Strategic Management
Jeff Dyer
Third Edition
Chapter 4
Cost Advantage
Two Generic Strategies
Cost
advantage Differentiation
advantage
Copyright ©2020 John Wiley & Sons, Inc. 2
The Cost Advantage Strategy
A firm reduces its prices below all of its competitors,
thereby allowing it to gain market share.
Cost Advantage
Strategy
A firm may choose the same price as competitors, which
results in greater profits rather than higher market share.
Copyright ©2020 John Wiley & Sons, Inc. 3
Sources of Cost Advantage: Economies
of Scale
1 Economies of Scale
2 Learning and Experience Effects
3 Lower Costs due to Proprietary Knowledge
4 Lower Input Costs
5 Different Business Model
Copyright ©2020 John Wiley & Sons, Inc. 4
Additional Mini-Case
ü First electronic bank (FEB) provides a store credit card to
Frys electronics.
ü 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?
Copyright ©2020 John Wiley & Sons, Inc. 5
Additional Mini-Case:
Analyzing Cost Advantage
Overview
How important is size/volume as a driver of costs (and
thus profitability) in my industry?
Scale/Experience Curve analysis Market-share/profitability analysis
Copyright ©2020 John Wiley & Sons, Inc. 6
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:
Ability to Spread Ability to Spread
Fixed Costs of Nonproduction
Production Costs
Specialization of Specialization of
Equipment People
Copyright ©2020 John Wiley & Sons, Inc. 7
Why Economies of Scale Lower Costs
Ability to Spread Fixed Costs
ProduScale is particularly valuable when Non-Production: R&D,
investments in PPE are indivisible or advertising, distribution, finance,
“lumpy”—unavailable in small sizes.
Property, plant and equipment. G&A.
Specialization
Specialization of machines and equipment. Specialization of tasks and people.
• A firm with high volumes is able to purchase • Small firms do not have the volume to create
and use specialized equipment or tools that high levels of employee specialization.
small firms simply cannot afford. • When do hire specialized may not be enough
work to keep them busy
Copyright ©2020 John Wiley & Sons, Inc. 8
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.
Copyright ©2020 John Wiley & Sons, Inc. 9
Figure 4.1: Economies of scale
Cost per Unit of Production
Economies of Scale
Minimum Efficient Scale Dis-economies of
(optimal quantity) Scale
Low 1 Q High
Volume of Production
Copyright ©2020 John Wiley & Sons, Inc. 10
Example: Scale Economies in Advertising: U.S. Soft Drinks
0.2 Schweppes
0.18 Diet Dr. Pepper
Tab
0.16
Diet 7-UP Diet Pepsi
0.14
Advertising Expenditure ($ per case)
Diet Rite
0.12
0.1 Fresca
7-Up
0.08
0.06
Dr. Pepper
0.04 Sprite Coke
Pepsi
0.02
0
0 100 200 300 400 500 600 700 800 900 1000
Annual Sales Volume (millions of cases)
Source: Boston Consulting Group
Copyright ©2020 John Wiley & Sons, Inc. 11
Example: Credit Card Company Scale Curve
$35.00
$30.00
Average Cost per Subscriber
$25.00
75.5 % Scale Curve
(Constant Dollars)
$20.00
-0.4052
y = 32534x
$15.00
$10.00
$5.00
$-
30,000,000 35,000,000 40,000,000 45,000,000 50,000,000 55,000,000
Number of Subscribers
Copyright ©2020 John Wiley & Sons, Inc. 12
Sources of Cost Advantage: Learning and
Experience Effects
1 Economies of Scale
2 Learning and Experience Effects
3 Lower Costs due to Proprietary Knowledge
4 Lower Input Costs
5 Different Business Model
Copyright ©2020 John Wiley & Sons, Inc. 13
Learning and Experience
Cost Advantage Strategy- A strategy in which the unique value offered
to customers is lower-priced products or services.
Learning Curve- The concept that labor costs per unit decrease with
increases in volume due to learning. New skills or knowledge can be
quickly acquired initially,
but subsequent learning becomes much slower.
Experience Curve- A representation of the relationship between
cumulative volume and product cost.
Copyright ©2020 John Wiley & Sons, Inc. 14
Figure 4.3: Semiconductor Experience Curve
60.00
50.00
Cost Per Unit ($)
40.00
30.00
Average Slope = 0.798
20.00 Average Decrease in Cost with
Doubling of Volume = 20.2%
10.00
y = 3693.8x-0.3261
0.00 Cumulative Volume (Units)
0 500000 1000000 1500000 2000000 2500000 3000000 3500000 4000000 4500000 5000000
Copyright ©2020 John Wiley & Sons, Inc. 15
The Experience Curve
Cost Per Unit of Output*
Industry
Price
A
B
C
Best Fit
Cumulative Output/Experience Line
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
Copyright ©2020 John Wiley & Sons, Inc. 16
Why the Experience Curve Works
• 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
Copyright ©2020 John Wiley & Sons, Inc. 17
The Importance of Relative Market Share
ü 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
ü There will be a relationship between market share and profitability in industries where
experience/volume drives lower costs per unit of experience.
te n d to
e t share me
k
mar size/volu
Profitability
h e r
w ith hig ability if
p an ies p rofit tab ility
Com e highe r p rofi
e s
hav driv
Relative Cumulative Experience (Market Share)
But Market Share is not always the cause of high profitability 18
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 leader
Profitability
10% 15% 20% 25%
Quality Market Share
Copyright ©2020 John Wiley & Sons, Inc. 19
Figure 4.4: The Market Share-Profit Relationship:
Home Improvement
8.0%
7.0%
Home Depot
6.0% Lowes
5.0%
Net Profit Margin
4.0%
3.0%
Wal-Mart
2.0%
Tru Value Sears
1.0%
Ace Hardware
0.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0%
Market Share in Revenues
20
Note: Market share figures are for 2004; profit figures are avg. of 2000-2005
Strategic Implications of the Scale/Experience
Curve
• First movers in a fast growing market will secure a widening cost
Growth/Investment advantage. Firm’s must grow as fast, or faster, than rivals or be at a
Strategy cost disadvantage. This is behind the “be #1 or #2 or exit” philosophy.
• As a basis for market share based pricing strategy
Pricing Strategy • As a basis for planning future prices
• As a basis for pricing a production run or contract
• Scale/X-curves can be plotted for a company and its competitors to
Benchmarking/Cost assess how well each company is managing its costs. Companies that
Analysis fall above the regression line may not be managing costs well.
• Scale/X-curves provide data on how much costs will likely decrease
Acquisition Strategy (cost synergies) if two firms combine their volume/scale.
Copyright ©2020 John Wiley & Sons, Inc. 21
Figure 4.5: The Value of Scale in Delivering Internet Service to Hotel
Rooms
$0.80
$0.75
Total Operating Cost Per Room Per Day
$0.70
$0.65
$0.60 Guest-Tek costs fall
$0.55 by an average of
$0.50 29 percent with
$0.45 every doubling of
$0.40 room count1
$0.35
$0.30
$0.25
$0.20 Acquisition of
$0.15
Golden-Tree (200K
rooms)
$0.10
0 70000 140000 210000 280000 350000 420000 490000 560000
Number of Rooms (Installed Base)
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.
Copyright ©2020 John Wiley & Sons, Inc. 22
Guest-tek Result
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.”
Copyright ©2020 John Wiley & Sons, Inc. 23
Limitations of the Experience Curve
• 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).
Copyright ©2020 John Wiley & Sons, Inc. 24
Disadvantages of Scale
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., Diversifying into businesses that are
outsourcing to make costs more variable; countercyclical
using labor instead of capital).
Copyright ©2020 John Wiley & Sons, Inc. 25
Example: Disadvantages of Scale in an Economic
Downturn
15.00
JetBlue
10.00
SouthWest
5.00
Operating Profit/Sales
0.00 Alaska Air
Continental
(2002-2006)
-5.00 America West
-10.00 US Air Northwest
-15.00
American
-20.00 Delta
-25.00
-30.00 United
-35.00
0.00% 5.00% 10.00% 15.00% 20.00% 25.00%
Average Market share for each Airline
(2002-2006)
Copyright ©2020 John Wiley & Sons, Inc. 26
Sources of Cost Advantage: Lower Costs
due to Proprietary Knowledge
1 Economies of Scale
2 Learning and Experience Effects
3 Lower Costs due to Proprietary Knowledge
4 Lower Input Costs
5 Different Business Model
Copyright ©2020 John Wiley & Sons, Inc. 27
Proprietary Knowledge
Proprietary Knowledge- Information that is
not public and that is viewed as the property of
the holder.
Copyright ©2020 John Wiley & Sons, Inc. 28
Lower Costs Due to Proprietary Knowledge
Some Key Principles of TPS:
1. Use a “pull” system: to avoid overproduction
2. Just-in-time delivery: to reduce inventories
3. Level out the workload: to smooth production
4. Use visual controls: to illuminate problems and
reduce defects
5. Find the bottleneck: to increase productivity
TPS is a very successful, but very difficult to imitate,
production system.
Copyright ©2020 John Wiley & Sons, Inc. 29
Sources of Cost Advantage: Lower Input
Costs
1 Economies of Scale
2 Learning and Experience Effects
3 Lower Costs due to Proprietary Knowledge
4 Lower Input Costs
5 Different Business Model
Copyright ©2020 John Wiley & Sons, Inc. 30
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 Cooperating
Bargaining Power Especially Well
Over Suppliers With Suppliers
Arranging Better
Getting Inputs
Access to Inputs
From Low-Cost
than Other
Locations
Companies Have
Copyright ©2020 John Wiley & Sons, Inc. 31
Lower Input Costs
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)
Copyright ©2020 John Wiley & Sons, Inc. 32
Sources of Cost Advantage: Different
Business Model
1 Economies of Scale
2 Learning and Experience Effects
3 Lower Costs due to Proprietary Knowledge
4 Lower Input Costs
5 Different Business Model
Copyright ©2020 John Wiley & Sons, Inc. 33
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.
Copyright ©2020 John Wiley & Sons, Inc. 34
Different Business Model
Reconfigure the Value Chain
Eliminate Activities/Steps in the Value
Chain
Example: Eliminate Retail Stores
i.e., Netflix and Amazon.com
Copyright ©2020 John Wiley & Sons, Inc. 35
Sources of Cost Advantage
Economies of Greater unit volume allows firms to have
lower costs by spreading fixed costs across
Scale more units.
Walmart
Greater cumulative volume drives cost
Learning and differences due to greater learning and
Experience experience within companies with more intel
Effects cumulative experience in production.
Proprietary Cost advantage from developing
Knowledge proprietary knowledge in the production Toyota
of their product or service
Lower Input Some companies may have lower input
Costs costs than others due to bargaining Nike
power, superior cooperation, low cost
locations.
Eliminating steps in the value chain or
Different using a different activity set may offer Netflix
Business Model lower costs
Copyright ©2020 John Wiley & Sons, Inc. 36
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responsibility for errors, omissions, or damages, caused by the use of these programs or
from the use of the information contained herein.
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