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Experience Curve for Your Company

How to develop the experience curve for the own company.

For the empirical proof of the experience curve, series of actual figures from various industries were used. These showed that the value-added costs per unit decreased by 20 – 30% for each doubling of the cumulative output quantity. This finding can also be used as a guideline for planning for one’s own company. Based on actual data (partly estimated), a company-specific experience curve can be drawn up. This can be used to analyze whether the medium-term planning figures will be suitable for implementing the experience curve in one’s own company.

Experience curve for Your company

The following initial data are required:

- Cumulative sales volume to date
- Value added costs of the most recent actual year
- Planned sales volumes for the planning horizon under consideration.

From this data, a “funnel”, i.e., a corridor for the development of the allowable value-added costs, can be calculated.

First, the annual context must be established (Compare with the table “calculation of cost reduction targets” below):

- In line 1, the actual sales volumes of year 1 and the planned sales volumes of the planning years 2-7 are entered.
- The sales volume of the assortment sold before year 1 is entered in line 2 (500,000 units). Since this is only a rough estimate, all product units are considered equal for simplicity. Also in line 2, the accumulated sales quantities until the end of the planning horizon are calculated.
- From this, the doublings per year can be calculated in line 3. The formula for this is:
  Formula to calculate annual doublings
  
  The fact that these values are continuously decreasing expresses that despite sales volume increases, an increasing number of years is needed to achieve another doubling.

- Line 4 shows the cumulative doublings of the planned years in relation to the initial situation. They form the basis for calculating the theoretical experience curve values.
- In line 5, the value added costs per unit of the actual year are calculated (1’800’000 : 200’000 sales volume = 9.00).
- Since a cumulative doubling of 0.4253 is to be achieved in planned sales in year 2 compared to actual year 1, the value-added costs of the previous year are exponentiated by the cumulative doubling factor (0.4253 in planned year 1). Depending on the selected experience curve target, this results in the value-added costs to be achieved in the respective plan year (e.g., 8.19 for the 20% experience curve for plan year 1, line 7).
- Purely arithmetically, the experience curves of 10%, 20% and 30% can be determined in lines 6-8 for the value-added costs per sales unit to be achieved.

Graphically, the “funnel” is created, in which the planned and effective value-added costs should move within the medium-term planning horizon shown (Plan1 to Plan 6).

Value-added cost targets for planned sales quantities

The next post will ask whether the medium-term cost center plans for the value-added cost areas will be able to meet these requirements. If not, ideas must be generated on how to reduce the planned costs of the affected cost centers. If this requirement cannot be met, the company will lose competitiveness due to excessively high value-added costs.

Importance of cumulative past sales volume

It is often difficult for companies to determine the cumulative sales volume to date, either because the data is missing or because estimates had to be made due to changes in the portfolio.

If, in the model presented above, the cumulative past sales volume is entered as 0 units, the value-added costs to be achieved per unit sold in plan year 1 and assuming an experience curve target of 20% will decrease from 8.19 to 6.49 per unit. In the opposite case, where the cumulative sales volume to date is 1,000,000 instead of 500,000 units, the allowable value-added costs increase to 8.49 per unit.

If these extreme variants are considered, it can be seen that an incorrectly estimated or calculated cumulative sales volume is significant, but the target values to be achieved change little. Overestimated cumulative past sales volumes lead to lower cost reduction targets for the planning years, while underestimated ones lead to higher ones. As these are planning targets, possible misestimates are justifiable.

Promises of the experience curve

In every company ways have to be found to implement the experience curve.

Bruce Henderson (cf. B.D. Henderson, The Experience Curve, Boston Consulting Group, Perspectives nr. 16, 1968 ) has proven with extensive empirical studies (ex post) for entire industries or for the product volumes offered in a market in various industries that:

The real (inflation-adjusted) full value-added costs decrease by 20 to 30% with each doubling of cumulative output volume.

Promises of the experience curve

The practical application of this finding in one’s own organization requires that the statement be viewed in a differentiated manner:

- The cost reduction applies to every doubling of the cumulative output quantity (since the market launch of an offering). How quickly a doubling takes place consequently depends on the market and on the company’s own growth. In fast-growing markets, a doubling of the cumulative output quantity (of all suppliers) can take place in a few months; in mature markets, it may take several years.
- Value-added costs comprise the costs of the services provided within the company itself. These are primarily the total (proportional and fixed) personnel costs and the externally purchased services consumed, as well as depreciation and amortization (fixed costs only). They are incurred so that the company’s own services can be delivered and profit can be generated. Direct product-related material and external service costs are not part of the value-added costs, as these are determined by the suppliers. Value-added costs are calculated by deducting from total expenses in the income statement the material and external service consumption directly caused by the products sold.

The value-added costs per unit sold must be reduced if competitiveness is to be increased. The graph shows the development of the value-added costs for each doubling of cumulative output quantity, assuming that the items sold remain the same.

Value added and cost of goods sold per unit must be reduced based on experience.

- The absolute company profit increases as long as the sales price can be maintained (in the example at 12.00) and the value-added costs as well as the costs for material and external services can be reduced according to the doublings.
- However, the experience curve also applies to competitors. If they manage the doublings faster, they also have the chance to reduce their value-added costs per unit faster. This increases their potential to lower their net selling prices and thus improve their market position.
- The graph does not contain a calendar reference. Therefore, it is not yet possible to derive which cost reductions can be realized in which years. The corresponding procedure will be explained in a further post.

There are four factors that determine the realization of experience curve progress: economies of scale, learning effect, improved processes, and product design.

- Economies of scale occur more or less automatically. If the sales volume and thus the production volume increase, the fixed cost block is distributed over more units, which reduces the average complete product cost.
- People and machines learn from experience. Through repetition, consistent processes can be completed in less time. Processes become more efficient, resulting in lower processing times per unit. Administrative processes can also be completed with less time and fewer errors. Integrated data processing makes information available across departments, and machine learning and artificial intelligence can automate many evaluation tasks.
- By using new and more powerful equipment, manufacturing can be done with less time and possibly improved quality. Often, such investments are combined with capacity expansions.
- New materials and new designs enable more cost-effective manufacturing. Changes in product design should at the same time allow for higher sales volumes and changed sales prices.

Application example:

Development of prices, costs and EBIT over 7 years

The table and the graphs show by way of example how the experience curve factors and the increase in sales volumes over seven years affect earnings before interest and taxes (EBIT):

- The increase in sales volumes over the years leads to sharply rising net revenues per unit, despite falling net revenues.
- Fixed costs fall per unit, although the absolute amounts for depreciation and fixed personnel and material costs rise (fixed cost degression).
- Due to learning effects and process improvements in production as well as possibly due to more favorable material purchases, the proportional manufacturing costs decrease from 10.00 to 8.00 per unit.

The form of presentation of the changes selected above presupposes that in management accounting a clear distinction is made between proportional and fixed costs and that a contribution margin calculation is prepared (cf., the corresponding posts on management accounting in this blog).

Note that only fixed cost degression is an automatic consequence of growing sales volumes. Realizing the promise of the experience curve in one’s own organization requires great effort in operational planning, implementation and control. Cost reduction opportunities must be sought everywhere in the company, not just in the products. Lower absolute personnel administration costs reduce the average costs per unit in the overall view just as much as a disproportionately low increase in IT costs in relation to sales growth over the same period.

In the next posts, methods and procedures will be shown which support the achievement of the improvements.

Experience curve and medium-term planning

The comparison of the current planning status with one’s own experience curve quantifies the cost gap that must be closed.

The experience curve adapted for the company itself forms the orientation framework for medium-term operational planning. Will it be possible to keep real costs within the empirically established “development corridor” of minus 20% to minus 30%?

The development of the income statements for the medium-term planning horizon, which is already known from previous posts, represents in condensed form the current processing status of medium-term planning. Lines 10 and 11 show that average value-added costs per unit are falling in absolute and percentage terms, although net revenue per unit is also declining. The planners expect that the competition will also reduce prices in the planning period.

Contribution margin and value-added cost

If the development planned to date is integrated into the company-related experience curve from the previous post, the following graphic results:

Experience curve and medium-term planning

It can be seen that the planned values to date are moving in the “funnel” but have not yet reached the 20% experience curve. The dotted trend line suggests an experience curve of about 15% for the planning horizon.

What is to be done?

Since it is not yet known in the planning phase whether the competition could grow faster through price reductions and thus achieve a better experience curve, the personnel and material costs as well as the imputed depreciation in the cost center plans must be revised again.

According to the budgeted income statements to date, personnel and non-personnel costs as well as imputed depreciation will rise sharply in plan year 2. In particular, fixed value-added costs will increase by 0.5 million. This explains the jump out of the “funnel” in plan year 2 and the resulting increase in the share of value-added costs from 42% to 46% of net revenues. In plan years 3 to 6, value added costs then rise again more slowly than net sales, which is reflected in the improvement in the company’s own experience curve and, of course, in higher EBITs.

Consequently, the plan revision must focus primarily on the plan values for personnel and material costs in the cost centers and look for ways to spread the useful live of the investments over more years, since they determine the amount of imputed depreciation.

The effort required to create your own experience curve is manageable. Comparing the curve with the company’s own medium-term plans makes it possible to see in which cost centers to look for cost-cutting opportunities first.

The comparison of the current planning status with one’s own experience curve quantifies the cost gap that must be closed in the coming years if the competitive cost position is to be maintained. The ability to compete is largely built up in the medium-term planning.