Ten major cost drivers determine the cost behavior of value activities: economies of scale, learning, the pattern of capacity utilization, linkages, interrelationships, integration, timing, discretionary policies, location, and institutional factors. Cost drivers are the structural causes of the cost of an activity and can be more or less under a firm’s control. Drivers often interact to determine the cost behavior of a particular activity, and the relative impact of cost drivers will differ widely among value activities. Thus no one cost driver, such as scale or the learning curve, is ever the sole determinant of a firm’s cost position. Diagnosing the cost drivers of each value activity allows a firm to gain a sophisticated understanding of the sources of its relative cost position and how it might be changed.
1. ECONOMIES OR DISECONOMIES OF SCALE
The costs of a value activity are often subject to economies or diseconomies of scale. Economies of scale arise from the ability to perform activities differently and more efficiently at larger volume, or from the ability to amortize the cost of intangibles such as advertis-ing and R&D over a greater sales volume. Economies of scale can result from efficiencies in the actual operation of an activity at higher scale as well as from less than proportional increases in the infrastructure or overhead needed to support an activity as it grows. In a bauxite mine, for example, actual mining costs go down less with scale than do infrastructure costs.
Economies of scale must be clearly distinguished from capacity utilization. Increasing capacity utilization spreads the fixed costs of existing facilities and personnel over large volume, while economies of scale imply that an activity operating at full capacity is more efficient at larger scale. Mistaking capacity utilization for economies of scale can lead a firm to the false conclusion that its costs will continue to fall if it expands capacity once its existing capacity is full.
Increasing complexity and costs of coordination can lead to diseconomies of scale in a value activity as scale increases. When the number of lines in a metal can plant exceeds about 15, for example, the complexity of the plant becomes unwieldy. Increasing scale also sometimes dampens employee motivation and may increase wage or purchased input costs. For example, a large plant may have a greater likelihood of unionization or lead to higher expectations and greater stridency of union negotiators. Diseconomies of scale in procurement can also occur if large requirements meet an inelastic supply, forcing up input prices. Diseconomies of scale appear to be present in many fashion-sensitive industries and professional services, which rely heavily on fast response times and creative individuals who do not function well in large organizations.
The scale sensitivity of activities varies widely. Value activities such as product development, national advertising, and firm infrastructure are typically more scale-sensitive than activities such as procurement and sales force operations because their costs are heavily fixed no matter what the firm’s scale is. However, economies (and diseconomies) of scale can be found to some extent in virtually every value activity of a firm.
Economies of scale reflect not only the technology in a value activity but also the manner in which a firm chooses to operate it. Scale economies in a plant can be strongly affected by the number of product varieties produced and the length of runs chosen. Similarly, the deployment of a sales force can influence economies of scale in sales force operation. In a sales force organized geographically, costs tend to fall as regional sales volume grows because a salesperson can write larger orders on each sales call and/or because travel time be-tween accounts is reduced by greater density. If the sales force is organized by product line, however, an increase in volume in one region may create diseconomies by requiring salespersons to travel more to that region than to other regions closer to home base.
Economies of scale are not all equivalent. The relevant measure of scale differs among value activities and industries. Firms that overlook this often undermine their relative cost positions. For some value activities, global or worldwide scale is the relevant cost driver. For other value activities, national scale, regional scale, local scale, plant scale, project scale, scale per production line, scale per buyer, scale per order, or some other measure of scale may underlie the behavior of cost.18
In product R&D, for example, global or national scale are often the relevant measure of scale. Developing a new model requires a fixed investment that is amortized over all the units sold. The development cost of a standard model sold worldwide is sensitive to global scale, while the development cost of a product that must be customized for individual countries may be more sensitive to national scale. Economies of scale in transportation typically hinge on regional or local scale or on scale per buyer, depending on the mode of transportation employed. Local or regional scale is a proxy for the density of buyers and hence the distances between deliveries to different buyer’s locations. Transportation suppliers also frequently offer discounts on containerload, carload, or trainload shipments to a given area that contribute to local or regional scale sensitivity. Finally, the cost of delivery to a given buyer often remains largely fixed regardless of the buyer’s order size, making large buyers less costly to serve. Understanding how economies of scale affect cost, therefore, requires an identification of the specific mechanisms underpinning them and the measure of scale that best captures these mechanisms.
The appropriate measure of scale is a function of how a firm manages an activity. For example, modifying products by country instead of selling a standard product worldwide, a policy choice, changes the appropriate measure of scale. Similarly, the authorization cost of a credit card processing firm that authorizes merchant charges electronically rather than manually becomes much more sensitive to the overall volume of transactions. Thus a firm can influence not only the extent of economies of scale but also the type of scale that most determines its cost in an activity. This suggests that a firm should manage its activities to maximize their sensitivity to the type of scale in which the firm has the greatest advantage over its competitors. A regional firm should accentuate the value of its regional scale, for example, while a national competitor without leadership in any region should manage its activities to maximize the value of its national scale.
2. LEARNING AND SPILLOVERS
The cost of a value activity can decline over time due to learning that increases its efficiency. The mechanisms by which learning can lower cost over time are numerous, and include such factors as layout changes, improved scheduling, labor efficiency improvement, product design modifications that facilitate manufacturing, yield improvements, procedures that increase the utilization of assets, and better tailoring of raw materials to the process. Learning can also reduce the cost of constructing plants, retail outlets, or other facilities. Thus the possibilities for learning in an activity are much broader than learning by personnel to perform their functions more efficiently.4 The rate of learning varies widely among value activities because each offers differing possibilities for learning improvements.5 Learning is often the cumulation of many small improvements rather than major breakthroughs. The rate of learning may increase during slack periods when attention is focused on reducing costs rather than meeting demand. Moreover, learning tends to vary with the amount of management attention devoted to capturing it.
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. Where spillover of learning among firms is high in a value activity, the rate of learning may stem more from total industry learning than from the learning of one firm. Since a sustainable cost advantage results only from proprietary learning, the rate of spillover also determines whether learning serves to create a cost advantage for a firm or simply lowers cost for the industry.19 Analysis of the rate of spillover plays a crucial role in diagnosing the relative cost differences among competitors due to differential rates of learning.
As with scale economies, the appropriate measure of the rate of learning is different for different value activities. The appropriate measure of learning reflects the specific mechanisms of learning that account for the fall in costs over time in a value activity. This will vary because mechanisms for learning are diverse and because of the influence of spillovers. In a value activity where learning affects cost behavior through improving worker efficiency, for example, the rate of learning may be tied to the cumulative volume in that activity. In this case, the rate of learning is correlated with scale because high scale makes learning accumulate rapidly. Where learning occurs through the introduction of more efficient machinery, however, its rate may reflect the rate of technological change in machinery and have little to do with the firm’s volume. The rate of learning can also be a function of calendar time or the level of investment expended in modifications to an activity. Understanding the specific mechanisms for learning in each value activity and identifying the best measure of its rate are necessary if a firm is to improve its cost position. The rate of learning is often subject to diminishing returns, and hence it may decline over time for some value activities as an industry matures.
Some alternative measures that may serve as a proxy for the rate of learning in an activity and typical value activities in which they apply are shown in Table 3-1.
3. PATTERN OF CAPACITY UTILIZATION
Where a value activity has substantial fixed cost associated with it, the cost of an activity will be affected by capacity utilization. Fixed costs create a penalty for underutilization, and the ratio of fixed to variable cost indicates the sensitivity of a value activity to utilization. Different ways of configuring a value activity will affect its sensitivity to capacity utilization. For example, the use of food brokers to sell to supermarkets usually reduces sensitivity to capacity utilization when compared to an in-house sales force. Brokers typically receive a commission on sales, while an in-house sales force is paid a fixed salary and expenses over and above commissions.
Capacity utilization at a given point in time is a function of seasonal, cyclical, and other demand or supply fluctuations unrelated to competitive position. Thus the pattern of utilization over the entire cycle is the correct cost driver instead of utilization at one point in time. Changes in the level of capacity utilization will involve costs of expanding or contracting, so that a firm that changes its utilization will have higher costs than one that keeps its utilization constant,though they both have the same average utilization. The pattern of utilization reflects such changes, and is thus the appropriate cost driver rather than the average level of utilization. The pattern of capacity utilization of an activity is partly determined by environmental conditions and competitor behavior (particularly competitor investment behavior) and is partly under a firm’s control through its policy choices in areas such as marketing and product selection.
4. LINKAGES
The cost of a value activity is frequently affected by how other activities are performed. As described in Chapter 2, two broad types of linkages exist: linkages within the value chain and vertical linkages with the value chains of suppliers and channels. These linkages mean that the cost behavior of a value activity cannot be understood by examining that activity alone. Linkages create the opportunity to lower the total cost of the linked activities. They provide a potentially powerful source of cost advantage because linkages are subtle and require joint optimization or coordination of activities across organizational lines. Competitors often fail to recognize their presence or are incapable of harnessing them.
Linkages within the Value Chain
Linkages among value activities pervade the value chain. Some of the most common linkages are those between direct and indirect activities (e.g., machining and maintenance), quality assurance and other activities (e.g., inspection and after-sale service), activities that must be coordinated (e.g., inbound logistics and operations), and between activities that are alternative ways of achieving the result (e.g,, advertising and direct sales, or writing airline tickets on-board the plane instead of at ticket counters or gates). Identifying linkages requires asking the question, “What are all the other activities elsewhere in a firm that have or might have an impact on the cost of performing this activity?”
When activities in the value chain are linked, changing the way one of them is performed can reduce the total cost of both. Deliberately raising cost in one activity may not only lower the cost of another activity but also lower total cost. As described in Chapter 2, linkages lead to opportunities for cost reduction through two mechanisms: coordination and optimization. Better coordination of linked activities such as procurement and assembly can reduce the need for inventory, for example. Inventory is typically a manifestation of a linkage between activities, and reducing inventory is possible by managing the linkage better. Jointly optimizing activities that are linked involves resolving tradeoffs among them. In copier manufacturing, for example, the quality of purchased parts is linked to the adjustment of copiers after assembly. Canon found it could virtually eliminate the need for adjustment in its personal copier line by purchasing higher precision parts.
Vertical Linkages
Vertical linkages reflect interdependencies between a firm’s activities and the value chains of suppliers and channels. The firm can identify them by examining how the behavior of suppliers or channels affects the cost of each of its activities and vice versa. Vertical linkages are frequently overlooked, because identifying them requires a sophisticated understanding of supplier and channel value chains.
Linkages with suppliers tend to center on the suppliers’ product design characteristics, service, quality assurance procedures, packaging, delivery procedures, and order processing. Supplier linkages also take the form of a supplier performing an activity that the firm might otherwise undertake. In these and other areas, the manner in which a supplier performs activities within its value chain can raise or lower a firm’s cost. Typical examples of supplier linkages important to cost include the linkage between the frequency and timeliness of supplier deliveries and a firm’s raw material inventory, the linkage between supplier application engineering and a firm’s technology development cost, and the linkage between a supplier’s packaging and a firm’s material handling cost. As described in Chapter 2, for example, delivery of bulk chocolate in liquid form instead of ten pound molded bars can reduce a confectioner’s processing costs. Often linkages with suppliers provide opportunities for cost reduction on both sides —e.g., delivery of liquid chocolate can reduce the supplier’s cost as well, since it eliminates the cost of molding bars and packaging them.
Managing supplier linkages can lower total cost through coordination or joint optimization, as in all linkages. The easiest linkages to exploit are those where both a firm’s and a supplier’s cost fall. Sometimes exploiting a linkage requires that a supplier’s cost go up to achieve a more than compensating fall in a firm’s costs, however. A firm must be prepared to raise the price it gives suppliers in such cases to make exploiting the linkage worthwhile. The opposite case is also possible, and the firm must be prepared to elevate its own internal cost if the supplier offers a more-than-compensating price cut.
A similar analysis applies to linkages with channels. The typical linkages mirror those with suppliers. For example, the location of a channel’s warehouses and the channel’s materials handling technology can influence a firm’s outbound logistical and packaging cost. Similarly, sales or promotional activities of channels may reduce a firm’s sales cost. As with supplier linkages, channel linkages may allow both the firm and its channels to lower cost. However, exploiting channel linkages may require the channel to raise cost for a more than offsetting reduction in the firm’s cost. It may be desirable, then, to raise margins paid to channels in return for changes in the way they operate that will reduce a firm’s cost. In the United States, for example, Seiko paid its jewelers a generous fee for accepting Seiko watches for repair and shipping them to Seiko. This minimized Seiko’s need for service locations and lowered the cost of processing repairs and of informing customers about repair procedures.
Since vertical linkages involve independent firms, reaching agreement on how to exploit them and how to divide the resulting gains can be difficult. Linkages that require a supplier or channel to raise cost to benefit the firm are quite difficult to achieve unless the firm has considerable bargaining power. Exploiting linkages may also require the creation of switching costs as a byproduct, tying one or both sides to the other. This often further complicates the task of agreeing on ways to exploit linkages, because reaching agreement in- volves a high level of commitment and trust. The payout to exploiting linkages may be great, however, because they are hard for competitors to match.
5. INTERRELATIONSHIPS
Interrelationships with other business units within a firm affect cost, as will be discussed in detail in Chapter 9. The most important form of interrelationships is when a value activity can be shared with a sister unit. American Hospital Supply has found that sharing an order processing and distribution organization across many units producing medical supplies has yielded a significant cost improvement, for example, while shared marketing and distribution are benefiting such financial services firms as Citicorp and Sears. Another form of interrelationship, that I term an intangible interrelationship, involves the sharing of know-how between separate but similar value activities. Emerson Electric, for example, uses cost reduction expertise gained in one division to help lower cost in others.
Sharing a value activity raises throughput in the activity. It reduces unit costs if cost in the activity is sensitive to economies of scale or learning, or if sharing improves the pattern of capacity utilization because different business units place demands on the value activity at different times. Sharing is potentially a way to achieve scale, go down the learning curve faster, or load capacity outside of the boundaries of a single industry. Sharing is thus a potential substitute for position in a particular industry. Sharing a value activity always involves costs, however, that must be weighed against any benefits from sharing. The other form of interrelationship, sharing know-how between separate activities, lowers cost if the activities are similar and if the know-how is significant to improving the efficiency of the activity. In effect, sharing know- how is transfering the fruits of learning from one activity to another.
6. INTEGRATION
The level of vertical integration in a value activity may influence its cost. The cost of an order processing system can be lower if the firm owns its own computer and software instead of contracting with a computer service bureau, for example, while the cost of an outbound logistics activity may vary depending on whether or not a firm owns its own fleet of trucks. Every value activity employs or could employ purchased inputs, and thus involves explicit or implicit integration choices.
Integration can reduce cost in a number of ways. It avoids the costs of using the market, such as procurement and transportation costs. It can allow the firm to avoid suppliers or buyers with considerable bargaining power. Integration can also lead to economies of joint operation, as where steel does not have to be reheated if it moves directly from the steelmaking to the fabrication process. However, integration can raise cost by creating inflexibility, bringing activities in-house that suppliers can perform more cheaply, undermining incen- tives for efficiency because the relationship with the supplying unit becomes captive, or raising exit barriers.21 Whether integration raises, lowers, or has no effect on cost thus depends on the particular value activity and purchased input involved. Sometimes de-integration is indicated.
A firm must assess the potential benefits of integration for each important purchased input in a value activity. Conversely, it must examine those functions currently performed internally to determine whether de-integration would lower the cost of the activity without undermining the firm’s strategy. Firms often ignore the de-integration option in their cost analyses. Integration and de- integration analysis must not limit itself to major inputs but should also examine ancillary services and other supporting functions. A product might be purchased without service, for example, though the two are often bundled.22 Firms can often lower cost by integrating into some ancillary services while continuing to buy the basic product.
7. TIMING
The cost of a value activity often reflects timing. Sometimes a firm may gain first-mover advantages from being among the first to take a particular action. The first major brand in the market may have lower costs of establishing and maintaining a brand name, for example. Gerber exploited this advantage in baby food. Learning is also inextricably linked to timing, because the timing of moves determines when learning begins. Disadvantages may also accrue to first movers. Late movers can enjoy benefits such as purchasing the latest equipment (an advantage today in computers and steel) or avoiding high product or market development costs borne by early movers. A late mover may also be able to tailor the value chain to prevailing factor costs. Another late-mover advantage may be a less senior, and therefore less costly, workforce. Newly established airlines such as People Express have much less senior workforces than established carriers such as PanAm. Furthermore, workforces assembled during difficult economic conditions may prove less interested in unionization. First-mover and late-mover advantages are discussed extensively in Chapter 5.
Timing’s role in cost position may depend more on timing with respect to the business cycle or market conditions than on timing in absolute terms. For example, the timing of purchase of an offshore drilling rig in the industry’s cycle strongly influences not only the interest cost but the purchase price of the rig. ODECO has purchased rigs during downturns when prices are depressed as an integral part of its cost leadership strategy. Depending on the value activity, then, timing can either raise or lower costs relative to competitors. Timing can lead to either sustainable cost advantage or a short-term cost advantage. A firm that has low cost assets because of fortuitous timing, for example, may find that the eventual need to replace those assets dramatically raises its relative cost position.
8. DISCRETIONARY POLICIES INDEPENDENT OF OTHER DRIVERS
The cost of a value activity is always affected by policy choices a firm makes, quite independently of other cost drivers. Discretionary policy choices reflect a firm’s strategy and often involve deliberate tradeoffs between cost and differentiation. For example, an airline’s cost position is determined by such policy choices as the quality of meals, which airports are used, the level of amenities in terminals, the baggage allowance offered, and whether the airline sells tickets on-board or has in-terminal ticketing and downtown ticket offices. A “no-frills” airline reduces cost by having no meals or charging for them, using secondary airports with spartan terminals, having no free baggage allowance, and ticketing on board.
Some of the policy choices that tend to have the greatest impact on cost include:
- product configuration, performance, and features
- mix and variety of products offered
- level of service provided
- spending rate on marketing and technology development activities
- delivery time
- buyers served (e.g., small versus large)
- channels employed (e.g., fewer, more efficient dealers versus many small ones)
- process technology chosen, independent or scale, timing, or other cost drivers
- the specifications of raw materials or other purchased inputs used (e.g., raw material quality affects processing yield in semiconductors)
- wages paid and amenities provided to employees, relative to prevailing norms
- other human resource policies including hiring, training, and employee motivation
- procedures for scheduling production, maintenance, the sales force and other activities
Though policy choices always play an independent role in determining the cost of value activities, they also frequently affect or are affected by other cost drivers. Process technology is often dictated partly by scale and partly by what product characteristics are desired, for example. Moreover, other cost drivers inevitably affect the cost of policies. For example, an automated ticketing and seat selection system may well be subject to economies of scale that make such a system very costly for a small airline to adopt.
Policies typically play a particularly essential role in differentiation strategies. Differentiation often rests on policy choices that make a firm unique in performing one or more value activities, deliberately raising cost in the process (see Chapter 4). A differentiator must understand the costs associated with its differentiation and compare them to the price premium that results. This can be done only by isolating the effects of policies on cost. Frequently, firms choose seemingly be-nign policies to differentiate themselves that prove enormously costly once their role in cost behavior becomes clear. In other cases, firms forego policies that can enhance differentiation with little impact on cost—or that are less expensive for them to implement than for their competitors. A market leader such as Owens- Corning Fiberglas, for example, can potentially differentiate itself at lower cost than other fiberglass competitors through a high spending rate on advertising. The resulting brand awareness is cheaper for Owens-Corning to achieve than competitors because of scale economies in advertising that are driven by national share.
Policies play a vital role in determining cost, and cost analysis must uncover their impact. Yet many firms do not recognize the extent to which the explicit and implicit policy choices they make determine cost. A firm must scrutinize each value activity to identify the explicit and implicit policy choices embodied in it. Sometimes policy choices are nearly invisible, because they are inherited or represent conventional wisdom that is unchallenged. An examination of competitors’ policies in each activity often yields insight into the firm’s explicit or implicit policy choices and suggests ways they might be modified or improved to lower costs. Policy choices can often be changed rap- idly, yielding immediate cost reduction.
9. LOCATION
The geographic location of a value activity can affect its cost, as can its location relative to other value activities. While location frequently reflects a policy choice, it can also stem from history, the location of inputs, and other factors. Hence, location should be treated as a separate cost driver.
The location of a value activity affects cost in a number of ways. Locations differ in the prevailing costs of labor, management, scientific personnel, raw materials, energy, and other factors. Prevailing wage levels and tax rates vary markedly by country, region within a country, and city, for example. Eaton Corporation has capitalized on this in automotive components, employing plants in Spain and Italy to achieve a low-cost position in Europe. Location can also affect the cost of a firm’s infrastructure because of differences in available local infrastructure. Climate, cultural norms, and tastes also differ by location. These affect not only product needs but also the way in which a firm can perform value activities. The amenities required in a plant, for example, are partly a function of local norms. Finally, logistical costs often hinge on location. Location relative to suppliers is an important factor in inbound logistical cost, while location relative to buyers affects outbound logistical cost. Location of facilities relative to each other affects the costs of transshipping, inventory, transportation, and coordination. Location also shapes the transportation modes and communication systems available to a firm, which can affect cost.
Location has some influence, then, on the cost of almost every value activity. Firms do not always understand the impact of location beyond obvious differences such as wage rates and taxes, however. Opportunities often exist for reducing cost through relocating value activities or by establishing new patterns of location of facilities relative to each other. Changing location often involves tradeoffs—it lowers some costs while raising others. Locating to minimize transportation or other costs also frequently trades off against scale economies. Technological change that alters scale economies may alter historical tradeoffs, however, as may shifts in relative wages and other costs. Thus firms may be able to create a cost advantage through recognizing opportunities for changing location first.
10. INSTITUTIONAL FACTORS
Institutional factors, including government regulation, tax holidays and other financial incentives, unionization, tariffs and levies, and local content rules, constitute the final major cost driver. Institutional factors represent perhaps the single most important cost driver in the trucking industry in the United States in the 1980s, for example. Regulatory approval for the use of double trailers could have as much as a 10 percent impact on cost. At the same time, unionized carriers have much higher wage costs relative to nonunion carriers. These two factors outweigh all the other major cost drivers by a considerable margin in determining the relative cost position of trucking firms. Another example of the role of institutional factors as a cost driver is in power costs, the single largest determinant of cost position in aluminum smelting. Power costs depend on the rates charged by power companies, a highly political issue in areas where governments own power companies. Rapid escalation of power rates in some countries has made them uncompetitive smelting locations. Favorable institutional factors can lower costs just as unfavorable ones can raise them. While institutional factors often remain outside a firm’s control, means may exist to influence them or minimize their impact.
11. DIAGNOSING COST DRIVERS
The same cost drivers determine asset utilization as well as operating costs in an activity. Finished good inventory turnover, for example, is often determined by the scale of the order processing activity and policies regarding delivery time. Tradeoffs can often be made between asset utilization and operating costs. A large-scale plant may have low operating costs but less asset turnover than a small-scale one, for example. Such tradeoffs must be identified in order to optimize the combination of assets and operating cost to lower total cost. Some illustrative drivers of asset utilization are shown in Table 3-2.
The cost behavior of a value activity can be a function of more than one cost driver. While one driver may exert the strongest influence on the cost of a value activity, several drivers often interact to determine cost. For example, the cost of gate operations for an airline reflects policies regarding how much service the airline provides, local scale (which influences the efficiency with which personnel and facilities are utilized), and the pattern of capacity utilization (which is a reflection of the flight schedule). Figure 3-2 illustrates the most important cost drivers in a consumer durable manufacturing firm.
A firm must attempt to quantify the relationship between cost drivers and the cost of a value activity whenever possible. This will require estimating for each activity the slope of the scale or learning curve, the cost impact of each important policy, the cost advantage or penalty of timing, and so on for each driver. Though a high degree of precision is not required, some level of quantification is necessary in order to determine the relative significance of each cost driver. Quantification will also greatly facilitate estimates of relative cost position vis-à-vis competitors.
The technology employed in a value activity is not itself a cost driver, but rather an outcome of the interplay of cost drivers. Scale, timing, location, and other drivers shape the technology employed in combination with policy decisions a firm makes. The relationship between technology and the cost drivers is important in determining the feasibility of technology changes, one of the subjects of Chapter 5.
Interactions Among Drivers. Cost drivers often interact to determine the cost of an activity. These interactions take two forms: drivers either reinforce or counteract each other. Drivers frequently reinforce or are related to each other in affecting cost. The extent of scale economies in an activity is partly determined by policy choices about how the activity will be performed as well as product mix, for example. The effect of location on cost is often related to institutional conditions such as unionization or regulation, while securing good locations may require early timing in such industries as retailing, policy choices can also make linkages easier or more difficult to achieve, and the cost of policies is often affected by other drivers as noted earlier. The advantages of early timing can be reinforced by scale economies or learning effects, as will be discussed in Chapter 5. Integration also frequently increases scale economies.
Figure 3-2. Cost Drivers in a Consumer Durable Manufacturing Firm
Cost drivers can also counteract each other, offsetting each other’s effects. This means that improving position vis-à-vis one driver may worsen a firm’s position vis-à-vis another. Large scale and high levels of vertical integration frequently increase the penalty of underutilizing capacity, for example. Similarly, increased scale can increase the likelihood of unionization, while scale economies can be offset because a single location raises transportation costs.
Identifying interactions among cost drivers is a necessary part of determining the cost behavior of a value activity. Where drivers are reinforcing, a firm must coordinate its strategy in order to achieve the lowest cost. For example, policy choices should enhance the firm’s ability to reap the benefits of scale economies or to achieve linkages. Early timing should be exploited by the aggressive pursuit of learning. Eliminating inconsistencies and harnessing the reinforcing effects of cost drivers can significantly improve relative cost position.
The presence of counteracting cost drivers implies the need for optimization. Location must optimize the tradeoff among scale economies, transportation costs, and wage costs, for example. The choice of plant scale must weigh the cost of underutilization. Policy choices can sometimes alter such tradeoffs—for example, the choice of a flexible manufacturing process can change the tradeoff between scale and product variety. Resolving such tradeoffs is only possible if the effect of each driver on the cost of an activity can be quantified.
Interactions among cost drivers are often subtle. They are frequently not recognized, especially if they are changing. The ability to translate insight about the interaction of cost drivers into strategy choices can thus be a sustainable source of cost advantage.
Identifying Cost Drivers. Identifying cost drivers and quantifying their effect on cost may not be easy, and a number of methods can be employed. Sometimes the cost drivers of a value activity will be intuitively clear from examining its basic economics. For example, sales force costs are often driven by local share because high local share lowers travel time. A reasonably accurate estimate of the shape of the relationship between sales force cost and share can be computed by estimating how rising share would cut average travel time. It is often illuminating for understanding and quantifying cost behavior to employ alternative measures of the efficiency of an activity besides total cost. For example, such measures as yield, scrap rates, labor hours, and others can be employed to probe the sources of cost changes in a value activity and their logic.
Another method of identifying cost drivers is for a firm to examine its own internal experience, particularly if the firm’s circumstances have changed over time or it operates multiple units. Past cost data may allow a firm to plot its historical learning curve in a value activity, for example, if it adjusts for inflation and changes in policies, product design, and product mix. Cost levels at different scales of output in the past may shed some light on scale economies. If a firm sells in several geographic regions or manufactures in several plants, differences among them can illuminate cost drivers.
Cost drivers can also be determined from interviews with experts. Individuals who have extensive knowledge of a value activity can be asked “what if” questions about the effects of changing various parameters on cost. For instance, interviews with production managers might address the impact of doubling line speed on such factors as manning levels, energy consumption, and yield.
The final method for identifying cost drivers is to compare a firm’s cost in a value activity to its competitors’ or compare competitors’ costs to each other. Since competitors will usually be situated differently vis-à-vis the cost drivers, such comparisons can expose which cost drivers are most important. Analyzing competitor cost behavior will be discussed below.
Source: Porter Michael E. (1998), Competitive Advantage: Creating and Sustaining Superior Performance, Free Press; Illustrated edition.