Analysis of the Steps Towards Cost Leadership - Essay Example

COST-LEADERSHIP MAPPING THE PRODUCTION PHASE CHECKLIST Analysis of the Steps Towards Cost Leadership STEP Distinguish between Economies of Scale, Economies of Size and Economies of Scope within the production process. Economies of scale refers to improved efficiencies, denoted by reduced costs per unit by increasing volume of production. In this sense, economies of scale result when fixed costs are spread over more and more units of production, resulting in a lower total cost per unit. To illustrate, the production of computer software entails a great deal of research cost from concept generation to commercial production. All these costs would be sunk at the time of actual production and would be in the nature of fixed cost. However, the cost of producing one unit of product containing the new software is minimal, almost nil, because it would comprise only of the material cost of the medium. For other industries, it is possible to attain economies of scale when the increased volume enables the assignment of resources more efficiently. This is particularly true of costs associated with manpower specialisation, where an increase in volume allows for individuals to be assigned specialised tasks, thus streamlining production methods. This results in improving rate of production without increasing the number of workers. Thus, increasing economies of scale occurs when the marginal increase in a factor of production is less than the marginal increase in the corresponding quantity of products produced. Economies of scope is similar to economies of scale because it aims to increase production faster than the attendant increase in costs. The difference lies in the number of products by which to attain this. Economies of scope seeks to reduce per unit total cost by diversifying the products a firm makes and sells. By increasing the number of product lines and extending the use of inputs (manpower and machinery) over the alternative products, the overall cost per unit of each product line is reduced because of the sharing of fixed costs among the product lines. For instance, Dunkin Donuts’ main product line is its number of variously flavoured donuts; somewhere along the line the firm decided to produce Munchkins, the bite-sized versions of the same flavours as the donuts, they tapped a new type of market demand which preferred the smaller versions. From the production aspect, the same machines and manpower were used to make the new product, thus spreading fixed costs over two product lines. Thus, increasing economies of scope occurs when the sum of the marginal increases in the cost of producing one additional unit in all the product lines is less than the increase in the marginal cost of each product line taken separately. Economies of size is even more similar to economies of scale than is economies of scope, and many authors even refer to economies of size and of scale alternately. This is because the scale of production is often associated with the size of the production facility. For instance, “economies of size” is described as the result of “spreading fixed costs over a large number of units of production” (Hofstrand, 2009). Economies of size, however, may be differentiated from economies of scale by the significant magnitude of fixed costs compared to variable costs as determinative of the quantity produced. In a high fixed cost business, reduction in total cost per unit of production is proportionately high for incremental increases in production, but in low fixed cost business where variable costs form a higher proportion of per unit costs, increase in production units will impact less on the decrease per unit cost of production. In these instances, “economies of size” becomes a more appropriate term due to the more significant relationship of the size of the brick-and-mortar assets to the quantity of production. The economies of size are more dramatic for the high fixed cost business (Hofstrand, 2009). STEP 2: Focus on increasing average productivity of labour APL. How? Note that APL = w/AVC, where w = wage proxy and AVC = average variable costs. In the short run, given a two factor production function, one factor, capital, is held constant and the other, labor, is allowed to vary. Given this, the variable cost is that attributable to labor, and the average variable cost would be equal to the total variable cost divided by the number of units produced. Quoted on a per person (per unit labor) basis, this would come out to be the wage of one worker divided by the number of units produced per worker, otherwise known as the average productivity of labor. Thus, average variable cost would be equal to the wage rate divided by average productivity of labor. Transporting terms, this would resolve into the average productivity of labour being equal to the proportion of incremental wage to average variable costs. Therefore, to increase average productivity of labour (denoted by APL), assuming capital is held constant, the firm needs to either increase the wage rates relative to average variable costs, or decrease the average variable costs relative to wage rates. Other than the interpretation based on the mathematical formula, which is not entirely operative, the practical measures by which labour productivity can be increased entails any means by which each person in the workforce may be enable to produce more products on the average. Measures that address the qualitative aspects such as creativity, innovation, teamwork and team organization, streamlined production techniques, and economical product design that would require fewer assembly steps, among others, are possible methods by which average labour productivity can be enhanced. One classic example was the invention of assembly line method of production by Henry Ford, in the production of the Model T, through the use of the scientific method in production. Instead of each car being manufactured from scratched by one person, the assembly line involved breaking down tasks into a few steps so that one person did one step repeatedly, and the assembly was passed down the line to another person for another set of tasks. In this way, cars were manufactured in a shorter amount of time, were standardised as to quality, and the average productivity of each worker increased significantly. At the present, possible improvements in average labour productivity may be realised through the employment of techniques of Japanese management (JM), which has proven quite effective in plants that have adapted techniques of JM appropriate to their systems. STEP 3: Normalise the wage structure: let w = 1. In other words, offer the workers incentives or bonus payments as productivity increases, revisit the organisational structure and consider the production process as a nexus of contracts. The agent of the production process is the firm, and legally the firm is a juridical person distinct from the actual persons that comprise it. It is a creation of law, capable of entering into legal relations and is thus a moral person. However, several economic theories of the firm tends to ignore the existence of the firm as organisation, and instead describes the latter as “a nexust of contracts” (Jensen and Meckling, 1976). According to Chassagnon (2008), the contractualist view renders the firm as legal fiction, that only the noun “firm” exists, and the firm or organisation is a simple abstraction without an existence. He states that the firm as a nexus of contracts is “not suitable to disclose its real nature. The main step for theorizing the firm is to recognise it as…a cohesive and durable whole of integrated human and non-human constituents that is other than a sum of its parts and members” (p.1). This writer tends to agree with Chassagnon’s point of view. The organisation is not merely comprised of the legal devises of contracts and ownership, but it extends to the possession by an entity – the firm – of power against the other entity – in this case, the worker or labourer – upon which it may exert pressure to comply with the wishes of the dominant power. On the other hand, the existence of labour unions, also a same legal creation, has come about to equalize the negotiating power between labour and firm. It is due to organised labour and the social stewardship function of the state that laws ensuring minimum wages have been promulgated. While workers incentives and bonus payments anchored on productivity may be welcome, it may not replace the existing wage structure that guarantees workers a basic pay that is delinked from productivity. While managerial economics deals with labour as a mere factor of production, in actuality the human aspect of labour demands consideration of humane levels of subsistence and welfare, and thus command the State’s protection and intervention in negotiating with the firm on the matter of wages. STEP 4: Demarcate between excess capacity (idle capacity) and reserve capacity (installed capacity), aware that excess capacity can occur if the product is not sufficiently differentiated fast enough in the market to capture market sales. At the point of production in phase 1 ensure sufficient installed capacity to meet demand in later phases of production. Excess capacity is defined as “output volume at which marginal cost is less than the average cost and, hence, where it is possible to decrease average cost by increasing the output” (Business Dictionary.com., 2009). In other words, excess capacity is that portion of a firm’s productive capacity that may still be exploited as it is still within the area of increasing economies of scale. By this definition, excess capacity may be measured by the amount of additional output that will reduce the average cost to a minimum. On the other hand, reserve capacity is capacity in excess of the maximum peak demand or load. Alternatively, it is called installed capacity, which is production capacity of a plant based either on its rated capacity or actual (practically determined) capacity (Business Dictionary.com, 2009). It is true that excess capacity is likely to occur if the product is not sufficiently differentiated. When the product is seen as similar to other products in the market such that it is easily substitutable by others, a slight difference in price will easily take market share away from the firm that has failed to differentiate because the only criterion that will sway customer decision will be relative price levels. The firm will be unable to maintain its market share, the corresponding drop in sales volume will cause the company to reduce production volumes, and excess or idle capacity shall be created. Idle capacity is not desirable, and it is a sign that the company is not meeting its targeted volumes. The excess capacity was intended to be used for the firm to realise economies of scale. On the other hand, installed capacity is capacity in-reserve – that is, during the early phases of production reserve capacity is still not intended to be utilized; however, towards the second phase of production, where the firm begins to realise added sources of efficiencies that would shift the point of constant returns to scale farther up in volume, then the reserve capacity will be used to yield added production volume. As an example, in the production of computers, the first releases of a new model may command a prohibitive price and thus the relatively low demand may warrant only a low volume of production. As technology progresses, the price of the new model may decrease and demand would increase, warranting a higher production volume. It is during the progression through the phases of production that the reserve capacity designed into the production system will be employed. STEP 5: Control more of the production costs to allow more costs to come under control during the production process. Hedge positions on material inputs, minimise exchange rate risks, workers on fix-wage fix-term contracts with incentives per flexible manufacturing. Many of the other factors of production are prone to price and supply uncertainties that may unnecessarily raise the costs of production, subsequently eroding profit margins or forcing the firm to raise product prices that would strain its competitiveness. The ebb and flow in the availability of raw materials necessary for production, or foreign currencies needed to pay for imports denominated in these currencies, may favourably lower costs if these materials and currencies are sufficient or abundant, but would raise variable costs if they experience a shortage. This is particularly true of agricultural and mining industrial products and commodities used for food and beverage production. Hedging against unexpected price changes of materials necessary for production or for currencies needed to finance imports is an important strategy if such materials are prone to price volatilities due to irregularities and uncertainties in volume availabilities. For instance, the price and availability of quantities of gold would be important to a jeweller, or oranges to an orange juice processor and bottler. For imports denominated in euros, in a regime where the euro is strengthening against the dollar, additional costs in purchasing euros may translate to higher materials costs in terms of dollars. In order to control the costs of inputs, the firm may take out forward contracts or futures on these commodities that would secure their prices into the uncertain future. In a falling market such contracts may constitute additional costs because spot prices may be lower than the contracted prices, but in a market of rising prices, the hedge may prove invaluable. It may also be possible to entice workers to voluntarily relinquish their fixed term, fixed wage contracts for higher paying productivity-linked payment schemes, although as said previously these should not be seen to be exploitative of the worker. The social aspect of wages is an important issue to consider as human being are more than just “resources” that are human. References Antonelli, C 2003 The Interdependence Between Transaction, Coordination, Production and the Generation of Knowledge: A Model of Governance. Unpublished thesis. Dipartimento di Economia, Universita’ di Torino Chassagnon, V 2008 The Network-Firm as a Single Real Entity: Beyond the Aggregate of Distinct Legal Entities. Entrepreneurship and Innovation – Organizations, Institutions, Systems and Regions. Copenhagen, CBS, Denmark. ____. Excess Capacity. Business Dictionary.com. Accessed 15 December 2009 from http://www.businessdictionary.com/definition/excess-capacity.html Hofstrand, D 2009 Economies of Size. Accessed 15 December 2009 from http://www.extension.iastate.edu/agdm/wholefarm/html/c5-206.html Jensen, M & Meckling, W 1976 Theory of the Firm: Managerial Behaviour, Agency Costs, and Ownership Structure. Journal of Financial Economics, vol. 3, no. 2, pp 305-360. Production Stages, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2009. Accessed 17 December 2009 from http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=production+stages Riley, G 2006 Economies and Diseconomies of Scale. Markets and Market Systems. Accessed 15 December 2009 from http://tutor2u.net/economics/revision-notes/a2-micro-economies-diseconomies-of-scale.html Read More