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The Breakthrough Imperative
How The Best Managers Get Outstanding Results

by Mark Gottfredson and Steve Schaubert

Examine and Manage Every Major Cost Element

Any seasoned manager knows how to cut some costs; he or she has probably had a lot of practice in recent years. But even veteran executives occasionally fall into the trap of thinking that some costs are beyond their control. What if hourly labor costs are determined by the terms of a union contract? What if the company has invested heavily in in-house production facilities, only to find that it can’t compete with outside vendors? Cost structures like these take time to change, but managing to the experience curve means examining every single cost element, including labor and procurement costs, and attacking them all with equal vigor. Indeed, it often entails a different way of thinking about the business. All costs must be seen as variable in the long run. As one CEO told us: “The world is moving too quickly for old distinctions and definitions to apply.”

Focus on productivity.

Managers in autos, steel, and other old-line manufacturing industries often have a ready scapegoat for their companies’ failure in the past to reduce costs commensurate with the experience curve. Union-negotiated contracts, they say, forced wages and benefits up every year. The contracts made it difficult to reduce headcount, to reorganize production systems, even to alter job descriptions. Executives of the so-called legacy airlines sometimes offer the same reason for their companies’ poor profit performance.

It’s true that these companies allowed their labor costs to rise beyond competitive levels. But nowhere is it written that unionization has to lead to this result. Japanese auto and steel workers are heavily unionized and enjoy wages comparable with those of American workers, yet their employers have lower costs than U.S. producers. Southwest Airlines employees are also heavily unionized, and receive overall compensation in line with (and in some cases better than) industry averages. In all these cases the unions realized that their own and their members’ well-being depended on the economic health of their employers, and so were willing to tie wage gains to gains in productivity or profitability. They were willing to put their shoulders to the wheel -- to figure out how the companies could reduce costs every year, make the production of goods or services more efficient, and grow. Today, the results are visible for all to see. Carl Kuwitzky, president of the Southwest Airlines Pilots Association (SWAPA), was recently quoted as saying, “We look forward to continuing the positive working relationship we have with our Company in order to provide excellent service for our passengers, encourage the team spirit we have with our fellow employee groups and assure growth for the Company and in turn our pilot group.” Such a sentiment would have been hard to find among union leaders at other airlines in the recent past.

“The lesson for a new CEO,” says Warren Knowlton of Morgan Crucible, “is that he or she must find ways to create this type of win-win. You have to start by understanding what is important to your customer and to your people from the very beginning.”

Analyze your suppliers’ experience curves.

Sourcing of goods and services is much more important strategically today than it was in the past. Most companies these days buy a large fraction of the materials, components, and services that they use in their business, and they are likely to be revisiting the make/buy decision regularly for those that they do not already outsource. Many companies are developing partnerships with suppliers that provide them with capabilities they cannot easily develop on their own. The experience curve -- different for every industry and for every company within that industry -- should inform all such decisions. If you are not yet outsourcing a particular item, is your internal production a significant portion of overall production of that item? Can you come down the experience curve faster than a potential supplier? Is there a specialized producer or service provider -- UPS in logistics, for example -- that has developed capabilities far beyond your own, and that will come down the curve faster? For goods and services that you do outsource, where are your vendors on the experience curve, and are you choosing them according to that criterion? Would you rather buy from a small supplier that gives a lowball bid in hopes of ramping up volume, or from a large supplier that will come down the experience curve more quickly? Are you taking actions that will help your suppliers lower their own costs and therefore ultimately benefit you?

Make/buy decisions can be costly to change, because companies often have big investments in in-house production facilities. But getting those decisions wrong can have dire consequences. Look at Polaroid. The conventional wisdom about Polaroid is that it somehow missed the impending revolution in digital photography. But that is wrong. The company’s extensive research and development in the field had allowed it to bring out the professional-grade camera called the PDC-2000 in 1996, when the market was still young. Seeing that camera’s apparent success, new CEO Gary DiCamillo asked the company’s Consumer Imaging division to come up with a plan for a digital camera priced for consumers. He knew that two-megapixel cameras were already selling for $1,200, so he set an aggressive target for his product-development staff: a three-megapixel model that could be sold for $800. But the market moved faster than Polaroid could. Before the company could produce that camera, competitive models with even more functionality were selling for half the price. Instead of bringing out its own product, Polaroid ended up selling a Chinese-made camera under the Polaroid brand.

Polaroid’s leadership team knew photography, and they knew instant photography better than anybody. Its in-house research-and-development teams could boast a proud history of pathbreaking products. But the rules were different in digital. No longer could Polaroid (or anybody else) sell cameras at low margins and make up the difference by selling or processing film. No longer would the relevant experience curve be that of photography -- companies in digital photography were now on the consumer-electronics curve. In consumer electronics, growth rates were high for many different products, and prices were dropping rapidly because accumulated experience was doubling so quickly. No longer could Polaroid (or any other company) expect to manufacture all of a camera’s components itself. Chip makers, battery manufacturers, soft ware developers -- all would be on experience curves of their own, producing better and cheaper components faster than any integrated manufacturer could. So long as it relied only on in-house product development for most of its components -- the very capability that had led to past successes -- Polaroid would always be behind the curve.

Set future price and cost targets according to the experience curve -- and expect competitors to do the same.

If your costs are higher than your competitors’ costs, you might be tempted to use your competitors as a benchmark and aim to equal their costs. That may have been what Polaroid was trying to do. The company underestimated the speed with which competitors would be managing down experience curves of their own. By the time it got to where it wanted to be, its competitors’ costs were lower still.

Ignoring this lesson can lead general managers to conclude that their competitors are colluding, dumping goods, or otherwise acting irrationally. Take the famous case of Allis-Chalmers, a big old-line industrial company then based in Milwaukee. In 1946, Allis was a relatively new entrant in the business of manufacturing steam turbines for generating electricity. Company executives carefully studied the industry leaders, Westinghouse and General Electric. They concluded that the two companies were producing turbines that cost about $330 per megawatt of electricity. Allis-Chalmers set its cost target at just that: about $330 per megawatt. By 1963 the company had moved down its experience curve to just that point.

All along, however, General Electric and Westinghouse had been undercutting Allis’s prices. The Milwaukee  company’s leaders were outraged; they concluded that the companies must be colluding to divvy up the market and drive Allis out of the business. They complained to the Federal Trade Commission that GE and Westinghouse were fixing prices (“predatory pricing”), with just such an aim in mind. They didn’t believe their competitors could be making money at those prices.

Of course, nothing of the kind was occurring. GE and Westinghouse had simply been moving down their own experience curves, and every year were gaining a cost advantage over the latecomer. By 1963, when Allis had reached a cost level of $330 per megawatt,  GE’s and Westinghouse’s costs were far lower. Allis-Chalmers lost its case and exited the steam-turbine business soon thereafter.

Incidentally, remember that the experience curve governs not just cost and price but quality and features. It wouldn’t have done Polaroid any good to come out with a three-megapixel model for $400 if competitors were offering a four-megapixel model at the same price.

Copyright © 2008 Mark Gottfredson and Steve Schaubert

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