Experience Curve Concept

Experience shows that practice makes perfect. It is common knowledge that beginners are slow and clumsy and that with practice they generally improve to the point where they reach their own permanent level of skill. Anyone with business experience knows that the initial period of a new venture or expansion into a new area is frequently not immediately profitable. Many factors, such as making a product name known to potential customers, are often cited as reasons for this nonprofitability. In brief, even the most unsophisticated businessperson acknowledges that experience and learning lead to improvement. Unfortunately, the significance of experience is realized only in abstract terms. For example, managers in a new and unprofitable situation tend to think of experience in vague terms without ever analyzing it in terms of cost. This statement applies to all functions of a business where cost improvements are commonly sought— except for production management.

As growth continues, we anticipate greater efficiency and more productive output. But how much improvement can one reasonably expect? Generally, management makes an arbitrary decision to ascertain what level of output reflects the optimum level. Obviously, in the great majority of situations, this decision is primarily based on pure conjecture. Ideally, however, one should be able to use historical data to predict cost/volume relationships and learning patterns. Many companies have, in fact, developed their own learning curves—but only in the areas of production or manufacturing where tangible data are readily available and most variables can be quantified.

Several years ago the Boston Consulting Group observed that the concept of experience is not limited to production alone. The experience curve concept embraces almost all cost areas of business.

Unlike the well-known "learning curve" and "progress function," the experience curve effect is observed to encompass all costs—capital, administrative, research and marketing—and to have transferred impact from technological displacements and product evolution.1

Historical Perspective

Implications

The experience effect was first observed in the aircraft industry. Because the expense incurred in building the first unit is exceptionally high in this industry, any reduction in the cost of manufacturing succeeding units is readily apparent and becomes extremely pertinent in any management decision regarding future production. For example, it has been observed that an "80 percent air frame curve" could be developed for the manufacture of airplanes. This curve depicts a 20 percent improvement every time production doubles (i.e., to produce the fourth unit requires 80 percent of the time needed to produce the second unit, and so on).2 Studies of the aircraft industry suggest that this rate of improvement seems to prevail consistently over the range of production under study; hence, the label experience is applied to the curve.

Although the significance of the experience curve concept is corporate-wide, it bears most heavily on the setting of marketing objectives and the pricing decision. As already mentioned, according to the experience curve concept, all costs go down as experience increases. Thus, if a company acquired a higher market share, its costs would decline, enabling it to reduce prices. The lowering of prices would enable the company to acquire a still higher market share. This process is unending as long as the market continues to grow. But as a matter of strategy, while aiming at a dominant position in the industry, the company may be wise to stop short of raising the eyebrows of the Antitrust Division of the U.S. Department of Justice.

During the growth phase, a company keeps making the desired level of profit, but in order to provide for its growth, a company needs to reinvest profits. In fact, further resources might need to be diverted from elsewhere to support such growth. Once the growth comes to an end, the product makes available huge cash throw-offs that can be invested in a new product.

The Boston Consulting Group claims that, in the case of a second product, the accumulated experience of the first product should provide an extra advantage to the firm in reducing costs. However, experience is transferable only imperfectly. There is a transfer effect between identical products in different locations, but the transfer effect between different products occurs only if the products are somewhat the same (i.e., in the same family). This is true, for instance, in the case of the marketing cost component of two products distributed through the same trade channel. Even in this case, however, the loss of buyer "franchise" can result in some lack of experience transferability. Exhibit 12-1 is a diagram of the implications of the experience curve concept.

Some of the Boston Consulting Group's claims about the experience effect are hard to substantiate. In fact, until enough empirical studies have been done on the subject, many claims may even be disputed.3 For example, conventional wisdom holds that market share drives profitability. Certainly, in some industries, such as chemicals, paper, and steel, market share and profitability are inextricably linked. But the profitability of premium brands—brands that sell for 25% to 30% more than private-label brands—in 40 categories of consumer goods, the market share alone did not drive profitability.

Instead, both market share and the nature of the category, or product market, in which the brand competes, drive a brand's profitability. A brand's relative market share has a different impact on profitability depending on whether the overall category is dominated by premium brands or by value brands. If a category is composed largely of premium brands, then most of the brands in the category are—or should be—quite profitable. If the category is composed mostly of value and private-label brands, then returns will be lower across the board.4

To summarize, the experience curve concept leads to the conclusion that all producers must achieve and maintain the full cost-reduction potential of their experience gains if they hope to survive. Furthermore, the experience framework has implications for strategy development, as shown in Exhibit 12-2. The appendix at the end of this chapter describes construction of experience curves, showing how the relationship between costs and accumulated experience can be empirically developed.

Application to Marketing

The application of the experience curve concept to marketing requires sorting out various marketing costs and projecting their behavior for different sales volumes. It is hoped that the analyses will show a close relationship between increases in cumulative sales volume and declines in costs. The widening gap between volume and costs establishes the company's flexibility in cutting prices in order to gain higher market share.

Continue reading here: Profit Impact Of Marketing Strategy Pims

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