Description
In microeconomics, economies of scale are the cost advantages that enterprises obtain due to size, with cost per unit of output generally decreasing with increasing scale as fixed costs are spread out over more units of output. Often operational efficiency is also greater with increasing scale, leading to lower variable cost as well.
Cost Advantage
Chapter 3
Objectives
• To study the framework for analysing the behaviour of cost • To study the determinants of cost position • To study the ways firm can gain sustainable cost advantage or minimise their cost disadvantage
Framework for analysing the behaviour of cost
• The behaviour of a firm’s cost can be understood by studying its value chain • Each value activity has its own cost structure and the cost’s behaviour is determined by interrelationship and linkages with other activities inside/outside the firm
Value chain for cost analysis
• Operating costs and assets (fixed and working capital) are to be assigned to each value activity • Amount of assets and efficiency of its utilisation will determine the activity’s cost • Value chain is split into individual activities in order to study its impact on cost. Three factor are to be taken into consideration 1. Size and growth of cost represented by activity 2. Cost behaviour of activity 3. Competitor differences in performing the activity
Assigning costs and assets
• Operating Costs are to be assigned to the activities that incur them • Assets are to be assigned to activities that employ, control and utilise them the most
Study of the determinants of cost position
• A firms cost position results from the cost behaviour of its value activities • Cost behaviour depends on a number of structural factors that influence cost – which are known as “Cost drivers” • A firms cost position depends upon its cost drivers
Cost Drivers
• 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. There are ten major cost drivers Economies of scale Learning Pattern of capacity utilisation Linkages Interrelationships Integration Timing Discretionary policies Location Institutional factors
Economies of scale
• It states that an activity operating at full capacity is more efficient at larger scale • It arises from the ability to perform activities differently and more efficiently at larger volume • Measure of scale is also very important in order to manage costs • For some value activities, global scale of operations is important, for others national scale is fine and for some other value activities even regional scale is good
Learning and Spillovers
• Learning is the accumulation of many small improvements rather than a major breakthrough • The cost of a value activity can decline over time due to learning that increases its efficiency • Learning can spill over from one firm in an industry to another through mechanisms such as suppliers, consultants, ex-employees and reverse engineering of products • Sustainable cost advantage is always due to proprietary learning, so if spillover happens it needs to be seen whether it creates cost advantage for a single firm or reduces cost for the entire industry • Learning and scale of operations is also correlated since high scale make learning accumulate rapidly.
Pattern of Capacity Utilisation
• If high fixed cost is linked to a value activity, its cost is affected by capacity utilisation, since high fixed cost is a penalty in case of underutilisation • Capacity utilisation can also be a function of seasonal, cyclical and other demand or supply fluctuations unrelated to competitive position, so pattern of capacity utilisation for an entire cycle is the cost driver • Changes in level of capacity utilisation will involve cost of expanding or contracting and thus affect cost behaviour.
Linkages
• Linkages indicate relationships between two value activities in terms of how the performance of one affect the cost and performance of the other • Linkages are of two types 1. Linkages within the value chain 2. Vertical linkages with value chain of suppliers and channels
Interrelationships
• Interrelationships with other firms help reduce costs • Sharing a value activity with a sister concern is a form of interrelationship • It can be of two types: Tangible and Intangible • Tangible interrelationships occur in case of sharing of physical resources • Intangible interrelationships occur in case of sharing knowhow between separate but similar value activities • Sharing can also increase scale of operations and affect learning as well
Integration
• The level of vertical integration in a value activity may influence its costs • One needs to study whether integrating all functions within the organisation lowers the cost in comparision to dis-integrating them (outsourcing them).
Timing
• Being a first mover has its own pros and cons • Similarly being a late mover advantage has it own advantages and disadvantages
Discretionary policies independent of other drivers
• It refers to the policy choices a firm makes and the resulting impact on its cost position • Some policy choices that affect cost behaviour are product performance, level of service, delivery time, channels employed, raw material used etc.
Location
• Geographical location of a value activity can affect its cost • Cost of location is affected by cost of labour, management, raw material, energy and other factors like taxes and wage rates
Institutional factors
• It includes government regulations, tax holidays, tariffs, government subsidy etc that influence cost
Diagnosing Cost drivers
• Cost drivers determine asset utilisation and operating costs of an value activity • It is also possible that cost behaviour of a value activity is a function of two or more cost drivers • Thus cost drivers often interact with each other to determine the cost of an value activity
Interaction among cost drivers
• They are of two forms: 1. Reinforcing : Where cost drivers support each other Good locations may require early timing in sectors like retailing Scale economies are partially determined by discretionary policies of the firm 2. Counteracting : where cost drivers counteract with each other, offsetting each others effects Economies of scale can be affected by institutional policies like unionisation
Cost of Purchased Inputs
• 1. 2. • It consists of two parts Purchased operating inputs Purchased assets The cost of purchased inputs is a function of three factors 1. Their unit cost 2. Their rate of utilisation 3. Their indirect effects on other activities through linkages
Cost dynamics
• A firm must consider how the absolute and relative cost of value activities will change over time independent of its strategy. This is known as cost dynamics
Sources of Cost dynamics
• • • • • • • Industry growth Differential scale sensitivity Different learning rates Differential technological change Relative inflation of costs Aging Market adjustments
Cost advantage
A firm has a cost advantage if its cumulative cost of performing all value activities is lower than competitor’s costs And its strategic value lies in the sustainability of the cost advantage A firm’s cost position is a function of 1. The composition of its value chain versus competitors 2. Its relative position in terms of cost drivers visà-vis the cost drivers of each activity of the competitors.
Gaining Cost advantage
• There are two major ways of gaining cost advantage 1. Control cost drivers 2. Reconfigure the value chain
Control cost drivers
1. Control scale a. Gain appropriate type of scale b. Set policies to reinforce scale economies c. Exploit the types of scale economies where the firm is favoured d. Emphasize value activities driven by types of scale where the firm has an advantage
Control learning
• Keep learning proprietary by back ward integration to protect knowhow, control information dissemination, retain key employees, non disclosure provisions in employee contracts • Learning from rivals
Controlling effect of capacity utilisation
• By leveling fluctuations through value chain • Reducing throughout fluctuations by using tapered integration
Control linkages
• Work with suppliers and channels to exploit vertical linkages • Exploit cost linkages within the value chain
Controlling Interrelationships
• Share appropriate activities • Transfer know how in managing similar activities
Controlling integration
• Examine systematically possibilities for integration and de-integration
Controlling timing
• Exploit first mover and late mover advantage • Time the firm’s purchases in the business cycle
Controlling discretionary policies
• Modify expensive policies that do not contribute to differentiation • Invest in technology to skew cost drivers in the firm’s favour • Avoid frills
Reconfiguring the value chain can reduce cost
• By using different production process • Through differences in automation • By using direct sales instead of indirect sales • By using a new raw material • By using a new distribution channel • By using new promotion medium
Pitfalls of cost leadership
• • • • Focus on cost of manufacturing activities Overlooking indirect or small activities Undermining differentiation Thinking incrementally
doc_919835939.ppt
In microeconomics, economies of scale are the cost advantages that enterprises obtain due to size, with cost per unit of output generally decreasing with increasing scale as fixed costs are spread out over more units of output. Often operational efficiency is also greater with increasing scale, leading to lower variable cost as well.
Cost Advantage
Chapter 3
Objectives
• To study the framework for analysing the behaviour of cost • To study the determinants of cost position • To study the ways firm can gain sustainable cost advantage or minimise their cost disadvantage
Framework for analysing the behaviour of cost
• The behaviour of a firm’s cost can be understood by studying its value chain • Each value activity has its own cost structure and the cost’s behaviour is determined by interrelationship and linkages with other activities inside/outside the firm
Value chain for cost analysis
• Operating costs and assets (fixed and working capital) are to be assigned to each value activity • Amount of assets and efficiency of its utilisation will determine the activity’s cost • Value chain is split into individual activities in order to study its impact on cost. Three factor are to be taken into consideration 1. Size and growth of cost represented by activity 2. Cost behaviour of activity 3. Competitor differences in performing the activity
Assigning costs and assets
• Operating Costs are to be assigned to the activities that incur them • Assets are to be assigned to activities that employ, control and utilise them the most
Study of the determinants of cost position
• A firms cost position results from the cost behaviour of its value activities • Cost behaviour depends on a number of structural factors that influence cost – which are known as “Cost drivers” • A firms cost position depends upon its cost drivers
Cost Drivers
• 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. There are ten major cost drivers Economies of scale Learning Pattern of capacity utilisation Linkages Interrelationships Integration Timing Discretionary policies Location Institutional factors
Economies of scale
• It states that an activity operating at full capacity is more efficient at larger scale • It arises from the ability to perform activities differently and more efficiently at larger volume • Measure of scale is also very important in order to manage costs • For some value activities, global scale of operations is important, for others national scale is fine and for some other value activities even regional scale is good
Learning and Spillovers
• Learning is the accumulation of many small improvements rather than a major breakthrough • The cost of a value activity can decline over time due to learning that increases its efficiency • Learning can spill over from one firm in an industry to another through mechanisms such as suppliers, consultants, ex-employees and reverse engineering of products • Sustainable cost advantage is always due to proprietary learning, so if spillover happens it needs to be seen whether it creates cost advantage for a single firm or reduces cost for the entire industry • Learning and scale of operations is also correlated since high scale make learning accumulate rapidly.
Pattern of Capacity Utilisation
• If high fixed cost is linked to a value activity, its cost is affected by capacity utilisation, since high fixed cost is a penalty in case of underutilisation • Capacity utilisation can also be a function of seasonal, cyclical and other demand or supply fluctuations unrelated to competitive position, so pattern of capacity utilisation for an entire cycle is the cost driver • Changes in level of capacity utilisation will involve cost of expanding or contracting and thus affect cost behaviour.
Linkages
• Linkages indicate relationships between two value activities in terms of how the performance of one affect the cost and performance of the other • Linkages are of two types 1. Linkages within the value chain 2. Vertical linkages with value chain of suppliers and channels
Interrelationships
• Interrelationships with other firms help reduce costs • Sharing a value activity with a sister concern is a form of interrelationship • It can be of two types: Tangible and Intangible • Tangible interrelationships occur in case of sharing of physical resources • Intangible interrelationships occur in case of sharing knowhow between separate but similar value activities • Sharing can also increase scale of operations and affect learning as well
Integration
• The level of vertical integration in a value activity may influence its costs • One needs to study whether integrating all functions within the organisation lowers the cost in comparision to dis-integrating them (outsourcing them).
Timing
• Being a first mover has its own pros and cons • Similarly being a late mover advantage has it own advantages and disadvantages
Discretionary policies independent of other drivers
• It refers to the policy choices a firm makes and the resulting impact on its cost position • Some policy choices that affect cost behaviour are product performance, level of service, delivery time, channels employed, raw material used etc.
Location
• Geographical location of a value activity can affect its cost • Cost of location is affected by cost of labour, management, raw material, energy and other factors like taxes and wage rates
Institutional factors
• It includes government regulations, tax holidays, tariffs, government subsidy etc that influence cost
Diagnosing Cost drivers
• Cost drivers determine asset utilisation and operating costs of an value activity • It is also possible that cost behaviour of a value activity is a function of two or more cost drivers • Thus cost drivers often interact with each other to determine the cost of an value activity
Interaction among cost drivers
• They are of two forms: 1. Reinforcing : Where cost drivers support each other Good locations may require early timing in sectors like retailing Scale economies are partially determined by discretionary policies of the firm 2. Counteracting : where cost drivers counteract with each other, offsetting each others effects Economies of scale can be affected by institutional policies like unionisation
Cost of Purchased Inputs
• 1. 2. • It consists of two parts Purchased operating inputs Purchased assets The cost of purchased inputs is a function of three factors 1. Their unit cost 2. Their rate of utilisation 3. Their indirect effects on other activities through linkages
Cost dynamics
• A firm must consider how the absolute and relative cost of value activities will change over time independent of its strategy. This is known as cost dynamics
Sources of Cost dynamics
• • • • • • • Industry growth Differential scale sensitivity Different learning rates Differential technological change Relative inflation of costs Aging Market adjustments
Cost advantage
A firm has a cost advantage if its cumulative cost of performing all value activities is lower than competitor’s costs And its strategic value lies in the sustainability of the cost advantage A firm’s cost position is a function of 1. The composition of its value chain versus competitors 2. Its relative position in terms of cost drivers visà-vis the cost drivers of each activity of the competitors.
Gaining Cost advantage
• There are two major ways of gaining cost advantage 1. Control cost drivers 2. Reconfigure the value chain
Control cost drivers
1. Control scale a. Gain appropriate type of scale b. Set policies to reinforce scale economies c. Exploit the types of scale economies where the firm is favoured d. Emphasize value activities driven by types of scale where the firm has an advantage
Control learning
• Keep learning proprietary by back ward integration to protect knowhow, control information dissemination, retain key employees, non disclosure provisions in employee contracts • Learning from rivals
Controlling effect of capacity utilisation
• By leveling fluctuations through value chain • Reducing throughout fluctuations by using tapered integration
Control linkages
• Work with suppliers and channels to exploit vertical linkages • Exploit cost linkages within the value chain
Controlling Interrelationships
• Share appropriate activities • Transfer know how in managing similar activities
Controlling integration
• Examine systematically possibilities for integration and de-integration
Controlling timing
• Exploit first mover and late mover advantage • Time the firm’s purchases in the business cycle
Controlling discretionary policies
• Modify expensive policies that do not contribute to differentiation • Invest in technology to skew cost drivers in the firm’s favour • Avoid frills
Reconfiguring the value chain can reduce cost
• By using different production process • Through differences in automation • By using direct sales instead of indirect sales • By using a new raw material • By using a new distribution channel • By using new promotion medium
Pitfalls of cost leadership
• • • • Focus on cost of manufacturing activities Overlooking indirect or small activities Undermining differentiation Thinking incrementally
doc_919835939.ppt