Cost Drivers of the firm

Ten m ajor cost drivers determine the cost behavior of value activi­ ties: 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.


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  advertis­ing 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 infrastruc­ ture 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 dis­ economies 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 heav­ ily 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 infrastruc­ ture are typically more scale-sensitive than  activities such as procure­ ment and sales force operations  because   their  costs are heavily fixed no matter what the firm’s scale is. However,  economies (and disecono­ mies) 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 an d /o r 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 o f scale differs among value activities and industries. Firms that over­ look 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.3

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 develop­ ment 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. Econo­ mies 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 loca­ tions. Transportation suppliers also frequently offer discounts on con­ tainerload, 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. Under­ standing 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.


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 possi­ bilities 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 differ­ ing possibilities for learning improvements.5 Learning is often the cumulation of many small improvements rather than m ajor break­ throughs. 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.  W here 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.6 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  mea­ sure of learning reflects the specific mechanisms of learning that  ac­ count  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. W here 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.7 The rate of learning is often subject  to diminishing  returns,  and hence it may decline over time for some value activities as an industry  ma­ tures.

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.


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 com­ mission 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 sea­ sonal,   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 condi­ tions and competitor behavior (particularly competitor investment be­ havior) and is partly  under a firm’s control  through  its policy choices in areas such as marketing and product selection.


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 power­ ful 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 be­ tween 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 re­ quires asking the question, “ W hat  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: coor­ dination 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 qual­ ity of purchased parts is linked to the adjustm ent  of copiers after assembly. Canon  found  it could virtually eliminate the need for ad­ justm ent in its personal copier line by purchasing  higher  precision parts.

Vertical Linkages

Vertical linkages reflect interdependencies between a firm’s activi­ ties 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 sophisti­ cated understanding of supplier and channel value chains.

Linkages with suppliers tend to center on the suppliers’ product design characteristics, service, quality assurance  procedures,  packag­ ing, 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 m anner  in   which a supplier performs  activities within   its value chain   can   raise or lower a firm’s cost. Typical examples of supplier linkages im portant 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 coordina­ tion 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. Some­ times 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 m irror 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 link­ ages 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  agree­ ment  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 re­ quire 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.


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 pro­ ducing 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 re­ duces unit costs if cost in the   activity   is sensitive   to   economies of scale or learning, or if sharing improves the pattern of capacity utiliza­ tion 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 bound­ aries of a single industry. Sharing is thus  a potential  substitute  for position in a particular industry. Sharing  a value activity always in­ volves costs, however, that must be weighed against any benefits from sharing. The other form of interrelationship,  sharing  know-how  be­ tween 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.


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 considera­ ble 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.8 W hether 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. Firm s often ignore the de-integration option in their cost analyses. Integration  and  de-integration  analysis must not limit itself to m ajor 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.9 Firms can often lower cost by integrating into some ancillary services while continuing to buy the basic product.


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 m ajor  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 deter­ mines 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. Furtherm ore, 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   pur­ chased rigs during  downturns  when   prices are depressed as an inte­ gral part  of its cost leadership strategy. Depending  on the   value activity, then, timing can either raise or lower costs relative to com­ petitors.    Timing    can    lead    to    either   sustainable   cost    advantage or a short-term  cost advantage. A firm that  has low cost assets be­ cause of fortuitous  timing, for example,   may find that  the eventual need to replace those assets dramatically  raises its relative cost posi­ tion.


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 activi­ ties
  • 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 semi­ conductors)
  • wages paid and amenities provided to employees, relative to prevailing norms
  • other hum an 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 deter­ mining 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 autom ated  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 under­ stand 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  conven­ tional 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.


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 infrastruc­ ture. 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 im portant 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 coordi­ nation. Location also shapes the transportation modes and communica­ tion 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. Tech­ nological 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.


Institutional factors, including government  regulation,  tax holi­ days and other  financial   incentives,   unionization,  tariffs and   levies, and local content rules, constitute the final m ajor cost driver. Institu­ tional factors represent perhaps  the single most im portant  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 m ajor 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   govern­ ments 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.


The same cost drivers determine asset utilization as well as operat­ ing 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 reflec­ tion of the flight schedule). Figure  3 -2 illustrates the most  important cost drivers in  a consumer durable manufacturing firm.

A firm must attem pt 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   im portant  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 posi­ tion vis-a-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 im portant  in determining the   feasibility   of technology   changes,  one   of the   subjects  of Chap­ ter 5.

Interactions Among Drivers. Cost drivers often interact  to de­ termine 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 institu­ tional 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. Integra­ tion 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-a-vis one driver may worsen a firm’s position vis-a-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 likeli­ hood 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 econo­ mies, 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 prod­ uct 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 fre­ quently   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, differ­ ences 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 parame­ ters 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 competi­ tors’ costs to each other. Since competitors will usually be situated differently vis-a-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.

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