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The Experience Curve

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:

The 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 a 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.

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.

The Value Chain

To better understand the activities through which a firm develops a competitive advantage and
creates shareholder value, it is useful to separate the business system into a series of value-
generating activities referred to as the value chain. In his 1985 book Competitive Advantage,
Michael Porter introduced a generic value chain model that comprises a sequence of activities found
to be common to a wide range of firms. Porter identified primary and support activities as shown in
the following diagram:

Porter's Generic Value Chain


M
A
Marketing
Inbound Outbound R
> Operations > > & > Service >
Logistics Logistics G
Sales
I
N

Firm Infrastructure
HR Management
Technology Development
Procurement

The goal of these activities is to offer the customer a level of value that exceeds the cost of the
activities, thereby resulting in a profit margin.
The primary value chain activities are:
• Inbound Logistics: the receiving and warehousing of raw materials, and their distribution to
manufacturing as they are required.
• Operations: the processes of transforming inputs into finished products and services.
• Outbound Logistics: the warehousing and distribution of finished goods.
• Marketing & Sales: the identification of customer needs and the generation of sales.
• Service: the support of customers after the products and services are sold to them.
These primary activities are supported by:
• The infrastructure of the firm: organizational structure, control systems, company culture,
etc.
• Human resource management: employee recruiting, hiring, training, development, and
compensation.
• Technology development: technologies to support value-creating activities.
• Procurement: purchasing inputs such as materials, supplies, and equipment.
The firm's margin or profit then depends on its effectiveness in performing these activities
efficiently, so that the amount that the customer is willing to pay for the products exceeds the cost of
the activities in the value chain. It is in these activities that a firm has the opportunity to generate
superior value. A competitive advantage may be achieved by reconfiguring the value chain to
provide lower cost or better differentiation.
The value chain model is a useful analysis tool for defining a firm's core competencies and the
activities in which it can pursue a competitive advantage as follows:
• Cost advantage: by better understanding costs and squeezing them out of the value-adding
activities.
• Differentiation: by focusing on those activities associated with core competencies and
capabilities in order to perform them better than do competitors.

The Value Chain System (Industry Value Chain)


A firm's value chain is part of a larger system that includes the value chains of upstream suppliers
and downstream channels and customers. Porter calls this series of value chains the value system,
shown conceptually below:

The Value System


Supplier Channel Buyer
Firm
... > Value > > Value > Value
Value Chain
Chain Chain Chain

Linkages exist not only in a firm's value chain, but also between value chains. While a firm
exhibiting a high degree of vertical integration is poised to better coordinate upstream and
downstream activities, a firm having a lesser degree of vertical integration nonetheless can forge
agreements with suppliers and channel partners to achieve better coordination. For example, an auto
manufacturer may have its suppliers set up facilities in close proximity in order to minimize
transport costs and reduce parts inventories. Clearly, a firm's success in developing and sustaining a
competitive advantage depends not only on its own value chain, but on its ability to manage the
value system of which it is a part.

The BCG Growth-Share Matrix

The BCG Growth-Share Matrix is a portfolio planning model developed by Bruce Henderson of the
Boston Consulting Group in the early 1970's. It is based on the observation that a company's
business units can be classified into four categories based on combinations of market growth and
market share relative to the largest competitor, hence the name "growth-share". Market growth
serves as a proxy for industry attractiveness, and relative market share serves as a proxy for
competitive advantage. The growth-share matrix thus maps the business unit positions within these
two important determinants of profitability.
BCG Growth-Share Matrix

This framework assumes that an increase in relative market share will result in an increase in the
generation of cash. This assumption often is true because of the experience curve; increased relative
market share implies that the firm is moving forward on the experience curve relative to its
competitors, thus developing a cost advantage. A second assumption is that a growing market
requires investment in assets to increase capacity and therefore results in the consumption of cash.
Thus the position of a business on the growth-share matrix provides an indication of its cash
generation and its cash consumption.
Henderson reasoned that the cash required by rapidly growing business units could be obtained
from the firm's other business units that were at a more mature stage and generating significant
cash. By investing to become the market share leader in a rapidly growing market, the business unit
could move along the experience curve and develop a cost advantage. From this reasoning, the
BCG Growth-Share Matrix was born.
The four categories are:
• Dogs - Dogs have low market share and a low growth rate and thus neither generate nor
consume a large amount of cash. However, dogs are cash traps because of the money tied up
in a business that has little potential. Such businesses are candidates for divestiture.
• Question marks - Question marks are growing rapidly and thus consume large amounts of
cash, but because they have low market shares they do not generate much cash. The result is
a large net cash comsumption. A question mark (also known as a "problem child") has the
potential to gain market share and become a star, and eventually a cash cow when the market
growth slows. If the question mark does not succeed in becoming the market leader, then
after perhaps years of cash consumption it will degenerate into a dog when the market
growth declines. Question marks must be analyzed carefully in order to determine whether
they are worth the investment required to grow market share.
• Stars - Stars generate large amounts of cash because of their strong relative market share,
but also consume large amounts of cash because of their high growth rate; therefore the cash
in each direction approximately nets out. If a star can maintain its large market share, it will
become a cash cow when the market growth rate declines. The portfolio of a diversified
company always should have stars that will become the next cash cows and ensure future
cash generation.
• Cash cows - As leaders in a mature market, cash cows exhibit a return on assets that is
greater than the market growth rate, and thus generate more cash than they consume. Such
business units should be "milked", extracting the profits and investing as little cash as
possible. Cash cows provide the cash required to turn question marks into market leaders, to
cover the administrative costs of the company, to fund research and development, to service
the corporate debt, and to pay dividends to shareholders. Because the cash cow generates a
relatively stable cash flow, its value can be determined with reasonable accuracy by
calculating the present value of its cash stream using a discounted cash flow analysis.
Under the growth-share matrix model, as an industry matures and its growth rate declines, a
business unit will become either a cash cow or a dog, determined soley by whether it had become
the market leader during the period of high growth.
While originally developed as a model for resource allocation among the various business units in a
corporation, the growth-share matrix also can be used for resource allocation among products
within a single business unit. Its simplicity is its strength - the relative positions of the firm's entire
business portfolio can be displayed in a single diagram.

Limitations
The growth-share matrix once was used widely, but has since faded from popularity as more
comprehensive models have been developed. Some of its weaknesses are:
• Market growth rate is only one factor in industry attractiveness, and relative market share is
only one factor in competitive advantage. The growth-share matrix overlooks many other
factors in these two important determinants of profitability.
• The framework assumes that each business unit is independent of the others. In some cases,
a business unit that is a "dog" may be helping other business units gain a competitive
advantage.
• The matrix depends heavily upon the breadth of the definition of the market. A business unit
may dominate its small niche, but have very low market share in the overall industry. In such
a case, the definition of the market can make the difference between a dog and a cash cow.
While its importance has diminished, the BCG matrix still can serve as a simple tool for viewing a
corporation's business portfolio at a glance, and may serve as a starting point for discussing
resource allocation among strategic business units.