The Erosion of Comparative Advantage (Part I)

The Erosion of Comparative Advantage
(Part I):

The Shattering of Scale

We guess the leverage points in your business aren’t working as well. As technology changes and information flows more swiftly, once strong competitors find it harder to win.

It will get worse. A rapid evolution – perhaps revolution – is altering the key sources of comparative advantage in most businesses. That means capital and expense investment bets are riskier.

Strategy Formation. We’ve always believed that strategy begins with figuring out what customers value and buy. These needs run deeper than quality, price and delivery. Understanding the underlying interests of the customer leads to insightful value packages. Comparative advantage will lie where the value package and the business system meet.

Superiority, built from comparative advantage, is progressively leverageable. Firms construct value and cost superiority in an increasingly efficient manner, creating “increasing returns.”

Many key sources of comparative advantage, like economies of scale or run length economics, have been related to plant size or volume. Others have been located more specifically in some function, such as product design, distribution, manufacturing engineering, or data processing.

The Shattering of Scale. Scale is diminishing as a key source of comparative advantage. Under the tag line of scale is an array of economic phenomena that produced leverage as volume increased. Product invention, design, warehousing, the creation of new materials, development of support functions – all of these activities created value that could be leveraged over the production of many units or the delivery of more service. The power of many of these is diminishing as their absolute cost declines. (Figure 1)

Today, the power of scale is diminishing because fixed and variable cost behavior is changing. Fixed costs rarely stay fixed. As their relative importance declines, so does the expected life of an investment in fixed costs.

In the past, publishing and printing had established “rules” for book run lengths and the number of editions. These were based on relationships of fixed cost-such as the cost of plate preparations for a new edition, the cost of getting the author to revise his material, and the cost of fussing around with formats, graphs, mistakes-with the useful life of the existing edition. Today, plate preparation costs have been declining. Authors have more efficient means of revising their work and publishers have more efficient methods for the mechanical makeup of new galleys.
In many industries like steel and chemicals, preemptive capital investment, built to withstand competitive action, is losing out to more flexible-“and fungible”-facilities. Fixed investments cannot be spread over volume because the market changes before investment costs are recovered.

There are “wheels within wheels.” What used to appear as variable cost was often a composite of fixed and variable cost yielding advantages to firms with greater volume. For example, in durable goods manufacturing, factory tooling-a fixed cost-is usually bought from vendors, not made.
But, for the vendor, tool making is also moving to less fixed and more variable cost. So the high volume of tools purchased no longer gains a big price advantage over lower volume rivals, further diminishing big companies’ cost superiority over smaller competitors.

Variety and Flexibility. Design costs are declining as a percent of total unit cost. Set up costs are declining as a percent of total unit costs. Runs are shorter. As these costs decline, product variety increases. Products are more frequently changed and upgraded. These changes-deeper and broader product lines, smaller run length and more frequent updates-allow products to be customized for micro-markets. Figure 2 shows how computer controlled manufacturing has flattened the cost curve for variety in a factory where a few engineers program production changeovers in real time.

Smaller is better. Not only is the unit cost gap between large and small companies shrinking, overhead costs, like payroll administration, are also falling. (Figure 3)

This decrease of fixed cost importance is not restricted to manufacturing. The growth of direct marketing, for example, can be partly attributed to low cost computing. Where once only larger companies like Sears could afford the “glass houses” with their legions of data processing specialists, many new catalog companies can manage their customer lists with PCs.

Trying Harder. As scale declined as a source of comparative advantage, businesses sought new ways to gird performance. Themes such as “close to your customer,” “employee empowerment,” or “re-engineering the value adding process” have emerged. These help achieve better results and contribute to reducing fixed expenses. Are they the new locus of comparative advantage?

We don’t think so. For firms to successfully defend competitive position, new factors fundamental to compelling economic power must be established.

The emerging locus of comparative advantage will reside in the relationship of information acquisition and application to three areas: response time, intellectual renewal, Electronic Commerce.

• Response Time: Time to market, the time to make business decisions, from evaluation of market potential for new products to the best location for the new factory.
• Renewal of Intellectual Capital: Constant, intensive updating of the knowledge and skills of a company will be the norm.
• Electronic Commerce: Transacting business electronically with customers and suppliers. In a recent study we estimated that adopting Electronic Commerce will result in a decline in costs of between six and ten percent of revenues. Electronic Commerce will allow large corporations to make faster decisions of all stripes and tremendously leverage their size in growth and renewal of intellectual capital.

In future articles, we’ll investigate how you might find these new leverage points for your business.