Cost Minimization and Lean

Firms should always choose production technologies and plans that are profit maximizing. One implication of choosing a profit maximizing production plan is that there is no way to produce the same amount of output at a lower total cost. Therefore, cost minimization is a necessary condition for profit maximization.

Lean production technologies aim at cost minimization, even although that objective may be unspoken. It is important to remember that the Toyota Production System (TPS), from which Lean thinking is derived, was Toyota’s response to achieving the same cost performance as mass producers.

The power of Lean comes from its ability to improve the marginal product of labour, therefore allowing a firm to produce more output with the same labour resource, or produce the same output with less labour resource. A Lean production technology also decreases a firm’s need for capital inputs by improving asset utilization and performance.

Good Lean practitioners should be able to demonstrate through an analytical framework how their interventions will impact a firm’s cost structure. The interventions should be aligned with a firm’s strategic position for competing in the marketplace. Too often, Lean interventions are couched in technical terms and the impact upon the marginal productivity of labour is never made explicit. Unless this relationship is made explicit, the issue of cost minimization will be unresolved.

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Experience Curve Revisited

Experience curve effects are most pronounced when economies of scale are achievable. As a firm moves down the experience curve and builds market share, scale effects kick in.

In our practice at ALCG, we model an industry’s experience curve using price as a proxy for cost. From the resulting curve it is easy to see the potential for lowering cost through accumulated experience.

Experience curve effects are most pronounced in new industries or new technologies. Early entrants may be able to rapidly move down the curve, building share and achieving hard-to-imitate cost positions. In mature industries or technologies, the gains to be achieved from experience effects can be much less pronounced.

Cost advantages can be built up in other ways than through the experience curve. Value chains which are tailored and configured differently than rivals can enjoy significant cost advantages. In fact, value chain design and configuration is the preferred approach to obtaining a cost advantage over rivals in a competitive industry. In such value chains, experience effects contribute to cost efficiency but are not the primary driver of cost advantage.

Prices Falling to Costs

In a competitive industry, when firms lose their market power prices must eventually fall to costs. This is because all firms become price takers – no single firm has sufficient market power to influence pricing. As prices fall to costs, profits are driven to zero and firms exit the industry seeking greater returns elsewhere. This is the dynamic of a perfectly competitive market.

In an imperfectly competitive market, failure to gain market power is a failure to compete. When a firm fails to gain market power, or relinquishes any that it has, it is prima facie evidence of competitive failure.

Market power results from offering superior and differentiated value that translates into consumer surplus. Market power is a function of advantages – the particular sets of resources and capabilities that a firm develops to create value. The more asymmetrical a firm’s advantages are from rivals, the more distinctive and powerful they are. Powerful advantages result in greater market power, and through this a firm is able to set its pricing. Asymmetric advantages are the key that unlocks market power.

Avoiding Sameness

Perfect competition – the economist’s market structure where many sellers are producing the same product, and selling it to many buyers, is an unfavourable scenario. Why? Because profits are ultimately driven to zero.

Why, then, would firms in imperfectly competitive markets want to pursue actions which would lead them closer to perfect competition? The answer is, of course, they wouldn’t (or shouldn’t).

The more firms are alike, the less reason there is for consumers to choose one seller over another. If all the firms in an industry have essentially the same product, the same quality, the same delivery, the same service, etc., then they have homogenized themselves into sameness. More than that, because of their sameness, no single seller has any ability to influence the market price for their product. Each firm thus gives up their market power and is reduced to the role of price-taking where they must accept the price consumers are willing to pay.

Sadly, many firms pursue policies and actions which lead to eroding their differences from rivals. Substituting operational excellence for strategy is one such example. Firms which are always striving to be “better than the competition” by doing the same things, only better, have fallen into this trap. Carried to its logical outcome, the blind pursuit of excellence leads to sameness, where all competitors are striving to outdo the other but yet achieving no valuable differences. Put another way, the more competition becomes symmetrical, the less profitable it becomes.

Does this mean firms should just be different for the sake of being different? Of course not. Differences must be valuable to customers, meaning that differences represent choices to be made – which customers to serve, which products to provide, which collaborators to involve, what activities to perform, what level of quality is appropriate, etc. Making choices and considering tradeoffs is the role of strategy, not operational improvement.

Competition is not about winner takes all. It is not a race where the most excellent company always wins. Competition is about building and leveraging valuable asymmetries between your firm and rivals. The more firms try to be the same, the more they set themselves up to fail.

Coherence

The policies and actions that make up a firm’s strategy should be coordinated. That is, they should fit and reinforce each other, multiplying their effect. Coherent strategies are those where a tight fit and coordination of policies and actions has been purposefully designed.

Coherence flows out of good analysis of a firm’s situation and challenges. The best business strategists are those who are adept at diagnosing problems – seeing beyond symptoms to the underlying forces and patterns. Once this insight is gained, it becomes possible to identify leverage points through which coordinated policies and actions can work.

In our strategy practice work at ALCG, we never approach strategy from a vision, mission, values and goals perspective. Such an approach is divorced from diagnosing a firm’s main problem or challenge. Usually, a vision-driven approach results in nothing more than a wish list of goals that are disconnected from reality and facts.

Coherent strategies compound a firm’s advantages. Because they are designed with fit between policy and actions in mind, they are much harder for rivals to emulate. Similarly, strategies which are incoherent are much less likely to be effective and result in competitive advantage. Coherence is a key marker for assessing the quality and depth of a firm’s strategy.

Accumulated Experience and Costs

Hardly anyone today disputes the importance of learning in firms. Learning is essentially the acquisition of knowledge, understanding and skill through experience, instruction or study. For most firms, experience will be the main pathway to learning where people gain knowledge and skill from actually performing a job. By acquiring and leveraging the learning acquired through accumulated experience, a firm can drive significant improvements in quality, work processes and routines, and products and services.

Economists and business strategists have long appreciated the impact of learning on organizational performance. The so-called experience or learning curve shows how costs fall as a function of cumulative output – as a firm acquires learning about how to better make and provide a product or service over a greater quantity of output, it can leverage that accumulated experience and learning to gain greater efficiencies and thereby reduce unit costs.

To see how this works, consider the learning curve for a firm shown below.

In this figure, as the firm accumulates output from quantity 1 (Q1) to quantity 2 (Q2), it also moves down the learning curve by accumulating experience and learning. At quantity Q1, the firm’s acquired learning results in an average unit cost of AC1. At quantity Q2, by moving down the learning curve and applying its accumulated experience, the firm is able to lower the average unit cost to AC2.

Proponents of the learning curve have generally held that, as accumulated experience doubles, unit costs can fall 15 to 20 percent. In some industries, the rate is higher. For example, in aircraft manufacture it is not uncommon for unit costs to fall by 25 percent or more by the fourth or fifth year following a new model introduction. However, it should be kept in mind that the learning curve is not uniform across all industries: the accumulated experience that a firm would acquire from making a simple stamped metal part would not be as deep, and therefore not as impactful on unit costs, as the learning that a complex microchip manufacturer, for example, might acquire.

Why do unit costs decrease with accumulated experience? Cost decreases generally result from employees gaining greater proficiency and experience in performing work, higher quality, and also from efficiencies gained by finding better ways to do things. Firms that are able to use learning to drive improved performance use less input factors of production – less labour, less materials, less machines, less facilities, etc. – resulting in lower costs.

An important feature of learning curves is their predictive ability. If a firm can calculate its learning curve, it can predict what its unit costs should be at a given cumulative volume. With this knowledge, and provided other market conditions are appropriate, a firm can set its pricing based on the future unit costs which will be attained once the firm drives down the learning curve and achieves the predicted cumulative volume.

A common mistake that some firms make when trying to estimate the economic impact of learning is to assume that economies of scale are necessary to realize a cost reduction. In the figure above, production quantity Q1 could occur over the period of a year, with the cumulative production quantity Q2 occurring over two years. Thus, there are constant returns to scale with the average cost curves being flat across the cumulative production volumes. This is different than economies of scale, where lower unit costs result from spreading a firm’s production costs over a greater production volume.

This distinction is important, because if a firm has lower unit costs due to economies of scale, then any reduction of the production volume will increase unit costs. However, if the lower unit costs are due to the effects of learning, a firm may be able to reduce its production volume without increasing its unit costs.

Firms which wish to create powerful learning economies must realize that managing the process is vital. A firm should not settle for the nominal gain on efficiency that accumulated experience usually delivers. Instead, a firm should seek to manage its way down the learning curve, leveraging every opportunity to learn from problems and gain contribution for improvement from employees. The Japanese concept of kaizen – making many small improvements to products and processes – is an example of how firms can create a powerful learning economy through effective management: kaizen results from a collaborative management system which encourages and gains a continuous learning contribution from workers that grows out of their accumulated experience.

To build sustainable learning economies, firms might also want to note the following:

  • Learning should be made firm-specific rather than task-specific. Workers who acquire specialized skill and knowledge through learning may be able to appropriate this value for themselves in the job market. In the worst case where employee turnover rates are high, the learning exits the firm with the workers and the firm never fully realizes any learning economies. When learning is firm-specific rather than task-specific, the learning of workers is tied to their employment with the firm.
  • Because it is workers, and not firms, which learn, codifying, sharing, and institutionalizing learning is critical to achieving learning economies. This is especially critical in those industries where the learning includes not only internal process or functional skill or knowledge, but includes learning about externalities to the firm such as suppliers, customers or clients, and markets.
  • Organizational policies, and union contracts, should not create learning diseconomies. For example, say a firm’s policy is to promote experienced employees to fill vacancies at higher levels. If these promotions cause a spill-over effect at lower levels where employee mobility among the resulting job openings is increased, the firm may find that its overall productivity is eroded by employees having to constantly relearn tasks that co-workers had already mastered.
  • Moving down the learning curve does not necessarily confer a competitive advantage. While a firm can use “penetration pricing” to acquire market share, whereby it prices according to the lower cost structure it expects to achieve by driving down the learning curve, this does not mean that competitors cannot either pre-empt the move by price matching, or follow the firm down the curve. This is especially true in those markets where the price elasticity of demand is high (elastic demand) and market shares are unstable.