Idea 20 - Experience curve
The
experience curve says that the more you do something, the less it costs to do
it. And that has important implications if you have chosen to build your market
share by having lower costs than your competitors - a cost advantage strategy.
Experience curve theory is not the same as economies of
scale, though scale can contribute to it. Its true ancestor is the learning
curve. T.P. Wright, who studied the US aircraft industry, first devised the
theory of the learning curve in the 1930s. He observed that every time
cumulative aircraft production doubled - that's the total number made over time
- the man-hours required to make each one fell by a constant percentage (10-15%
according to his study).
That percentage may change from industry to industry,
ranging up to around 30%, but in most it remains fairly constant. Let's say
it's 10%. If, after making 1,000 units of a particular product, each unit takes
one hour to produce, when cumulative volumes reach 2,000, it should take only
54 minutes. At 4,000 that will have fallen to 48.6 minutes, at 8,000 to 43.7
minutes, and so on.
The theory makes sense, especially if you consider that
Wright was studying a labour-intensive production line. As volumes build over
time, workers become more confident and quick with their hands. They spend less
time scratching their heads or making errors, and they learn quicker ways of
doing things. The same applies, in its own way, to their managers.
Labour costs money, so the learning curve reduces costs over
time. The experience curve is based on the same principle - it says that there
is a relationship between experience and efficiency - but takes a broader view.
Like the Boston matrix, it was developed by Bruce Henderson and his colleagues
at the Boston Consulting Group (BCG) in 1966. Consultants at the BCG were aware
of the effects of the learning curve. During an assignment for a semiconductor
manufacturer, however, they observed that a cumulative doubling of production
reduced production costs by 20-30%. This phenomenon became particularly visible
in the electronics industry as rapid volume growth in those same
semiconductors, and hence electronic calculators, personal computers and other
electronic appliances, resulted in dramatically falling costs and prices.
Suppliers
too Henderson wrote later that, while the effect was beyond question,
understanding of its causes was still 'imperfect'. The learning curve is
clearly a contributor, as workers become more dextrous. Standardization and
automation contribute to increased efficiencies and, as production increases,
equipment becomes better utilized. That too has the effect of lowering unit
costs. Other efficiencies may come from tweaking the product design and the mix
of inputs. Suppliers will also benefit from the experience curve, which should
lower the cost of components.
BCG used its discovery in two ways. The first was as a
sensor to identify cost reduction opportunities. If a company had not cut
production costs in line with the experience curve, it was time they started to
look for ways to do so. The other important application of the experience curve
lay in its implications for competitive strategy.
To have lower costs than your rivals is a powerful
competitive advantage. The effects of the experience curve make it even more
important for a company to grow its market share since, all else being equal, the
biggest share will translate into the lowest costs. That cost advantage can men
be enjoyed as greater profitability, or used to put downwards pressure on
prices and maintain market dominance.
BCG argued strongly that it was short-sighted to allow the price
curve to be flatter than the cost curve - to settle for bigger profit margins,
in other and increase their own experience curve benefits. If they choose not
to, but settle for comfortable margins themselves, these very margins will
eventually attract new players into the industry, and they will cut prices. So
the market leader should always reduce prices by at least as much as it has
reduced costs. That will either scare off competition or keep it unprofitable,
and consolidate both competition or keep it unprofitable, and consolidate both
market dominance and low costs. These ideas played an important part in the
developmenr of the Boston matrix, BCG's famous asset allocation tool.
Technology and innovation have a habit of interrupting me
curve, however. The introduction of new products or processes puts an end to
the old curve and starts a new one. Of course, if every player in the industry
is aware of the experience curve, the knowledge becomes less useful. If all
firms pursue a strategy based upon it, they will all end up with low prices,
too much capacity and no increase in share.
Reference: 50 Management Ideas You Really Need to Know
Book by Edward Russell-Walling
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