CHAPTER 4

Cost Advantage

TATA’S NANO STRATEGY(OPENING MINICASE)

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

COST LEADERSHIP STRATEGY

• What is Cost Leadership?

• What benefits of Cost Leadership?

• What Cost Leadership is NOT?

OVERALL COST LEADERSHIP

• 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

VALUE-CHAIN ACTIVITIES: OVERALL COST LEADERSHIP

Exhibit 5.3 Value-Chain Activities: Examples of Overall Cost LeadershipSource: 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.

OVERALL COST LEADERSHIP (CONT.)

• 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

OVERALL COST LEADERSHIP: IMPROVING COMPETITIVE POSITION VIS-À-VIS THE FIVE

FORCES

• 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

PITFALLS OF OVERALL COST LEADERSHIP STRATEGIES

• 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

SOURCES OF COST ADVANTAGE

Economies of Scale1

Learning and Experience Effects2

Lower Costs due to Proprietary Knowledge3

Lower Input Costs4

Different Business Model5

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?

MINI-CASE

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

industry?Scale/Experience Curve

analysisMarket-share/profitability

analysis

Overview

ANALYZING COST ADVANTAGE

ECONOMIES OF SCALE

Volume of Production

Cost

per

Un

it o

f P

rod

ucti

on

Q1Low High

Dis-economies of Scale

Economies of Scale

Minimum Efficient Scale (optimal

quantity)

SpecializationSpecialization 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 CostsProduction: 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.

WHY ECONOMIES OF SCALE LOWER COSTS

0 100 200 300 400 500 600 700 800 900 10000

0.02

0.04

0.06

0.08

0.1

0.12

0.14

0.16

0.18

0.2

Coke

Pepsi

7-Up

Dr. Pepper

Sprite

Fresca

Diet Rite

Diet 7-UP Diet Pepsi

Tab

Diet Dr. Pepper

Schweppes

Annual Sales Volume (millions of cases)

Ad

vert

isin

g E

xpen

dit

ure

($

per

cas

e)

Source: Boston Consulting Group

SCALE ECONOMIES IN ADVERTISING: U.S. SOFT DRINKS

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

Avera

ge C

ost

per

Su

bscri

ber

(Con

sta

nt

Dollars

)CREDIT CARD COMPANY SCALE

CURVE

0 500000 1000000 1500000 2000000 2500000 3000000 3500000 4000000 4500000 50000000.00

10.00

20.00

30.00

40.00

50.00

60.00

f(x) = 3693.84830617876 x^-0.326139258680167

Cumulative Volume (Units)

Co

st

Pe

r U

nit

($

)

Average Slope = 0.798Average Decrease in Cost with Doubling of Volume = 20.2%

SEMICONDUCTOR EXPERIENCE CURVE

SOURCES OF COST ADVANTAGE

Economies of Scale1

Learning and Experience Effects2

Lower Costs due to Proprietary Knowledge3

Lower Input Costs4

Different Business Model5

A

BC

Industry Price

Best Fit

Line

Cost

Per

Unit

of

Outp

ut*

Cumulative Output/Experience

The Law of ExperienceVariable 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/

THE EXPERIENCE CURVE

• 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

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.

Pro

fitab

ility

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

ENSURING CAUSALITYSometimes 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

0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0%0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

Home Depot

Lowes

Ace Hardware

Tru Value Sears

Wal-Mart

Market Share in Revenues

Ne

t P

rofi

t M

arg

in

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

THE MARKET SHARE-PROFIT RELATIONSHIP: HOME

IMPROVEMENT

• 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

0 70000 140000 210000 280000 350000 420000 490000 560000$0.10

$0.15

$0.20

$0.25

$0.30

$0.35

$0.40

$0.45

$0.50

$0.55

$0.60

$0.65

$0.70

$0.75

$0.80

Tota

l O

pera

ting C

ost

Per

Room

Per

Day

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

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)

THE VALUE OF SCALE IN DELIVERING

INTERNET SERVICE TO HOTEL ROOMS

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

• 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

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

0.00% 5.00% 10.00% 15.00% 20.00% 25.00%-35.00

-30.00

-25.00

-20.00

-15.00

-10.00

-5.00

0.00

5.00

10.00

15.00

United

American

Continental

Northwest

Delta

Alaska Air

US Air

America West

JetBlue

SouthWest

Average Market share for each Airline(2002-2006)

Op

era

tin

g P

rofi

t/S

ale

s(2

00

2-2

00

6)

DISADVANTAGES OF SCALE IN AN ECONOMIC DOWNTURN

SOURCES OF COST ADVANTAGE

Economies of Scale1

Learning and Experience Effects2

Lower Costs due to Proprietary Knowledge3

Lower Input Costs4

Different Business Model5

Toyota Production System (TPS) vs. Mass Production

Some Key Principles of Toyota Production System (TPS):

1. Use a “pull” system: to avoid overproduction2. Just-in-time delivery: to reduce inventories3. Level out the workload: to smooth production4. Use visual controls: to illuminate problems and

reduce defects5. Find the bottleneck: to increase productivity

TPS is a very successful, but very difficult to imitate, production system.

LOWER COSTS DUE TO PROPRIETARY KNOWLEDGE

SOURCES OF COST ADVANTAGE

Economies of Scale1

Learning and Experience Effects2

Lower Costs due to Proprietary Knowledge3

Lower Input Costs4

Different Business Model5

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

SOURCES OF COST ADVANTAGE

Economies of Scale1

Learning and Experience Effects2

Lower Costs due to Proprietary Knowledge3

Lower Input Costs4

Different Business Model5

WHAT 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.

BUSINESS MODEL CANVASKey Partners

Key Activities

Value Propositions

CustomerRelationships

CustomerSegments

Key Resources

Channels

Cost Structure Revenue Streams

35

NINE BUILDING BLOCKS

1. Customer SegmentsAn organization serves one or several Customer Segments.

3. ChannelsValue 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

NINE BUILDING BLOCKS (CONT.)

4. Customer RelationshipsCustomer relationships

are established and

maintained with each

Customer Segment.

6. Key ResourcesKey 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

NINE BUILDING BLOCKS (CONT.)

7. Key Activities…by performing a number

of Key Activities.

9. Cost StructureThe business model

elements result in the

cost structure.

8. Key PartnershipsSome activities are

outsourced and some

resources are acquired

outside the enterprise.

38

Reconfigure the Value Chain and/or Supply Chain

Eliminate Activities/Steps in the Value Chain and/or Supply Chain

Example: Eliminate Retail Stores

i.e., Netflix and Amazon.com

DIFFERENT BUSINESS MODEL

Sources of Cost AdvantageEconomies 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