.g., country comparative advantage)

De Beers: Preferred access to inputs

(e.g., DeBeers owns diamond mines)

Lower Input Costs

If we think about why we get lower input costs, there tend to be three or four main reasons. Number one is it’s a bargaining story. It’s a volume story. Volume really does matter. Or it could be not a volume story if you look at, for example, Toyota’s costs of their inputs from suppliers or Honda’s, they have historically been lower than those at GM or Ford even though GM and Ford were bigger, and they really had more bargaining power over their suppliers. But it was because of the way they worked with their suppliers in a cooperative fashion that they figured out ways that they could mutually lower costs together. So I think I mentioned a supplier that built the conveyor belt, they took the seats from their plant into the Toyota plant. Well that really saves a lot of costs in terms of inventory instead of building your seats 500 miles away, putting them in a truck and shipping them there. That’s one way that you lower costs through better cooperation. And then, you could just be sourcing from low cost locations. We’ll do a Nike case in not too long where we will look at how, their sourcing strategy has been an important part of their success by being the first to really aggressively source their shoes in Asia, and, try and get the lowest cost of labor possible. And then finally, you might have lower costs because you just have preferred access to those inputs, and that’s what De Beers does by owning the diamond mines, as they find raw materials, the diamond mines as they buy them that they own them and then get them at a lower cost.

Sources of Cost Advantage: Different Business Model

Economies of Scale

Learning and Experience Effects

Lower Costs due to Proprietary Knowledge

Lower Input Costs

Different Business Model

One of the first things to appreciate is how you solve various different kinds of problems for a company or how you help them by understanding how to do cost analysis.

Business Model and Value Chain

Business Model- The plan and set of activities implemented by a company to offer unique value and generate revenue and make a profit from operations.

Value Chain- The sequence of all activities that are performed by a firm to turn raw materials into the finished product that is sold to a buyer.

Different Business Model

Finally, different business models. But it could be reconfiguring the value chain, it’s often to reconfigure or eliminate steps in the value chain, in some cases it might be to eliminate stores. So if we think about Amazon versus Barnes & Noble and Borders in the way they have been successful in books, it was really a very different business model, selling over the internet as opposed to in stores. And Dell for years didn’t sell through stores either, it was all ordered and customized, delivered to your doorstep.

Reconfigure the Value Chain

Eliminate Activities/Steps in the Value Chain

Example: Eliminate Retail Stores

i.e., Netflix and Amazon.com

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

Now you have this high level summary of different ways that a company can generate cost advantage. It can come from a variety of different sources, sometimes it is from scale and experience, but sometimes it’s from lower cost inputs or proprietary knowledge of how to do something. The key is of course, once you have figured out a way to do something as you’re trying to figure out, “How do we make sure others can’t figure out how to do it like we do,” Because ultimately you’re trying to create barriers.

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