Accumulated Experience and Costs

Hardly anyone today disputes the importance of learning in firms. Learning is essentially the acquisition of knowledge, understanding and skill through experience, instruction or study. For most firms, experience will be the main pathway to learning where people gain knowledge and skill from actually performing a job. By acquiring and leveraging the learning acquired through accumulated experience, a firm can drive significant improvements in quality, work processes and routines, and products and services.

Economists and business strategists have long appreciated the impact of learning on organizational performance. The so-called experience or learning curve shows how costs fall as a function of cumulative output – as a firm acquires learning about how to better make and provide a product or service over a greater quantity of output, it can leverage that accumulated experience and learning to gain greater efficiencies and thereby reduce unit costs.

To see how this works, consider the learning curve for a firm shown below.

Image

In this figure, as the firm accumulates output from quantity 1 (Q1) to quantity 2 (Q2), it also moves down the learning curve by accumulating experience and learning. At quantity Q1, the firm’s acquired learning results in an average unit cost of AC1. At quantity Q2, by moving down the learning curve and applying its accumulated experience, the firm is able to lower the average unit cost to AC2.

Proponents of the learning curve have generally held that, as accumulated experience doubles, unit costs can fall 15 to 20 percent. In some industries, the rate is higher. For example, in aircraft manufacture it is not uncommon for unit costs to fall by 25 percent or more by the fourth or fifth year following a new model introduction. However, it should be kept in mind that the learning curve is not uniform across all industries: the accumulated experience that a firm would acquire from making a simple stamped metal part would not be as deep, and therefore not as impactful on unit costs, as the learning that a complex microchip manufacturer, for example, might acquire.

Why do unit costs decrease with accumulated experience? Cost decreases generally result from employees gaining greater proficiency and experience in performing work, higher quality, and also from efficiencies gained by finding better ways to do things. Firms that are able to use learning to drive improved performance use less input factors of production – less labour, less materials, less machines, less facilities, etc. – resulting in lower costs.

An important feature of learning curves is their predictive ability. If a firm can calculate its learning curve, it can predict what its unit costs should be at a given cumulative volume. With this knowledge, and provided other market conditions are appropriate, a firm can set its pricing based on the future unit costs which will be attained once the firm drives down the learning curve and achieves the predicted cumulative volume.

A common mistake that some firms make when trying to estimate the economic impact of learning is to assume that economies of scale are necessary to realize a cost reduction. In the figure above, production quantity Q1 could occur over the period of a year, with the cumulative production quantity Q2 occurring over two years. Thus, there are constant returns to scale with the average cost curves being flat across the cumulative production volumes. This is different than economies of scale, where lower unit costs result from spreading a firm’s production costs over a greater production volume.

This distinction is important, because if a firm has lower unit costs due to economies of scale, then any reduction of the production volume will increase unit costs. However, if the lower unit costs are due to the effects of learning, a firm may be able to reduce its production volume without increasing its unit costs.

Firms which wish to create powerful learning economies must realize that managing the process is vital. A firm should not settle for the nominal gain on efficiency that accumulated experience usually delivers. Instead, a firm should seek to manage its way down the learning curve, leveraging every opportunity to learn from problems and gain contribution for improvement from employees. The Japanese concept of kaizen – making many small improvements to products and processes – is an example of how firms can create a powerful learning economy through effective management: kaizen results from a collaborative management system which encourages and gains a continuous learning contribution from workers that grows out of their accumulated experience.

Takeaway Lessons:

  • Learning should be made firm-specific rather than task-specific. Workers who acquire specialized skill and knowledge through learning may be able to appropriate this value for themselves in the job market. In the worst case where employee turnover rates are high, the learning exits the firm with the workers and the firm never fully realizes any learning economies. When learning is firm-specific rather than task-specific, the learning of workers is tied to their employment with the firm.
  • Because it is workers, and not firms, which learn, codifying, sharing, and institutionalizing learning is critical to achieving learning economies. This is especially critical in those industries where the learning includes not only internal process or functional skill or knowledge, but includes learning about externalities to the firm such as suppliers, customers or clients, and markets.
  • Organizational policies, and union contracts, should not create learning diseconomies. For example, say a firm’s policy is to promote experienced employees to fill vacancies at higher levels. If these promotions cause a spill-over effect at lower levels where employee mobility among the resulting job openings is increased, the firm may find that its overall productivity is eroded by employees having to constantly relearn tasks that co-workers had already mastered.
  • Moving down the learning curve does not necessarily confer a competitive advantage. While a firm can use “penetration pricing” to acquire market share, whereby it prices according to the lower cost structure it expects to achieve by driving down the learning curve, this does not mean that competitors cannot either pre-empt the move by price matching, or follow the firm down the curve. This is especially true in those markets where the price elasticity of demand is high (elastic demand) and market shares are unstable.

Author:
Stewart Anderson
Principal Partner at ALCG
stewart@andersonlyall.com
www.andersonlyall.com

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