Experience curve as a step towards business productivity

Experience curve is a mathematically and proved in practice example of a man’s ?innate? ability to learn, optimize and minimize. Using this knowledge one can see the true picture of their company, set realistic standards, and get people motivated to raise labor productivity, as well as pay bonuses fairly.

The experience curve idea was generated by Boston Consulting Group in the mid-60s. Advisors who worked with semiconductor’s producers noted a peculiar feature. Every time when cumulative volume of production doubled, the direct cost per unit produced decreased by 20%. Such relationship is called the experience curve. The greater experience a company has in a certain product production, the less the direct cost of this product is. This rule was first noted in the 1930s by aeronautical engineer T. P. Wright and confirmed by Crawford in the 1940s.

According to Wright’s Law for every cumulative doubling of units produced, costs will fall by a certain percentage of the previous value. Depending on an industry, this value varies from 1-2% to 30%. At the same time, industry indicators always remain the same and may not change depending on the range of activities.

Learning Curve Graph. Pic. 1

The type of the curve changes depending on the produced product. According to Rand Corporation research, a doubled number of nuclear reactors in the power plants construction can reduce the time and capital costs of building facilities by 5%.

The reason why cost and time reduction for industries is different is different opportunities for gaining experience. Large-scale facilities (for example, nuclear reactors) are produced in small volumes in comparison with other goods. It is rather difficult for companies to increase the volume of products that take several years to produce. Moreover, the total number of such objects on the market is only a few hundred units.

The beginning of a new product production is characterized by low productivity and frequent production interruptions. Over time, workers learn the ropes. Production time and costs decrease. An example of such a process is when one assembles furniture oneself. First you need to look through the manual, parts, fasteners, and the general assembly sequence. Many people may doubt if they are able to do it on their own. However, during the assembly process, the skill improves, you understand how the furniture should be assembled and act faster and faster. This is exactly the learning effect got in production.

The learning effect appears because people learn from their mistakes and aim to speed up the process they are doing. Learning is intuitive and natural. In this respect, the experience curve is a reflection of human behavior.

The labor productivity increase over time is connected with the fewer workers’ mistakes and their improved skills. In some cases, suggestions how to simplify and speed up the production process are made. This is how specialization arises. When clear consistency and standards emerge work efficiency increases. This rule concerns not only workers involved in the direct production, but also to management and other employees. The more experience a company has, the easier it is to cope with different tasks. Adopting your own approach to the production process implementation, you can change the structure of resources, thus reducing costs. For instance, the learning curve can be used while determining the price of an agreement, including government ones.

The experience curve fairly reflects the situation in production when:

● production is labor intensive;

● the production process is the same for each unit of goods;

● there are no downtime;

● the is low staff turnover.

The experience curve formula is the following:

An experience curve is not the way to reduce production costs. It only reflects the rate of future cost reductions while maintaining the rate and mode of production at the current level. It is possible to reduce the cost of production by organizing additional training, offering employees new labor tools, optimizing the production process, motivating staff to increase productivity, and unifying business processes.

In theory, firms that have been operating in the market for several years can benefit from the experience curve. It should be difficult for beginners to enter the market. However, in practice, things are different. New companies enter industry easily and quickly become major players. This often happens when new technologies and inventions are implemented in production, as well as when goods are advanced. A bright example is beginning of using smartphones. All experience in the production of push-button devices faded away.

This allows us to highlight the following limitations when applying the experience curve:

● when there is a high staff turnover, it is difficult to use the learning curve to develop standards and planned targets (production and budget). Management should apply incentive programs for staff to reduce staff turnover.

● the use of new technologies limits the learning curve effectiveness.

● in case of mergers and acquisitions of companies, the learning effect rolls back to the initial indicators.

● insufficient industry statistics to apply the experience curve.

Information on reducing the production time makes it possible to use the learning curve in different directions:

● efficiency evaluation of using production assets;

● labor productivity;

● setting standards;

● calculation of budget variances and other performance indicators.

In the beginning, enterprise employees gain experience. They learn and find ways to increase productivity. During this period, strategic programs and budget do not include the learning effect, which leads to budgetary slacks (overstatement of costs, understatement of profits). There is an increase in planned costs and, as a consequence, an increase in the prime cost and price of products. A high price of finished products attracts new players to the market, which will further lead to competition increase and may cause loss of profits.

If the learning effect is not taken into account, current and future market share and production costs are mispresented. Thus, the marketing strategy is developed incorrectly, and its productivity is reduced.

Let's take a short budget excerpt as an example and examine the impact of the learning curve on control and budgeting process. Let's suppose using this budget you need to make a decision on bringing a product to the market, setting the product price and developing motivation for managers regarding production, sales and economics. To make calculations easier, the products will not have opening and final balances in warehouses. Let's suppose the volume of production is equal to the volume of sales.

Using a standard costing method, it is necessary that standard costs let us calculate a reliable database for calculating variances. While using standard costs without considering the learning curve, budget variances in time and labor will be favorable because target man-hours and allocated to them variable costs will be high. As a result, the conclusions drawn from these variances will be incorrect.

In the first case, when reaching the production plan goals, it will be the managing director who will receive a bonus, because he will save on payroll budget of the main production personnel. The sales manager may not have a bonus, because the price of the product will be too high and problems with selling the product may occur. The owner of the company will suffer losses, because he spent resources on organizing manufacture, paid bonuses, received less profit or did not receive any profit at all due to the refusal to bring the product to the market.

This example reflects simple data demonstrating the benefits of using the experience curve in setting targets and budgeting. Measures to increase business productivity should be applied at the very beginning of work, when there are more opportunities for this.

I would like to note that thinking this way business owners and people responsible for business productivity will gradually be able to duly implement such important tools as:

●     ABC method;

●     Functional and cost analysis;

●     cost management by objectives;

●     balanced Scorecard.

The current economic situation, created due to the pandemic, has caused great challenges for companies in various fields. These problems clearly indicated that many managers do not know the size of cost provisions, profit and their drivers, they have never analyzed the sensitivity of their company to such fluctuations in financial condition.

It is necessary to know one’s financial robustness not only under crisis conditions, but under ordinary ones as well. It could happen that such disturbances would be a part of our life over time.

Here a quotation of P. Drucker could be appropriate:

"Repeating crises are a symptom of carelessness and laziness."

Such tool as the experience curve can easily adapt to a company’s strategy and can be used to optimize production, as well as find solutions to raise labor and business productivity.