The experience curve is a principle developed by Bruce Henderson of the Boston Consulting Group. Working with a leading manufacturer of semiconductors, the consultants noticed that the company’s unit cost of manufacturing fell by about 25% for each doubling of the volume that it produced. This led them to the hypothesis that the more experience a firm has in producing a particular product, the lower its costs of production. Costs characteristically decline by 20-30% in real terms each time accumulated experience doubles. This means that when inflation is factored out, costs should always decline. The decline is fast if growth is fast and slow if growth is slow.
The experience curve can be explained by a combination of learning (the learning curve), specialization, scale, and investment. The learning curve describes the observed reduction in the number of required direct labor hours as workers learn their jobs.
The strategic value of the experience curve lies in the positive relationship between growth in market share, which implies an increase in production volume which results in the reduction in costs. The attendant implication is that businesses which are in a market leadership position with high production volumes have a significant advantage over new entrants.
If a firm is able to gain market share over its competitors, it can develop a cost advantage. Penetration pricing strategies and a significant investment in advertising, sales personnel and production capacity. However, there are some pitfalls inherent in absolute adherence to the experience curve.
- The fallacy of composition holds: if all other firms equally pursue the strategy, then none will increase market share and will suffer losses from over-capacity and low prices. The more competitors that pursue the strategy, the higher the cost of gaining a given market share and the lower the return on investment.
- Competing firms may be able to discover the leading firm’s proprietary methods and replicate the cost reductions without having made the large investment to gain experience.
- New technologies may create a new experience curve. Entrants building new plants may be able to take advantage of the latest technologies that offer a cost advantage over the older plants of the leading firm.