Diagnosing Cost and Benefit Drivers • 319

and forth, at some points seeking to emulate Target’s fashionability and trendiness (e.g., offering the Martha Stewart line on some merchandise), while at other points seeking to compete on price with Wal-Mart (e.g., its move to Every Day Low Pricing in 2001). But over no prolonged period of time has Kmart sustained a deep, consistent focus on achieving either superior customer benefits or superior cost efficiency relative to its key competitors. As a result, Kmart has attained neither.

DIAGNOSING COST AND BENEFIT DRIVERS

Cost and consumer benefits drive value creation. Understanding how a firm creates value and why it creates more or less value than its competitors often requires a diagnosis of cost and benefit drivers.

Cost Drivers

Cost drivers explain why average costs vary across firms. We can classify cost drivers into three broad categories, each of which has several subcategories:

•Cost drivers related to firm size, scope, and cumulative experience

•Cost drivers independent of firm size, scope, or cumulative experience

•Cost drivers related to organization of the transactions

Cost Drivers Related to Firm Size, Scope, and Cumulative Experience

Chapter 2 contains an extensive discussion of economies of scale, scope, and cumulative experience, so here we will just review the key ideas. A paramount source of economies of scale and scope is indivisible inputs. Indivisible inputs cannot be scaled down below a certain minimum size and thus give rise to fixed costs. As the volume or variety of output increases, these fixed costs get spread out, leading to lower per-unit costs of production. In the short run, fixed costs are often spread because of greater capacity utilization. In the long run, fixed costs are spread when it becomes economical for a firm to substitute a technology with high fixed costs but low variable costs for one with low fixed costs but high variable costs. Other important sources of economies of scale are: (1) the physical properties of processing units (i.e., the cube-square rule); (2) increases in the productivity of variable inputs as volume increases (e.g., because of greater specialization of labor); and (3) economies of inventory management. Cumulative experience can reduce average costs as firms move down the learning curve.

Cost Drivers Independent of Firm Size, Scope, or Cumulative Experience

These factors make one firm’s unit costs different from a competitor’s even if their sizes and cumulative experience are the same. An important cost driver independent of scale is input prices (e.g., wage rates, energy prices, and prices of components and raw materials). When firms in the same industry purchase their inputs in national markets, their input prices will be the same. But firms in the same industry often pay different prices for inputs. Differences in wage rates may be due to differences in the degree of unionization. Differences in wages, the price of energy, or the price of delivered materials can also be attributed to location differences among firms.

Economies of density refer to cost savings that arise with greater geographic density of customers. Economies of density can arise when a transportation network within