Cost Dynamics in firm

In addition to analyzing cost behavior at a point in time, a firm must consider how the absolute and relative cost of value activities will change over time independent of its strategy. I term this cost dynamics. An analysis of cost dynamics enables a firm to forecast how the cost drivers of value activities may change and which value activities will increase or decrease in absolute or relative cost importance. A firm with insight into cost dynamics may be able to position itself to gain a cost advantage by anticipating these changes and moving quickly to respond to them.

Cost dynamics occur because of the interplay of cost drivers over time, as a firm grows or as industry conditions change. The most common sources of cost dynamics include:

Industry Real Growth. Growth of an industry as a whole often has a number of effects on costs. Growth can flow through to purchased inputs, affecting the scale of supplier industries and thereby the cost of inputs. In some industries, industry growth forces up the cost of purchased inputs by worsening the supply/demand balance, while in others it lowers the cost of inputs by making suppliers more efficient. Industry growth can also open up possibilities for scale economies by making the introduction of new technologies feasible in value activities.

Differential Scale Sensitivity. Real growth (or decline) in the sales of firms can dramatically change the absolute and relative costs of value activities if activities have differing scale sensitivity. For example, software cost has become increasingly high relative to hardware cost in many electronics-related industries such as computers, video games, and telecommunication equipment, as hardware cost has proven more scale- and learning-sensitive than software cost. The same process can shift the relative cost position of firms that have value chains with differing degrees of scale sensitivity. For example, Eli Lilly’s DNA-based technology for manufacturing insulin is believed to be more scale- sensitive than Novo Industries’ process. If this proves to be true, Lilly’s relative cost position will improve as volume grows.

Different Learning Rates. The relative cost of different value activities will change if learning occurs in them at different rates. Learning reduces the relative costs of those value activities in which it proceeds most rapidly. For example, rapid learning has dramatically reduced assembly costs as a percentage of sales for many electronics firms. As a result, differences among regions and countries in labor rates for assembly workers have diminished in importance in determining relative cost position.

Differential Technological Change. Technological changes that proceed at different rates can clearly affect the relative cost of different value activities and their cost drivers. For example, the availability of low-cost computers and the development of airfreight have fundamentally shifted the economics of many distribution industries. These changes have caused dramatic reductions in order processing costs as a percentage of total costs, and have allowed the restructuring of distributors in the direction of fewer and more centralized warehouses.

Relative Inflation of Costs. The rate of inflation in key cost elements in value activities often differs and this can significantly shift their relative cost. Differential inflation rates can quickly turn an insignificant value activity into one of critical strategic importance, or can convert a modest cost item within an activity into the dominant one. For example, because of the rapid inflation in oil prices relative to salaries and equipment, fuel costs now constitute almost 50 percent of airline operating costs. As a result, the fuel efficiency of the fleet, the inherent efficiency of the route system, and operating procedures have taken on critical strategic importance.

Aging. An aging capital base or workforce can shift the relative cost of value activities. Older offshore drilling rigs require more maintenance and insurance, for example, and an older workforce typically has higher salary and benefit costs.

Market Adjustment. The operation of market forces often works to counteract high or low purchased input costs and to eliminate or reduce cost differentials based on favorable purchasing by individual firms. People Express and other new airlines have enjoyed extremely low aircraft costs by purchasing used planes during the recent glut. Imitators of their strategy will eventually eliminate the stock of used planes, and People Express will compete with other airlines on a more equal basis.

Cost dynamics can lead to significant changes in industry structure and relative cost position. In steelmaking, for example, technological change and changing material costs have shifted the stage at which the minimum efficient scale of a steelmaking complex is determined. The primary rolling mill historically set minimum scale, but now the blast furnace stage does. Continuous casting has emerged as a lower- cost process than primary rolling for producing semifinished steel slabs. It is also less scale-sensitive than primary rolling. These shifts have major implications for the relative cost positions of competitors, depending on their process configurations. They have led to the success of mini-mills such as Nucor and Lone Star that use continuous casting technology and also have lower-cost labor than established competitors. Early identification of cost dynamics can yield a significant cost advantage by directing a firm toward those value activities that will have the greatest leverage for future relative cost position but may not now be receiving attention.

Source: Porter Michael E. (1998), Competitive Advantage: Creating and Sustaining Superior Performance, Free Press; Illustrated edition.

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