3.7 Tools: Scale Economies and Learning Effects

Scale economiesThee cost advantages that come with larger-scale production. For example, your supplier can spread fixed costs out over a larger number of products, reducing the cost per unit. are the cost advantages that come with larger-scale production. For example, your supplier can spread fixed costs out over a larger number of products, reducing the cost per unit. Operating efficiencies also tend to improve as scale increases. Specifically, your supplier can invest in more automated processes and better technology, driving costs down. Similarly, with larger volumes, your supplier can also buy materials in larger quantities—lowering its cost of materials. Further, your supplier can justify hiring more highly skilled workers and improve its training programs. As worker skills and confidence improve, they spend less time hesitating, experimenting, or making mistakes. The result: Labor efficiency improves and labor costs per unit go down. These cost savings add up to bigger discounts for you.

The learning curveThe idea that the time it takes to perform a task decreases as you gain experience with the task; that is, you learn as you do the same thing over and over again. is based on the simple idea that the time it takes to perform a task decreases as you gain experience with the task; that is, you learn as you do the same thing over and over again. You’ve probably noticed the power of learning many times in everyday tasks such as baking an apple pie or learning to drive. The first time you baked an apple pie, you likely spent a large percent of the total time reading the instructions and measuring the ingredients so you could get the crust just right. As you gained more experience, you became less reliant on meticulously following the recipe. The result: Baking a delicious desert became easier and you spent less time in the kitchen. Simple experiences like learning to bake teach three important facts about the experience curve.

1. Labor Content Matters: The more labor intensive the process—e.g., baking a cake from scratch versus from a box—the greater your opportunity to lower costs through learning.

2. Complexity Matters: The more complex the process, the greater your opportunity to learn. That is, you don’t need a lot of practice to master a simple recipe.

3. Diminishing Returns Exist: Most of your learning takes place in your early efforts. In other words, there is a limit to learning.

Mathematically, a learning curve expresses the cost relationship between the number of items produced and the cost per item. Every time total production volume doubles, the cost of the nth item produced decreases by the rate at which you learn. This relationship between production volume and learning has been formalized by the following equation:

• T_n=T₁n^b

• where

• T_n = time required to produce the n^th unit

• T₁= time required to produce first unit

• n = cumulative number of units produced

• b = ln(rate of learning)/ln(2) with the rate of learning expressed as a decimal.

Let’s walk through an example. Imagine, for example, that every time your supplier doubles production, the supplier reduces the labor content by 20%. The supplier’s learning rate is 20%. The process would be said to be operating on an 80% learning curve (100% - 20% = 80%). If the first unit produced requires 148.96 hours, the second unit will require 119.17 hours (i.e., .8 × 148.96 = 119.17). The fourth unit produced will require 95.34 hours (i.e., .8 × 119.17 = 95.34). How much time would be required for the 250th unit?

If your supplier’s labor costs were $20 per hour, the labor cost for the first unit would have been $2,979.32. The labor costs for 250^th unit would have dropped to $503.60—that is an 83% reduction in labor cost! The bottom line: When learning effects are important—e.g., you are ordering a custom or a newly introduced product—increasing the number of items you buy enables your supplier to leverage learning to lower costs. Anything you can do to accelerate the rate of learning will speed the cost savings.