In the 1960's, management consultants at The Boston Consulting Group observed a consistent relationship between the cost of production and the cumulative production quantity (total quantity produced from the first unit to the last). Data revealed that the real value-added production cost declined by 20 to 30 percent for each doubling of cumulative production quantity:
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| Experience Curve |
The vertical axis of this logarithmic graph is the real unit cost of adding value, adjusted for inflation. It includes the cost that the firm incurs to add value to the starting materials, but excludes the cost of those materials themselves, which are subject the experience curves of their suppliers.
Note that the experience curve differs from the learning curve. The learning curve describes the observed reduction in the number of required direct labor hours as workers learn their jobs. The experience curve by contrast applies not only to labor intensive situations, but also to process oriented ones.
The experience curve relationship holds over wide range industries. In fact, its absence would be considered by some to be a sign of possible mismanagement. Cases in which the experience curve is not observed sometimes involve the withholding of capital investment, for example, to increase short term ROI. The experience curve can be explained by a combination of learning (the learning curve), specialization, scale, and investment.
What is Experience Curve?
Experience curve refers to the systematic decrease in production costs that occur over the life of a product. Learning effects and economies of scale lie behind the experience curve and moving down that curve allows a company to lower the costs. A company that moves down the experience curve more quickly will have a cost advantage over its competitors. Most of the sources of experience-based cost economies are generally found at the plant level. Dispersing the fixed costs of building productive capacity over a large output reduces the cost of producing a product. Hence the answer to riding down the experience curve as rapidly as possible is to increase the accumulated volume produced by a plant as quickly as possible. Global markets are larger than domestic markets and, therefore, companies that serve a global market from a single location are likely to build up accumulated volume faster than companies that focus primarily on serving their home market or on serving multiple markets from multiple production locations.
Implications for Strategy
The experience curve has important strategic implications. If a firm is able to gain market share over its competitors, it can develop a cost advantage. Penetration pricing strategies and a significant investment in advertising, sales personnel production capacity, etc. can be justified to increase market share and gain a competitive advantage.
When evaluating strategies based on the experience curve, a firm must consider the reaction of competitors who also understand the concept. Some potential pitfalls include:
- The fallacy of composition holds: if all other firms equally pursue the strategy, then none will increase market share and will suffer losses from over capacity and low prices. The more competitors that pursue the strategy, the higher the cost of gaining a given market share and the lower the return on investment.
- Competing firms may be able to discover the leading firm's proprietary methods and replicate the cost reductions without having made the large investment to gain experience.
- New technologies may create a new experience curve. Entrants building new plants may be able to take advantage of the latest technologies that offer a cost advantage over the older plants of the leading firm.
What is experience curve effect?
Cost has been correlated with the accumulated experience (of say production) by the Experience Curve Effect. The underlying principle behind the experience curve is that as total quantity of production of a standardized item is increased, its unit manufacturing cost decreases in a systematic manner. The concept of the experience curve was presented by BCG in 1966 and since then it has been accepted as one of the important phenomena.
The experience curve is a rule of thumb. It says “costs of value-added net of inflation will characteristically decline 25% to 30% each time the total accumulated experience has been doubled” (Henderson, 1989).
This is also known as learning curve. Initially, this inverse relationship was discovered for the learning costs which are the costs for direct labor input in the manufacturing cost. Thus, as the production of a particular item (such as aircraft components) increased, the quantum of time of direct labor component to make each of these successive items declined. This helped the aircraft manufacturers to predict the cost of man hours required to manufacture in future, say the number of aircraft, and helped them to fix the price accordingly. The Experience Curve Effect phenomenon, where costs fall with accumulated volume of experience, was known to industrial managers for many years. It took momentum as a tool in business strategy after Boston Consulting Group (BCG) provided the concept.
Let us take an illustration to understand this concept. When one starts the production of a new product (2 units), the unit cost is, say Rs. 100. Then, as the accumulated production volume reaches 4 units, the unit cost is reduced by say 20%, to Rs. 80. Furthermore, as the accumulated production reaches 8 units, the costs get reduced by another 20%, to only Rs. 64, and so on. This trend has been tabulated in table below.
As we have seen in the illustration, the experience curve is a cost relationship but looking at the practical situation, the prices may not go hand in hand with costs in the long run. In every nation, there are certain cases where the prices of a particular commodity or service remain unchanged in terms of their respective currency while the costs decrease. But this case then is followed by prices falling faster than the costs. This then results in a shift in the market share and leadership of an enterprise. Japan is one country where this unstable pattern rarely occurs.
In the experience curve one thing is to be noted that each element of cost in an end product experience curve goes down its own independent cost curve and each such element has its own starting point (Henderson, 1989). Therefore, the slope of each element may be different and each cost element may share experience with other end products. Looking at this explanation, it can be said that an experience curve is an approximation of a trend line.
Causes of experience curve effect
In order to fully utilize the experience curve effect, it is important to fully grasp what causes this effect. With increase in accumulated production of a standardized product, the experience curve effect of systematic reduction in cost is caused due to management synergy, as follows:
- Improved Productivity of Labor - As the accumulated production of standardized product increases, the labor force acquires the skills to do their task more efficiently. This may be in the form of memorizing the steps involved, or developing reflex actions for doing the needed operations. However, as the experience accumulates, not only the direct labor, but also the supervisory staff as well as managers must successively streamline the needed operation to improve the efficiency. It is important to note that to consolidate the above gains for a sustained improvement, adequate training facilities have to be provided to the new entrants.
- Increased Specialization - Increased volume of standardized production may also merit specialization of individual or a group of skills among different employees. Thus as the production volume increases, individual components may also become viable to be produced in different profit centers. Alternatively, suitable vendors for ancillaries may be developed to shift the overheads and other non-productive expenses away from the organisation. For example, a large vehicle plant can procure engines, transmission train, drive, wheel, gear boxes etc. from outside, and do their assembly only within their plants.
- Innovation in Production Methods - With accumulated experience and higher specialization, the concerned workers are likely to come across innovative ways of improving the production processes. For instance, Japanese engineering workers evolve unique jigs and fixtures which facilitate their working and smooth flow of operations. However, fixed investments in such jigs and fixtures are viable only at high volumes of production, and they can’t be utilized at low production volumes. On enlarged volumes, the unit fixed cost per item reduces substantially, and benefits far exceed the cost.
- Value Engineering and Fine Tuning - As the experience with the production as well as usage of a product accumulates, newer ideas based on value engineering may be adopted to cut down the unnecessary material consumption and other under utilized inputs. For instance, for conduction of electricity, copper wires are often the preferred choice. However, by now it has been also scientifically demonstrated that in copper conductors, the current flows only on the surface of the conductors. Thus, to save cost without compromising performance, the lead conductors coated on the surface by copper have been successfully substituted with substantial economies in initial costs and replacement costs. But such coating operations would necessarily require high volume of production.
- Balancing Production Line - Sometimes, by mere addition of balancing equipment's, substantial increases in capacities can be increased without incurring the proportionate new investments. Thus, all these factors have an accumulated integrated influence of reducing the cost with accumulated experience, and the manager must facilitate and promote these factors to get the desired reduction in cost. In the absence of the above, cost economies would not come about.
- Methods and System Rationalization - The standardization in production, marketing and administrative procedures results in efficiencies over time. Also, more up-to-date technology with better economies of scale can be inducted as the volume increases.
