Experience Curve Effect

The ultimate goal of any company is to achieve competitive advantage in the marketplace. A key component in a company�s effort to achieve this advantage is to increase the experience it has in its particular field or domain. This experience can come with time, by hiring experienced staff, or by acquiring / partnering with other organizations.

While �experience� is a relatively qualitative term, its impact has been quantified: costs tend to decrease by 20-30% as a company�s �experience� in delivering a specific product or service is doubled.
The foundation for this key concept of business strategy is the Experience Curve. The Experience Curve helps to explain many issues top of mind for senior management in a company: evolution of costs associated with a product, drivers of change in product lifecycles, and variations in market share and position.

As a result, understanding what the Experience Curve is (and is not) can help management to evaluate the overall performance of the company it is running, evaluate potential behaviour of its competitors, and can play a role in determining its pricing strategy.

What is the Experience Curve?

The concept of the Experience Curve was first hypothesized by Bruce Henderson of the Boston Consulting Group in 1966, as a result of observations he made related to the semiconductor market. The concept was revised over subsequent years and has now become a universally accepted principle of business strategy. Similar to the Law of Gravitation (and other fundamental principles in Physics), the proof of the Experience Curve concept is purely empirical.

The Experience Curve is defined as: �Costs of value added activities, net of inflation, will characteristically decline 25 to 30 percent each time the total accumulated experience has been doubled.�
In other words, as a company has increased experience in producing a specific product, costs associated with that product correlate with a decrease 25-30% per year (when quantified, �experience� is usually expressed in number of cumulative units produced). A graph of this relationship would plot as a straight line in logarithmic coordinates as shown in the following figure.

 

This correlation is best thought of as a trendline, and is the result of a decrease of each element of cost associated with the product. These elements include R&D, sales expense, advertising, and overhead (in contrast to the Learning Curve analysis which only incorporates costs associated with labor and production). These elements will of course all decrease at their own specific rates (and with their own specific starting points in time), the aggregation of which will can be approximated with the Experience Curve trendline.

Of course this reduction in cost as volume increases does not happen automatically. The relationship is the result of conscious actions taken by management to actively bring down costs over time, usually in the face of competitive pressures. Thus, one can think of the Experience Curve relationship as the result of a company fully realizing its potential.

In this vein, many business concepts are essentially subsets of the Experience Curve. For example, scale effects, the learning curve, substitution effects, and critical mass of knowledge are all manifestations of (or arguably explanations for) the Experience Curve. Failure of companies to enjoy benefits brought about by the Experience Curve can be the result of any number of factors, including inadequate investment by the company in the product at hand, or mismanagement by company leadership.

The classic example used to illustrate the Experience Curve is from steam turbine generators, where the total direct cost per megawatt was shown to decrease as the total cumulative megawatts supplied increased (In the following figure - Decrease in costs associated with production of steam turbine generators trend towards a line with constant slope (on a log-log plot). Each data point represents one year.)

Implications of the Experience Curve

The Experience Curve has far reaching implications on the success of a business, its performance relative to competitors, and its pricing strategies. A market leader will usually have greater demand for its goods and services than its competition. As a result of increased production, the Experience Curve suggests its costs will decrease over time. This will allow the company to decrease its prices to levels below what is sustainable for the competition, resulting in increased competitive advantage. As the cycle repeats itself the company should continue to strengthen its overall position.

In a situation such as this there may be a desire to hold prices steady and enjoy increased margins. Past experience suggests this is not advisable as it can (almost paradoxically) threaten the market leader�s position and result in price instability. The reason for this is that by holding prices steady, the market leader gives its competition the opportunity to continue to sell the product, albeit at relatively lower margins. As the competition gains the necessary experience, it can catch up with the market leader along the experience curve and perhaps even pass it.

This would result in both a switch in relative margins, and changes in market share. Furthermore, as market share shifts, the new leader will likely begin to decrease prices to match its decreasing cost, resulting in significant changes in prices for consumers.

Some of the OIC (Organization of Islamic Conference) member countries are acutely aware of the Experience Curve phenomenon and are actively pursuing ways in which to leverage its effects. For instance, their governments are actively pursuing ways to attract knowledge from more industrialized nations in an effort to kick start or support their own industries.

A great example of this is the creation of �Free Zones� where companies are incentivized to build a presence in a host country. By doing so, governments can tap into the wealth of knowledge held by international companies, and learn from their optimized processes. Free Zones are particularly popular in GCC countries, with the UAE having set the standard. In Dubai, for example, incentives to free zone companies include 100% foreign ownership rights, 50 year renewable land leases, blanket exemption in taxes, and full repatriation rights for capital and/or profit.

This effort has proved very successful. Consider Dubai Internet City (DIC) which launched in September 2000 � it now hosts over 900 companies, has had an average annual growth rate of 53% (in terms of number of companies), and its roster includes major multi-national companies such as Apple, Cisco Systems, HP, Microsoft, and Siemens.

As companies in the Muslim world continue to compete with each other and international players, they will need to remain cognizant of Experience Curve effects. The market favours efficiency, and it is only through constant vigilance of a company�s leadership to optimize that it can be successful. Leveraging insights and advantages offered by the Experience Curve will allow companies to both appropriately design their strategic initiatives, and identify potential weaknesses within their competitors.

References

http://www.dinarstandard.com/management/Experience_Curve061507.htm