Cost curve significance: a hint to who survives the business cycle

Tuesday 3rd May 2011 - By Leo Alarcon    Share    

In boom times in any industry unit costs or cost competitiveness are not the most important issue at the forefront of most business leader's or operations manger's minds. The significance of the cost curve is rarely seen among mangers or in management commentary, instead boom time and selling price increases grab most of the attention.

By boom times I am referring to a market which is in supply deficit and suppliers can simply not satisfy the demand therefore average selling prices are usually high and even high cost producers are profitable. These times are usually characterised by capacity expansion projects and the entrant of new players within the industry trying to cash into the high prices. Depending on the industry, many of these new players will try and compete with sub-standard skill sets among their workforce, second hand or old high cost plants and processing facilities, sub standard raw materials and supply sources of these, in mining lower grade ores and mines which were not profitable in the past and a heavy reliance on contractors and third party suppliers to keep operations going. Established players in the industry will usually posses lower cost operations and access to key infrastructure, secure supply agreements, low cost raw material sources, a wealth of knowledge and human resource power.

These differences get overlooked in boom times and they can be clearly seen when comparing the cost curve or unit cost of production among these different producers. Like any boom market in the past the eventual response in capacity coming onto the market coupled with the rise of inflation, producer prices and the peak of the business cycle bring a cooling off in demand and consumption growth rate. This coupled with new capacity online eventually stops the music and prices, depending on the run up they have had, moderate or experience a retreat which eventually marks the end to the boom.

So who survives the shakeout? Who will live to see the next cycle in the industry? The plot of the cost curves among the different producers of their key products usually gives the strongest insight into survival economics. High cost producers, usually new players or badly run operations who haven't invested in market leading facilities and operations usually find themselves at the high end of the cost curve and face a significant margin squeeze when prices and demand do retreat and if they have invested cash flows from the boom times into new capacity to try and lever the cycle and their balance sheet then the picture becomes gloomier. The low cost producers will eventually survive the cycle and come up on top sometimes picking at the carcasses of competitors forced into bankruptcies for any assets worth bolting on to their operations.

Cost curves are a significant strategic operational metric and should never be neglected, no matter where in the cycle the business or industry is operating in, as industry profitability in the good times and the bad will ultimately depend on revenue versus cost base. Revenue will depend on volume and average selling prices which can't usually be predicted with much accuracy into the future, but unit costs can be measured and gauged among industry competitors providing, among other factors, an insight into the future position of players within the market.

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