Pathways to Efficiency

A firm may have lower average costs than rivals because it has been able to realize production process efficiencies that these rivals have not yet attained. Thus, a firm may use less inputs than its competitors to produce a given level of output, or a firm’s production technology may use lower-priced inputs than those used by its competitors.

Realizing production process efficiencies is often a product of learning – this type of change is epitomized by the so-called learning curve, where a firm’s efficiency is a function of cumulative output and learning. Improving production processes through learning by doing is a powerful pathway to greater efficiency and lower average costs.

However, moving down a learning curve through learning by doing is not the only pathway to greater efficiency and lower costs. Other pathways involve adjusting a firm’s market scope, discretionary cost control, and superior coordination and execution of customer transactions.

A firm may lower its average costs by scoping or focusing its activities on selected segments in the market. By targeting only one or a few market segments, a firm can achieve lower costs by purposefully choosing to eliminate certain activities which add little or no value to the targeted customers. Thus, the wisely scoped firm is able to configure its value chain in such a way that it operates at a lower cost than that of rivals who choose to serve the broader market.

Discretionary cost control is another way for a firm to lower its average costs. A firm may choose to avoid incurring some costs that rivals are bearing by avoiding the activities that result in these costs. Thus, a firm may incur lower marketing costs than rivals by emphasizing online marketing and social media strategy rather than national advertising in more expensive media such as print and TV.

Interactions and transactions with customers and suppliers also drive a firm’s costs by consuming resources unnecessarily. Information asymmetries are often at the root of high transaction costs in customer and supplier-facing processes. Addressing the root cause of these asymmetries can often reduce transaction costs considerably. A firm that conducts a supplier exchange via the market may also have higher transaction costs than a firm in which the same exchange is vertically integrated. In this case, vertically integrating the supply function within the firm’s boundaries will result in lower costs.

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