Chances are, if you were to hear the term “experience curve” on the streets, you would have no idea what it means. You might think of a learning curve, but what is the meaning of the experience curve? In plain English, the experience curve is a business term that says that per-unit production costs go down in relation to an increase in production. The implications the experience curve can have on your business are crucial to consider as you build for the future! Let’s get into the nitty-gritty details.
Meaning Of The Experience Curve
The most basic meaning of the experience curve is that the more experience a business has in producing a particular product, the lower the costs. That concept is represented by the below inverted graph.
For those of you who love your algebra, we’ll give you another way to express the meaning of experience curve through the following function: Cn = C1X-a
- C1 = direct cost of first unit of production
- Cn = direct cost of nth unit of production
- X = cumulative volume of production
- a = experience rate (%)
This formula is fairly easy to grasp – the more you do something the better you get at it! Although the experience curve might be easier to imagine in a production environment, the same principles can be applied to high-volume companies that offer services. The only challenge is in identifying a single “unit” of the service being offered so you can measure the cost. Once you do that, you can calculate the costs associated with the service. After costs are calculated, you can find ways to reduce production costs. In any environment, it depends on management taking an active role in lowering costs through every iteration.
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Experience Curve Effect
It is important to know the difference between the learning curve effect and the experience curve effect. The learning curves only takes into account a reduction in costs associated with labor. The experience curve effect, however, looks at the broader picture i.e. marketing, distribution, manufacturing, etc. One of the most important by-products of the experience curve is that it can lead to market domination, because it weeds out organizations that are unable to look at the big picture of their costs and only focus on reducing labor costs.
The experience curve effect can also be seen by looking at the factors that contribute to cost reductions:
More Efficient Labor
Staff becomes more skilled and highly trained with each iteration. They also become more confident and make fewer mistakes. Short cuts and improvements are naturally discovered.
Standardization & Method Improvements
When employees are able to focus on a certain set of tasks, they become more efficient and find methods to improve what they do.
Technology Driven Improvements
New technologies can be developed in response to what is learned through each iteration, and existing technology can be used more efficiently.
As providers and customers have more experience with the product, they will inevitably find areas of improvement. This is a result of greater market penetration.
The experience curve effect is multiplied when you have two products that share a common activity or use the same resource. This is because anything you learn in one area can be applied in multiple areas.
Experience Curve Pricing
Experience curve pricing refers to the strategies that companies who are utilizing the experience curve to their advantage can employ. When launching a new product, if they utilize experience curve pricing, they will set their price point at a lower-than-average price with the belief that production costs will drop and profits will increase over time. This is an aggressive pricing strategy that will put the price of the product or service below the current market value. There are several advantages to using experience curve pricing:
- Competitors will be driven from the market if they can’t price-match.
- The more experienced firm will be able to absorb the “market shares” that were left behind by their competitors.
- New customers will be drawn to the market due to the lower prices, increasing the more experienced company’s profit even more.
Experience curve pricing can also be implemented in response to a new competitor entering the market. When Company A sees Company B coming to market with a product, they can most likely afford to lower their prices. The more experienced Company A should have lower costs, allowing the company the option of lowering their price to protect market share.
Experience Curve Example
Let’s look at an experience curve example we are all familiar with: the battle between Apple and Android. The first iPhone was released in 2007 and Android released their first model approximately a year later. Having the jump on the market, one would think that Apple should be the leader in this field. However, that is not the case. In 2020, worldwide smartphone shipments were forecasted to be 85% Android and 15% iPhone.
Why is this? Despite having another player in the game, Apple chose to keep the cost of the iPhone at a remarkably consistent price point. Android, on the other hand, chose to play the price game and utilize experience curve pricing. They have consistently lowered prices and now an Android is roughly 1/3 of the price of an equivalent iPhone. This experience curve example is proof that honing capabilities and reducing production costs are effective – no matter what type of product or service you offer.
The experience curve is a critical concept for companies and consultants alike to understand in today’s competitive market. It may provide that edge that is the difference between mere survival and great success. At Management Consulted, we have resources dedicated to helping organizations standing out. Write us for more info!
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