Management Strategy/Cost Advantage

There are many sources of cost advantage:

Economies of Learning
Caused by an increase of dexterity and a continuous improvement of routines.

The experience curve
The cost of the nth unit of production is equal to the cost of the first unit of production times the cumulative volume of production to the negative of the elasticity of cost with regard to output.

C[n] = C[1]*(n^-a)

In laTex: $$Cn = C1*(n^-a) $$

Examples of experience curve: Honda, Harley Davidson.

Note that costs do not drop automatically as production increases, but rather that costs must be brought down by management's learning process.

Economies of Scale
Caused by indivisibility and specialization.

Economies of scale start benefiting an organisation when the volumes of transactions/production go up. The increase in profits as number of transactions/production go up because certain fixed costs are incurred irrespective of whether the volume is one or a hundred. For Example a Barber giving haircuts has to pay a fixed rental for his premises on a monthly basis whether he gives five customers a haircut or a hundred.

Let us assume that his rental is US $ 100 per month and he charges $ 10 for each haircut. Let us assume that other fixed costs like his salary, electricity etc.. are US $ 50 and his variable cost is negligible.

If he gets 10 customers a month he will incur a loss of US $ 50.

Revenue 10 x US $ 10 = US $ 100 Cost 150 US $.

Net Loss US $ 50.

If he gets 15 customers a month he will Break even.

Revenue 15 x US $ 10 = US $ 150 Cost 150 US $.

No Profit/No Loss.

If he gets 20 customers a month he will make a profit of.

Revenue 20 x US $ 10 = US $ 200 Cost 150 US $.

Net Profit US $ 50.

If he gets 25 customers a month he will make a profit of.

Revenue 25 x US $ 10 = US $ 250 Cost 150 US $.

Net Profit US $ 100.

Thus an addition of 5 customers has grown profits by 100 %.

Thus the more the volumes grow the profit will grow exponentially initially and then slowly grow at a constant pace. This is the power of Economies of Scale.

However if the premises is able to handle a fixed limit of 100 customers with the 101st customer requiring the renting of another premises with rental of US $ 100, the total profit will reduce from the 101st customer onwards till the 110th customer.

If he gets 100 customers a month he will make a profit of.

Revenue 100 x US $ 10 = US $ 1000 Cost 150 US $.

Net Profit US $ 850.

If he gets 101 customers a month he will make a profit of.

Revenue 101 x US $ 10 = US $ 1010 Cost 250 US $. (Increase rental of 100 $)

Net Profit US $ 760.

Thus an addition of 1 customer has decreased profits by US $ 90.

This is called diseconomies of scale.

The same analogy can be used for the other input factors like employees, furniture etc..

Production Techniques
Caused by automatization, better use of raw materials, and better quality.

Product design
Caused by facilitating automation and reducing use of materials.

Input costs
Caused by better locations, ownership of sources, bargaining power, and good relations with suppliers.

Capacity utilization
Caused by a ratio of fixed-to-variable-costs and because of the costs of increasing or reducing capacity.

Managerial Efficiency
Caused by a desire to be efficient.