The Experience Curve, or “Henderson’s Law”, is defined by The Boston Consulting Group’s founder Bruce D. Henderson, as an inverse correlation between a product’s value added and the manufacturer’s experience in its production and marketing.
Therefore, as a company’s understanding and knowledge increases, the cost per unit tends to decrease according to the Experience Curve. This economic term was introduced in the 1960’s as a tool for analyzing the cost behavior of products.
Below you can find the Experience Curve’s mathematical formula, its explanation and some examples and applications:
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Experience Curve Formula
Henderson defines the Experience Curve as:
Cn = C1 n -a
- C1 is the cost of the first unit of production
- Cn is the cost of the n-th unit of production
- n is the cumulative volume of production
- a is the elasticity of cost with regard to the output
Graphically, the formula above will look like an inverse variation:
Why does the Experience Curve work?
There can be many factors that justifies the experience curve’s correlation. See below some examples:
- Labor Efficiency: As the labor force produces goods and services, they become more efficient, experienced and confident. Fewer mistakes are made, and as times passes there is more room for improvement and learning new skills.
- Standardization and specialization of staff, tools and processes also increases the organizational productivity, generating cost reduction and a profit boost.
- Technological changes and IT also helps workers with newer and more efficient methods of manufacturing.
- The Experience Curve effects are reinforced as two or more products share a common resource or activity, as the efficiency achieved from one product can be applied to the others. This is known as the Shared experience effect.
Implications and Considerations of the Experience Curve
But what does this correlation mean in the real world? Well, the Experience Curve defines how ‘elastic’ the costs are compared to the amount produced. It then implies that if costs become lower as the output increases, then companies that have been producing for a longer period and in larger quantities will have their expenses reduced and will take over the market.
If a company does not get enough market share to be competitive, it should abandon that business and concentrate its resources somewhere where it is possible to take advantage of the Experience Curve effects and achieve a market share leadership.
Also, if following an experience curve strategy, a business should apply cost saving measures as price decreases instead of keeping it as profit margin increases. If high profits are kept, even though it can be very profitable in the short-term, the long-term implications are that it will attract competition, which will generate an overall lower price. When prices are reduced as unit cost decreases, then competition will be discouraged while the overall profitability is maintained by the market share increase.
It is also important to note that “Experience Curves”, in comparison to the classic “Learning Curves”, measure the total efficiency as it contemplates, other than simply labor productivity, the logistics, distribution and technological development.