c hapter 4 cost advantage. t ata ’ s nano s trategy (o pening m inicase ) 1.what markets served 2....
TRANSCRIPT
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