Experience Curve

The Experience Curve (also known as the 'Learning Curve') is a powerful business concept that describes how the cost of doing something tends to decrease as experience in doing it increases. Specifically, it observes that for many activities, the real cost per unit declines by a predictable percentage each time the total cumulative experience doubles. This isn't just about getting a bulk discount; it's about getting smarter, faster, and more efficient over time. The idea was popularized by Bruce Henderson and the Boston Consulting Group (BCG) in the 1960s. They noticed that industries from aircraft manufacturing to semiconductor production followed this pattern. This cost advantage, built through accumulated know-how and volume, can create a formidable Competitive Advantage for market leaders, making it incredibly difficult for newcomers to compete on price.

Imagine a company starts making a new type of electric widget. The first 1,000 widgets are expensive to produce. Workers are clumsy, processes are unrefined, and mistakes are common. But as the company produces its 10,000th, and then its 100,000th widget, things change dramatically. The magic behind this cost reduction isn't one single thing but a combination of factors:

• Learning by Doing: Workers simply get better at their jobs. Repetition builds skill and speed, reducing errors and wasted materials. This is often called Labor Efficiency.
• Specialization: As production volume grows, tasks can be broken down and assigned to specialized workers or teams, leading to greater proficiency.
• Process Innovation: With experience, managers and engineers find clever ways to streamline the production line, improve workflow, and optimize the use of equipment.
• Product Redesign: The company learns how to design the product to be cheaper and easier to manufacture without sacrificing quality.

A typical experience curve might see a 20-30% cost reduction for every doubling of cumulative output. For example, with a 20% curve, if the 100,00th unit costs $100 to produce, the 200,000th unit would cost $80 (100 x 0.8), and the 400,000th unit would cost $64 (80 x 0.8).

It's easy to confuse the experience curve with Economies of Scale, but they are distinct concepts.

• Economies of Scale is about being big at a single point in time. A large factory gets lower per-unit costs than a small factory because it can buy raw materials in bulk, use more efficient large-scale machinery, and spread its fixed costs (like rent) over more units. It's a snapshot of size advantage.
• The Experience Curve is about being experienced over a long period of time. It tracks the reduction in costs as the cumulative number of units ever produced grows. A small, old factory could have lower costs than a brand new, large one if it has vastly more cumulative production experience.

Think of it this way: Economies of scale is the discount you get for buying the giant Costco-sized ketchup bottle today. The experience curve is the skill Heinz has developed over 150 years that lets them make that ketchup cheaper than anyone else, regardless of the bottle size.

For the value investor, understanding the experience curve isn't just academic; it's a vital tool for analyzing a business's long-term competitive strength, or its Competitive Moat.

A steep experience curve can create a massive moat. The first company to gain significant market share in a new industry starts moving down the cost curve faster than anyone else. This creates a virtuous cycle:

1. Lower costs allow the leader to lower prices.
2. Lower prices attract more customers, increasing market share and production volume.
3. Higher cumulative volume pushes the company further down the experience curve, reducing costs even more.

A new competitor entering the market starts at the very top of the curve with high costs. It's forced to either lose money on every sale to match the leader's price or charge a higher price and struggle to gain any customers. This is the kind of durable advantage that investors like Warren Buffett love.

If you can identify a company in an industry with a strong experience curve effect, you can make better predictions about its future Profit Margins. As the company continues to expand its cumulative output, its costs should continue to fall. If it can maintain its pricing power, that cost reduction flows directly to the bottom line, increasing profits for shareholders. By analyzing a company's Cost of Goods Sold (COGS) as a percentage of revenue over time, you can often see this effect in action.

While powerful, the experience curve isn't a universal law. Investors must be aware of its limitations:

• Technological Disruption: A game-changing new technology can make all prior experience obsolete. A new startup with a revolutionary manufacturing process can render the incumbent's decades of experience worthless overnight.
• Stagnation: The market leader can become complacent, assuming its cost advantage is permanent. If it stops innovating, a hungry competitor can catch up.
• Limited Applicability: The effect is strongest in industries with complex, repeatable processes (e.g., manufacturing, data processing). It is far less relevant in industries driven by creative talent (e.g., movie studios) or bespoke services (e.g., high-end consulting).
• Forgetting Curve: If production stops or slows dramatically, skills can be lost and processes forgotten, causing costs to creep back up.