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LOWERS COSTS
COST DYNAMICS
The advantages of large scale production that result in lower unit (average) costs (cost per unit)
Economies of scale – spreads total costs over a greater range of output
Larger the plant, greater will be the production, cost will spread over more number of units and therefore
this reduces the overall cost and leads to economies of scale
• For e.g. a 90-m t refinery costs only 1.5 times as much as a 45-m t refinery, thus reducing the cost per unit of capacity
by 25%.
• Many efficiency enhancing features can be added to the plant, which would be uneconomical for smaller scale firms
(Say processing of waste to be sold).
• As clerical work is more, greater automation is possible which reduces administrative costs
• A chain store with 30 outlets in a city needs much less than 3 times advertising expense vis-à-vis a chain store with 10
stores.
(All of the above are value added cost elements i.e. costs of operations provided by the business for itself)
5. Scale effects arise from utilizing fully the fixed cost resources:
• E.g. full utilization of plant capacity, sales force, and service force.
Thus we see that large size provides an opportunity for scale economies; to achieve them requires appropriate
strategies and action
EXPERIENCE EFFECT
It has been found that for certain standardized products, the total unit cost of the product reduced by a consistent percentage
every time the volume is doubled. This is measurable and predictable.
-b
q
Cq = Cn ___
n
Where:
Q = the experience (cumulative production) to date
SOURCES
1. Labour efficiency:
• Both direct labour and others like supervisory staff / managers / persons employed in all functional areas.
• Firms improve production technology by devoting a large percentage of its R&D investments to process improvements.
• E.g. Semi-conductor industry, refineries, steel mills, etc. have achieved experience curve of about 80% via
improvements.
• When first designed, a piece of production equipment may have a conservatively rated output. Experience may reveal
innovative ways of increasing its output.
• Less skilled workers may replace skilled ones alternatively automation can replace labour.
7. Product re-designs:
• Through experience both manufacturers and customers gain a clearer understanding of performance requirements and
this understanding allows the product to be redesigned to:
• Conserve materials
Economies of scale, learning curve effect and the experience curve effect provide opportunities that alert management
can exploit.
The compensation plan of the firm and employee relations’ policies can also have an important influence on its
experience curve.
STRATEGIC IMPLICATIONS
Industry price
Company
cost
C
C’s loss Current price
B
A
In an industry where total cost can be reduced due to scale or experience, pursuing a strategy geared to accumulating
experience faster than competitors can have important cost advantage.
Therefore it is clear that being a leader facilitates cost reduction and enables becoming a cost leader vis-à-vis being a
distant follower.
However, as a firm cannot lead in all markets, it must decide which market to lead, in which to hold a viable non-
leadership position and which to abandon.
Thus we can see that economies of scale, the learning curve effect & the experience curve effect can help a firm to bring
down its costs & can even lead to a position of cost leadership.