Cost Drivers

Cost and consumer benefit drives value-creation. Understanding how a firm creates value and why it creates more or less value than its competitors often requires a diagnosis of cost and benefit drivers. We discuss cost drivers first.

Cost drivers explain why costs vary across firms. We discuss cost drivers in terms of average costs, rather than total costs, because a larger firm's total costs would be higher than a smaller firm's simply because it is larger.59 We

S9One way to control for the effects of size in analyzing cost difference among different size firms is to express total costs as a percentage of sales revenue. Accountants call this common-size analysis. Although useful, common-size analysis contains a potential source of confusion. To illustrate, we can write the ratio of total costs to sales revenue as (AC x Q) + (P x Q) ~ AC/P, where Q denotes the volume of output per period. This expression implies that one firm's total cost-to-sales ratio might be lower than another's either because its average costs are lower or its price is higher (or both). Common-size analysis of cost advantage should account for differences in prices among firms. Such differences might be due to product quality, product mix, or geographical point of sales.

can classify cost drivers into four broad categories, each of which has several subcategories:

• Cost drivers related to firm size or scope

• economies of scale

• economies of scope

• capacity utilization

• Cost drivers related to cumulative experience 0 learning curve

® Cost drivers independent of firm size, scope, or cumulative experience 0 input prices ° location

• economies of density ° complexity/focus

® process efficiency

• discretionary policies

• government policies

• Cost drivers related to the organization of transactions ° organization of the vertical chain

• agency efficiency

We will discuss each cost driver in turn.

Cost Drivers Related to Firm Size, Scope, and Cumulative Experience

Chapter 2 contains an extensive discussion of economies of scale, scope, and cumulative experience, so here we will just review the key ideas. Economies of scale exist when average costs go down as the scale of operation increases. Economies of scope exist when average costs go down as the firm produces a greater variety of goods. A paramount source of economies of scale and scope is indivisible inputs. Indivisible inputs cannot be scaled down below a certain minimum size and thus give rise to fixed costs. As the volume or variety of output increases, these fixed costs get spread out, leading to lower per-unit costs of production. In the short run, fixed costs are often spread because of greater capacity utilization. In the long run, fixed costs are spread when it becomes economical for a firm to substitute a technology with high fixed costs but low variable costs for one with low fixed costs but high variable costs. Other important sources of economies of scale are: (1) the physical properties of processing units (i.e., the cube-square rule); (2) increases in the productivity of variable inputs as volume increases (e.g., because of greater specialization of labor); (3) economies of inventory management.

Cumulative experience can reduce average costs as firms move down the learning curve. Learning economies should not, however, be confused with economies of scale that arise when the firm spreads out nonrecurring fixed costs over the volume of output it produces over time. To illustrate this distinction, consider a small producer of a specialty valve. The up-front costs of designing the valve are incurred only once. The dies and jigs used to fabricate the valve can be reused from one year to the next, so these costs are also nonrecurring. Even though the firm's annual rate of production may be small, its average cost per unit might still be low because it has produced the same model year after year.60 Spreading nonrecurring fixed costs causes unit production costs to decrease with volume, even if the firm does not become more proficient in manufacturing the good as it accumulates experience.

Cost Drivers Independent of Firm Size, Scope, or Cumulative Experience

These factors make one firm's unit costs different from a competitor's even if their sizes and cumulative experience are the same. An important cost driver independent of scale is input prices, (e.g., wage rates, energy prices, and prices of components and raw materials). When firms in the same industry purchase their inputs in national markets, their input prices will be the same. But firms in the same industry often pay different prices for inputs. Differences in wage rates may be due to differences in the degree of unionization (e.g., large trunk airlines, such as United and American, are unionized, but many new entrants, such as Kiwi, are not). Differences in wages, the price of energy, or the price of delivered materials can also be attributed to location differences among firms.

Location can also influence costs in other ways. For example, because of weak local infrastructure and coordination problems that arose due to the distance between corporate headquarters and its production facility, the Lionel Corporation found it more expensive to produce toy trains in Tijuana, Mexico, than in Michigan, despite the large wage-rate advantage of the Mexican location.61

Economies of density refer to cost savings that arise with greater geographic density of customers. Economies of density can arise when a transportation network within a given geographic territory is utilized more intensively (e.g., when an airline's unit costs decline as more passengers are flown over a given route). They also arise when a geographically smaller territory generates the same volume of business as a geographically larger territory (e.g., when a beer distributor that operates in a densely populated urban area has lower unit costs than a distributor selling the same amount of beer in more sparsely populated suburbs). In both cases, the cost savings are due to an increase in density (e.g., passengers per mile, customers per square mile) rather than an increase in scope (e.g., number of routes served) or scale (e.g., volume of beer sold).

One firm may achieve lower average costs than its competitors because its production environment is less complex or more focused. A firm that uses the same factory to produce many different products may incur large costs associated with changing over machines and production fines to produce batches of the different products. It may also incur high administrative costs to track different work orders. A good example of the impact of complexity on production costs is the rail

60Spreading nonrecurring fixed costs over time is sometimes referred to as economies of model volume. See McGee, J., "Efficiency and Economies of Size," in Goldschmidt, H. J., M. H. Mann, and F. J. Weston (eds.), Industrial Concentration: The New Learning, Boston: Litde, Brown, 1974, pp. 55-96.

61"U.S. Companies are Coming Home: Costs, Quality Concerns Spell End for Offshore Operations," Chicago Tribune, November 22, 1987, p. F10.

road industry. Historically, the Pennsylvania and New York Central railroads had some of the highest costs in the business because they carried a much higher proportion of less-than-carload freight than railroads such as the Norfolk and Western and the Southern.62 The Pennsylvania and the New York Central needed more classification yards, more freight terminals, and greater manpower per ton of freight than their more focused counterparts, which specialized in bulk traffic, such as coal and lumber. After the two roads merged to form the Penn Central in 1968, they were spending 15 cents for every dollar of sales revenue on yard expenses, as compared with an average of less than 10 cents per dollar of sales for all other railroads.63

A firm may have lower average costs than its rivals because it has been able to realize production process efficiencies that its rivals have not achieved; that is, the firm uses fewer inputs than its competitors to produce a given amount of output, or its production technology uses lower-priced inputs than those utilized by rivals. For example, in the early 1990s, Ford was using 25 percent less labor than General Motors to produce a typical vehicle. This effect is often difficult to disentangle from the learning curve, because the achievement of process efficiencies through learning-by-doing is at the heart of the learning curve. An example of a process efficiency not based on experience is the Chicago and Northwestern Railroad's (CNW) decision in the mid-1980s to reduce the crew size on its freight trains from four to three by eliminating one of the brakemen. This move allowed the CNW to become one of the lowest-cost competitors in the railroad business.

One firm may also have lower average costs than its competitors because it avoids expenses that its rivals are incurring. Its costs are lower because of discretionary factors that, at least to some extent, are within the firm's control. For example, in the tire business, Cooper Tire and Rubber generally refrains from national advertising. This results in sales and administrative expenses that are significantly lower than its competitors (e.g., in the early 1990s, Cooper's selling and general administrative expenses were about 5 percent of sales, while Goodyear's were roughly 16 percent).

Finally, a firm may have lower average costs than its rivals because of the effects of government policies. For obvious reasons, this factor affects international markets. For example, Japanese truck producers have long been at a disadvantage in selling trucks in the United States because of the steep import duty the U.S. government levies on Japanese trucks.

Cost Drivers Related to the Organization of the Transaction

Chapters 3, 4, and 5 discussed how the vertical chain can influence production costs. For transactions in which the threat of holdup is significant, in which private information can be leaked, or coordination is complicated, a firm that organizes the exchange through the market may have higher administrative and production

62Less-than-carload shipments are those that take up less than a full railroad car, and thus necessitate greater handling. The Pennsylvania's and New York Central's disadvantage was related to location. The Norfolk and Western and the Southern had lines through Appalachian coal country and could operate far more unit coal trains than the Pennsylvania and New York Central could.

63Daughen, J. R. and P. Binzen, The Wreck of the Penn Central, Boston: Little Brown, 1971, pp. 210-212.

expenses than a firm in which the same exchange is vertically integrated. In the production of men's underwear, for example, vertical integration of sewing and textile conversion operations in the same plant reduces coordination costs by improving scheduling of production runs.

One firm's costs may be higher than another's because of differential degrees of agency efficiency. A firm's internal administrative systems, organizational structure, or compensation system may make it more vulnerable to agency or influence costs than its competitors are. Paul Carroll's account of IBM's struggles in the late 1980s and early 1990s is full of examples of delays in decision making and excessive costs that arose from IBM's "contention system" that allowed executives within one business or functional area to critique ideas that came from outside their primary areas of responsibility.64

Agency costs often increase as the firm expands and gains more activities to coordinate internally or grows more diverse and thus creates greater conflicts in achieving coordination. The firm's agency efficiency relative to other firms can also deteriorate as its competitors adopt new and innovative internal organization that solve the same coordination problems at lower cost.

Cost Drivers, Activity-Cost Analysis, and Cost Advantage

In general, the cost of each activity in the firm's vertical chain may be influenced by a different set of cost drivers. For example, in the production of men's underwear, cumulative experience is an important cost driver in sewing but not in the more capital-intensive processes of yarn production and textile conversion. Economies of scale, by contrast, are an important cost driver in yarn production and textile conversion, but not in sewing.

Viewing firms as a collection of activities, each influenced by its own set of cost drivers, suggests that there are two major routes to achieving a cost advantage. The first is to exploit or control the key cost drivers within various activities better than competitors. The second is to fundamentally alter activities in the vertical chain. Changes in the vertical chain may be necessary due to changes in technology, which will alter the tradeoffs between outsourcing activities or performing them internally. They may also stem from changes in market conditions, which alter the prevailing costs of using the market rather than the internal organization to coordinate transactions. Altering the vertical chain is at the heart of what has come to be known as "process reengineering," a management philosophy that urges firms not to take the existing configuration of activities and processes for granted, but rather to redesign the chain of activities to maximize the value that it can deliver.65 Classic examples of this include Federal Express, which dramatically changed the economics of small-package delivery in the 1970s by using the hub-and-spoke network; Dell, which ignored conventional wisdom in the computer business by selling personal computers directly to consumers, thereby avoiding sales force and distribution expenses; and Wal-Mart, which pioneered the use of electronic computerized inventory control systems and hub-and-spoke-based logistics systems, fundamentally changing the economics of mass-merchandising.

fi4Carroll, P., Big Blues: The Unmaking of IBM, New York: Crown, 1993.

6SSee Hammer, M. and Champy, J., Reengineering the Corporation, New York: Harper-Business, 1993.

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