Use this framework to determine your pricing strategy
The experience curve framework was developed by the Boston Consulting Group in the mid-1960s. It postulates that the more experience a business has in producing a product, the lower will be its unit costs.
The experience curve which leads to lower unit costs happens for a number of reasons. Greater experience leads to more efficient and better skilled labour. Products can be standardised. Robots and automation can be applied to the greater volumes. Experience may also show how products can be redesigned for lower production costs and without losing performance.
The experience curve leads to lower costs which in turn help a company lower its prices and achieve a competitive advantage (or pocket the price advantage in additional profits).
The experience curve theory confers an advantage on companies that produce and sell a lot of product. A high market share is therefore highly desirable. The experience curve supports other frameworks we have discussed. For example Michael Porter argues that low-cost is one of three important strategies that can be adopted by a company, the other two being a niche supplier or a supplier of differentiated products.
One of the main advantages of the experience curve framework is the potential for significant cost reduction over time. As experience accumulates, companies often become more efficient in production processes, leading to lower unit costs. This means that firms that embrace the experience curve concept can achieve a competitive advantage by consistently producing goods or services at lower costs than their competitors. This advantage can contribute to market dominance.
The concept aligns with the economies of scale principle, emphasizing the cost advantages associated with increased production volume. Larger scale production allows for better utilization of resources, spreading fixed costs over a larger output.
The framework encourages a focus on learning and continuous improvement. Companies are prompted to refine processes, adopt best practices, and invest in technology to enhance efficiency.
As unit costs are lowered it provides companies with more flexibility in pricing strategies. They can choose to pass on cost savings to customers, potentially gaining market share, or maintain higher profit margins.
The Experience Curve is a valuable tool for strategic planning. It helps companies anticipate cost trends and plan for the long term, guiding decisions related to production scale, investment, and market positioning.
It should be pointed out that achieving a low cost advantage isn't simply about volume production. It is also associated with a company culture. A company wanting to benefit from the experience curve is likely to have very efficient distribution channels, spartan offices, and a workforce which isn't in the top quartile of remuneration. Complacency is a threat to companies following the experience curve.
A word of caution. The Experience Curve framework assumes a linear relationship between cumulative production and cost reduction. In reality, other factors, such as technological disruptions or changes in input costs, can influence cost dynamics and disrupt linearity.
Also, the applicability of the Experience Curve may vary across industries. In some industries, technological advancements or changing consumer preferences might have a more significant impact on costs than cumulative production volume.
In the early stages of production, companies may face high initial costs before experiencing significant cost reductions. This period of high costs can be challenging for new entrants or companies in the early stages of a product life cycle.
The framework primarily focuses on cost reduction, potentially leading to a myopic focus on efficiency at the expense of other critical factors such as innovation, product quality, or customer satisfaction.
As companies approach the lower end of the experience curve and unit costs stabilize, further cost reductions become marginal. This can limit the long-term sustainability of a cost advantage, especially if competitors catch up.
The success of companies relying on the Experience Curve may lead to complacency, assuming that cost advantages will persist without ongoing efforts in learning and improvement.
Some things to think about:
How important is cost reduction in the positioning of your company? If you are aiming to position your company with a very aggressive price, this could be the framework for you.
Beware of cutting costs to the point were your product fails to meet the expectations of customers. A low-cost position with a tarnished reputation for low quality, is not worth having.
This framework is one for the volume manufacturers. If you are in a niche market or producing high quality goods for the luxury market, it is unlikely to be for you.