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 impor­ tance. 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.    Grow th of an industry as a whole often has a number of effects on costs. Grow th 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/dem and  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 activi­ ties.

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 exam­ ple, 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 m anufacturing  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 determin­ ing 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 funda­ mentally 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 o f Costs. The rate of inflation in key cost ele­ ments in value activities often differs and   this can   significantly   shift their relative cost. Differential inflation rates can quickly turn an insig­ nificant 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 mainte­ nance 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,  de­ pending 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 competi­ tors. 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 fu ture  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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