Idea 20 - Experience curve (50 Management ideas you really need to know)

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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