A firm's cost position results from the cost behavior of its value activities. Cost behavior depends on a number of structural factors that influence cost, which Porter terms cost drivers.
Ten major cost drivers determine the cost behavior of value activities: economies of a scale, learning, the pattern of capacity utilization, linkages, interrelationships, integration, timing, discretionary policies, location, and institutional factors.
- Economies or diseconomies of scale
- Economies of scale arise from the ability to perform activities differently and more efficiently at larger volume, or from the ability to amortize the cost of intangibles such as advertising and R&D over a greater sales volume. However, increasing complexity and costs of coordination cal lead to diseconomies of scale in a value activity as scale increases. Value activities such as product development, national advertising, and firm infrastructure are typically more scale-sensitive than activities such as procurement and sales force operations. The appropriate measure of scale is a function of how a firm manages an activity.
- Learning and spillovers
- The mechanisms by which learning can lower cost over time are numerous, and include such factors as layout changes, improved scheduling, labor efficiency improvement, product design modifications, procedures that increase the utilization of assets, and better tailoring of raw materials to the process. Learning can spill over from one firm in an industry to another, through mechanisms such as suppliers, consultants, ex-employees, and reverse engineering of products. The appropriate measure of the rate of learning is different for different value activities.
- Pattern of capacity utilization
- Where a value activity has substantial fixed cost associated with it, the cost of an activity will be affected by capacity utilization. Capacity utilization at a given point time is a function of seasonal, cyclical, and other demand or supply fluctuations unrelated to competitive position. The pattern of capacity utilization of an activity is partly determined by environmental conditions and competitor behavior (particularly competitor investment behavior).
- Linkages create the opportunity to lower the total cost of the linked activities. Linkages among value activities pervade the value chain. Vertical linkages are frequently overlooked, because identifying them requires a sophisticated understanding of supplier and channel value chains.
- Interrelationships with other business units within a firm affect cost; particularly when a value activity can be shared with a sister unit.
- The level of vertical integration in a value activity may influence its cost.
- Sometimes a firm may gain first-mover advantages from being among the first to take particular action. Timing can lead to either sustainable cost advantage or a short-term cost advantage.
Discretionary policies independent of other drivers.
The cost of a value activity is always affected by policy choices a firm makes. Some of the policy choices that tend to have the greatest impact on cost include:
- product configuration, performance, and features
- mix and variety of products offered
- level of service provided
- spending rate on marketing and technology development activities
- delivery time
- buyers served (e.g., small versus large)
- channels employed (e.g., fewer, more efficient dealers versus many small ones)
- process technology chosen, independent or scale, timing, or other cost drivers
- the specifications of raw materials or other purchased inputs use (e.g., raw material quality affects processing yield in semiconductors)
- wages paid and amenities provided to employees, relative to prevailing norms
- other human resource policies including hiring, training, and employee motivation
- procedures for scheduling production, maintenance, the sales force and other activities.
- The geographic location of a value activity can affect its cost. However, firms do not always understand the impact of location.
- Institutional factors
- Institutional factors, including government regulation, tax holidays and other financial incentives, unionization, tariffs and levies, and local content rules, constitute the final major cost driver.
- Diagnosing cost drivers.
- The cost behavior of a value activity can be a function of more that one cost driver. A firm must attempt to quantify the relationship between cost drivers and the cost of a value activity whenever possible.
The interactions among drivers take two forms: drivers either reinforce and counteract each other. Drivers frequently reinforce or are related to each other in affecting cost. For example, the effect of location on cost is often related to institutional conditions such as unionization or regulation. Cost drivers can also counteract each other. This means that improving position vis-a-vis one drive may worsen a firm's position vis-a-vis another.
The presence of counteracting cost drivers implies the need for optimization.
Identifying cost drivers and quantifying their effect on cost may not be easy, and number of methods can be employed. Sometimes the cost drivers of a value activity will be intuitively clear from examining its basic economics. Another method of identifying cost drivers is for a firm to examine its own internal experience. Cost drivers can also be determined from interviews with experts. The final method for identifying cost drivers is to compare a firm's cost in a value activity to its competitors' or compare competitors' costs to each other.