COST DYNAMICS

LEARNING / EXPERIENCE EFFECTS

& SCALE EFFECTS

LOWERS COSTS

INCREASES MARKET SHARE

BETTER R.O.I & E.V.A

P.I.M.S (profit impact of market share) FINDING:

10 % DIFFERENCE IN MARKET SHARE BETWEEN COMPETITORS

5 % DIFFERENCE IN PRE TAX R.O.I

COST DYNAMICS

ECONOMIES OF SCALE – SOURCES

The advantages of large scale production that result in lower unit (average) costs (cost per unit)
Economies of scale – spreads total costs over a greater range of output

It can enable reduction in costs via the following:

1. Larger plants cost less to build :

Larger the plant, greater will be the production, cost will spread over more number of units and therefore
this reduces the overall cost and leads to economies of scale

• For e.g. a 90-m t refinery costs only 1.5 times as much as a 45-m t refinery, thus reducing the cost per unit of capacity
by 25%.

• This also reduces depreciation per unit of output.

2. Larger plants have lower operating cost per unit of output:

• This is because workers required are less (due to mechanization).

• Many efficiency enhancing features can be added to the plant, which would be uneconomical for smaller scale firms
(Say processing of waste to be sold).

3. Scale effects reduce marketing, administration, R&D and service costs:

• As clerical work is more, greater automation is possible which reduces administrative costs

• Automation of large ware houses can reduce marketing costs.

• A chain store with 30 outlets in a city needs much less than 3 times advertising expense vis-à-vis a chain store with 10
stores.

(All of the above are value added cost elements i.e. costs of operations provided by the business for itself)

4. Scale effects are also achievable for purchased items:

• E.g. volume discounts, discount for shipping, etc.

5. Scale effects arise from utilizing fully the fixed cost resources:

• E.g. full utilization of plant capacity, sales force, and service force.

Thus we see that large size provides an opportunity for scale economies; to achieve them requires appropriate
strategies and action

EXPERIENCE EFFECT

It has been found that for certain standardized products, the total unit cost of the product reduced by a consistent percentage
every time the volume is doubled. This is measurable and predictable.

80% Experience Curve

Accumulated experience Cost/ unit Rs.

2 100
4 [100 x .80] 80
8 [ 80 x .80] 64
16 [ 64 x .80] 51
32 [ 51 x .80] 41
64 [ 41 x .80] 33
 Experience Curve Formula

-b
q
Cq = Cn ___
n

Where:
Q = the experience (cumulative production) to date

n = the experience (cumulative production) at an earlier date

Cq = the cost of unit ‘q’ (adjusted for inflation)

Cn = the cost of unit ‘n’ (adjusted for inflation)

b = a constant that depends on the learning rate

SOURCES
1. Labour efficiency:

• Both direct labour and others like supervisory staff / managers / persons employed in all functional areas.

2. Work specialization and methods improvements:

• Especially due to enlarged operations.

3. New production processes:

• Firms improve production technology by devoting a large percentage of its R&D investments to process improvements.

• E.g. Semi-conductor industry, refineries, steel mills, etc. have achieved experience curve of about 80% via
improvements.

4. Better performance from production equipment:

• When first designed, a piece of production equipment may have a conservatively rated output. Experience may reveal
innovative ways of increasing its output.

5. Changes in the resource mix:

• Less expensive resources may be used without affecting quality.

• Less skilled workers may replace skilled ones alternatively automation can replace labour.

6. Product standardization: E.g. Ford Motors Ltd.

7. Product re-designs:

• Through experience both manufacturers and customers gain a clearer understanding of performance requirements and
this understanding allows the product to be redesigned to:

• Conserve materials

• Allow greater efficiency in manufacturing

• Substitute less costly materials and resources.

• E.g. New designs and substitution of plastic material.

• E.g. Less combustible seats in cars and air crafts.

• E.g. Car bumpers from metal to molded plastics.

 Economies of scale, learning curve effect and the experience curve effect provide opportunities that alert management
can exploit.

 Left unmanaged, costs rise.

 It is important that the work force is of high quality and stable.

 The compensation plan of the firm and employee relations’ policies can also have an important influence on its
experience curve.

Cost – Price Phase

‘Y’ axis: Log industry price and cost per unit

Develop- Price Umbrella Shake-out Stability

ment
 ‘X’ axis: Log cumulative industry production (units)

STRATEGIC IMPLICATIONS

‘Y’ axis: Price per unit

Industry price
Company
cost

C
C’s loss Current price

B
A

A’s profit margin

‘X’ axis: Experience (accumulated volume)

 In an industry where total cost can be reduced due to scale or experience, pursuing a strategy geared to accumulating
experience faster than competitors can have important cost advantage.

 A lot depends on the market growth rate.

 Therefore it is clear that being a leader facilitates cost reduction and enables becoming a cost leader vis-à-vis being a
distant follower.

 However, as a firm cannot lead in all markets, it must decide which market to lead, in which to hold a viable non-
leadership position and which to abandon.
Thus we can see that economies of scale, the learning curve effect & the experience curve effect can help a firm to bring
down its costs & can even lead to a position of cost leadership.