The Irreducible Constraints
It is convenient to introduce the concept of an irreducible set of
constraints on the transfer of technology between the R&D and product
environments. Simply stated these constraints are: performance,
reliability and cost. Performance relates to functionality; it might
include such parameters as efficiency, frequency of operation,
bandwidth, power dissipation and the like. Weight or volume can also
be part of a performance specification. The definition of reliability is
deceptively simple: reliability is the maintenance of functionality
(performance specification) over the life cycle of the component or
subsystem. Finally, product cost is calculated in terms of functionality,
i.e., cost per unit of performance. Understanding cost is critical to
estimating return on investment. And it is the anticipated return on
investment that provides the rationale for taking a prototype out of
R&D and into production.
In the R&D environment we sometimes talk of trade-offs among cost, performance and reliability. If we package a device using plastic, say, instead of ceramic, the device might not meet the most stringent reliability criteria, but it will be cheaper to fabricate. Likewise, we might choose simpler packaging at the expense of performance (bandwidth, for instance) to achieve lower cost. Since there are numerous examples of such trade-offs, it would appear that these irreducible constraints are not truly independent of each other. This interdependence, however, exists only in the R&D environment.
Application Space
In the product environment, the specification of cost, performance and
reliability is determined by, and mapped onto, an application
(otherwise there isn't a product!) In effect, this mapping process
defines an "application space" having three independent
(orthogonal) axes. For a given application there is a minimum
performance specification, a minimum reliability specification and a
maximum allowable cost; this set constitutes a point in application
space. The total market, then, is the collection of all points in
application space. Any trade-off among the fundamental constraints
will define, at best, a new application (a different point in application
space.) At worst, the "product" will no longer be matched
to any existing application. The latter is sometimes referred to as "a
solution in search of a problem." Sound familiar?
Figure 1 is a graphical depiction of application space. The orthogonal axes are labeled performance, reliability and, for consistency, reciprocal cost. Lower cost, greater reliability and higher performance are points found furthest from the origin. Applications A and B are defined by the vectors a and b. For example, Figure 1 might represent all diode laser applications. Point A might represent a CD laser; it has only modest performance and reliability specifications, but cost constraints are severe. In contrast, point B would represent a communications laser where performance and reliability are demanding, but allowable cost is substantially higher than that of the CD laser. All the points, A, B, C, D...., taken together constitute the total market for diode lasers.
Figure 1. Application space. Each point defines the requirements of a particular application. The collection of all points represents the total market.
In the typical R&D environment, higher levels of performance or new functionality are the primary focus; cost and reliability are usually of secondary concern. Once the functionality or new performance level has been established, however, the decision whether to make the transition to product development has to be faced. And at this point, cost and reliability considerations become important.
Cost, performance and reliability are essential ingredients that go into determining total market, market share, competitive position and eventually, return on investment. Estimating the return on investment (ROI) should be a mandatory step in the decision to bring a product to market. How can the investment be justified if the return is unknown?
We can get insight on the question of ROI if we add to our business model the empirical result taught by the experience curve and by establishing a specific relationship between cost and price. First, however, we should understand how total market, market share and competitive position relate to the fundamental set of constraints, cost, performance and reliability.
When the transition from R&D to product is made, the component specification has to intersect specific points in application space. To the extent that it does, we can arrive at potential market share. Realizing this potential often means having flexibility in product pricing in order to capture market share. This is where the relationship between cost and price becomes important.
Nominally, there is only a tenuous relation between unit cost and price. Unit cost is determined by internal factors such as labor and materials costs, efficiency, quality of management, etc. and the experience curve. Price is determined externally by the market and the competition. It is ROI that establishes the relationship between cost and price. Upon product introduction, unit cost may (inevitably will) exceed unit price. As the product moves down the experience curve, unit cost eventually dips below price, and the potential for a positive ROI emerges.
The Experience Curve
Let's now look at the experience curve to get a better feel for the
process. First, let's establish what the experience curve is and what it
is not. (For an interesting discussion of the experience curve, see
"The Logic of Business Strategy," by Bruce D. Henderson,
Ballinger Publishing Co. Cambridge Mass., 1984.) The experience curve
reflects the evolution of unit cost with cumulative production volume. It
derives from empirical observations taken over many products, in many
industries, and over many decades of time. The experience curve, or
cost-volume (C-V) curve, teaches that, in a well managed company, unit
cost can be expected to decline, on the average, about 30% (sometimes
less) with each doubling of cumulative volume. Figure 2 is a logarithmic
plot of unit cost vs. volume; it is a straight line that fits the equation
CV^n = constant. When the exponent n = 0.5, we have the 30% experience
curve. However, while it may be convenient to describe the relation
between cost and volume with an equation, it is also somewhat misleading.
Remarkably, there is evidently no fundamental economic law that predicts
the existence of such a curve. Nevertheless, as suggested earlier, the
C-V curve is a universally observed phenomenon.
Figure 2. The experience, or C-V, curve is an average relation between unit cost (C) and cumulative volume (V). For a well managed company, n is approximately 0.5, corresponding to a 30% cost reduction with each doubling of volume. (Not to scale.)
It can be a useful, and sometimes surprising, exercise for the product manager to plot a C-V curve for his product portfolio. It is also an essential step in predicting return on investment for a new product.
Return on Investment
To estimate ROI, we need to superimpose price on the C-V curve; this is
illustrated in Figure 3. Figure 3 shows the initial price of the
product, as determined by external market forces, to be lower than unit
cost. Eventually, as the producer moves down the cost curve, unit cost
dips below price and profitability is on the horizon. Also shown in
Figure 3 are subsequent price reductions. These may be in response to
aggressive pricing by a competitor or by the desire of the producer to
capture greater market share. In a stable market (for the particular
product), price will tend to track unit cost. For instance, in the
semiconductor industry, margins are small, and, for those products that
are commodity-like, e.g., memory, price and unit costs tend to track
closely.
The final step in estimating ROI is to establish the relation between time and cumulative volume of product sold. In Figure 3, the area under the cost curve is total expense; the area under the price curve is total revenue. Clearly, the integrated area between the price curve and the cost curve is the total income generated by that product. Given the time required to reach a particular level of sales, total return on investment can be calculated.
Figure 3. Price superimposed on the experience curve. The area under the price curve is total revenue; the area under the cost curve is total cost. The difference is the total cumulative income used to calculate ROI.
The decision to move a component out of R&D and into production can be rationalized only by going through the exercise of constructing the cost model behind the cost-volume curve. The best-case scenario starts with establishing the initial unit cost and assuming a 30% experience curve. Then, realistic pricing and annual sales volume are introduced. From these inputs, net revenues and cumulative costs can be compared over the appropriate investment period to determine ROI. The well-established validity of the experience curve is an essential ingredient in the process.
As a product moves down the cost-volume curve, it may benefit from a significant advance in the underlying technology or, perhaps, in the method of manufacturing the product. It is then possible that the C-V curve will experience a sharp downward discontinuity.
There are numerous examples of how a discontinuity can develop. For instance, a minor investment in robotics (which puts a small upward spike in the C-V curve) may lead to greatly increased yield and reduced labor costs with a subsequent and profound drop in the unit cost. As shown in Figure 3, the product then jumps to a new C-V curve well below (and roughly parallel to) the previous one. Suddenly, market share, pricing strategy and margin become new variables accessible to the producer. The producer may now be able to move from a position of, say, third-tier player to one that dominates the market. An already dominant player would have the option of either extracting greater income or garnering greater market share by lowering prices.
Conclusion
In summary, cost, performance and reliability are the essential
determinants in technology transfer between the R&D and product
environments. They define the application space that constitutes the
total market and available market share. Once initial cost is
established, the experience curve is a reliable guide to estimating future
costs and, by extension to price, return on investment. The introduction
of advances in technology or in production methodology can lead to sharp
discontinuities in the cost-volume curve and to new levels of market share
or profitability.
* Originally published in IEEE Circuits and Devices, Vol.12, No.1, p.32, Jan. 1996 ©